The Variance Measurement Quagmire—the Nightmare Continues

Managers use some remarkably creative ways to avoid reporting variance. That’s the first mistake

By Scott Sedam | October 2, 2017
Octopus, sleeping figure in bed, Illustration: Allan Swart / 123RF
Managing VPOs is essential for cost control (Illustration: Allan Swart / 123RF)

And this year’s award for lowest cost variance goes to … the Virginia division! As the VP of purchasing strides to the podium to collect his hardware—a plexiglass plaque with the company logo sandwiched inside—there’s polite applause from around the room. Two of the corporate participants, however, having just spent time working on a special project with the Virginia division, clap at the lowest possible decibel level, flashing each other a knowing look that simply says, “This is such BS.” Yes, Virginia, there is a Santa Claus … but your numbers still lie. 

The company—a large, multi-division national builder—puts unrelenting emphasis on cost control. It’s a constant topic of conversation and evaluation, and the divisions compete mightily to win this award. The pressure to use certain national low-bid suppliers, despite their inability to deliver or service locally, is unrelenting. 

But the low bid is a mirage. Although there’s some begrudging acknowledgement that bid price means nothing outside of total cost, which necessarily includes all variance, each calculation and buying decision has been based on bid price alone. The Virginia division managed to fool virtually everyone into believing it has the genuine expertise to manage cost. How did they do it? And what are the implications for those who read my August article, “Welcome to Your VPO Nightmare,” and decided this is the year they’ll get on top of this issue? 

What’s the Big Deal?

In the world of cost variance, accurate no-tears measurement is critical. Whether you call it a VPO (variance purchase order), an FPO (field purchase order), an EPO (exceptions purchase order), or simply “Extras,” every cent you spend after the initial house budget is a loss and must be accounted for. (For our purposes in this article, we’ll use the most common term: VPO.) The old adage, “You can’t manage what you don’t measure,” applies both perfectly and painfully. So what’s the big deal? Just measure variance and get on with it! Not so fast … .

My fascination with numbers began at an early age. I was that odd student who actually enjoyed statistics and took the advanced class in college that wasn’t required. The good news is that understanding the nuances of the numbers reveals what so many miss and, in some cases, are trying to hide. The bad news is that the guy who exposes problems of bad measurement becomes decidedly unpopular with the purveyors of bad data. So heed this warning: Most builders do a poor job of measuring variance and an even worse job of using the data to drive process and system improvements. If you’re the one who takes on the challenge of identifying such issues, don’t expect accolades from admiring multitudes. There will be blood. Case in point is the Virginia story I described. Just like Santa Claus, the division’s variance performance was based on mythology. Whereas the myth of Santa Claus is a mostly harmless one used to entertain small children, The Myth of the Virginia Division misled, confused, and resulted in bad decisions. The two employees who exposed the fallacy of Virginia’s calculations paid a heavy price—no matter that they were right. Let’s take a deeper look into these calculations.

Know and Fix your Costs

Years ago I had the privilege of working for Bill Pulte, founder and former chairman of Pulte Homes, now retired. During my first month on the job in January 1989, Bill conducted his annual three-day seminar for construction and purchasing. I’d give anything to have videotape of those sessions. I still follow almost every lesson I learned from him, and there are scores of folks in the industry today who do the same. One of Bill’s mantras was, “Know and fix your costs,” and he would repeat it over and over. That admonition is both true and troubling because it causes reluctance in the field to report things honestly, as costs too often change during the building process. Similarly, purchasing departments that are heavily judged on variance will do almost anything to avoid a VPO. 

After watching the remarkably creative methods many managers use to avoid reporting variance, it dawned on me that there are three basic ways to rig the numbers: fudging the numerator, manipulating the denominator, and—if all else fails—simply ignoring their existence.

Fudging the Numerator

Most business numbers are expressed in percentages, which requires a ratio of two numbers: the numerator, which is an accounting of the occurrence, over the denominator, which is the base from which the occurrence deviates, good or bad. The simplest example is “margin.” Say we have two groups of kids selling lemonade. Group 1 sells $100 worth of lemonade; that’s our base, the denominator. They subtract all costs and count what’s left. Now they have a numerator for the top of the equation, which is $10. And $10/100 = 10%. Simple, right? But wait, the kids in Group 1 didn’t allow anything for Mom’s time spent helping. And although they paid for the cups and lemonade mix, nothing was paid to rent the pitchers, wooden spoons, or paper towels, nor did they allow for the use of Dad’s portable work table for the stand out by the street. And what about their labor? So is this number real? Group 1 is feeling pretty proud because the kids down the block report they made just 8 percent. But how is that other group measuring? What are those kids including or not including? Does GAAP (generally accepted accounting principles) apply to lemonade stands? Bottom line: Neither group of kids has a clue as to which lemonade stand was most profitable. These numbers tell us little. 

 

Scott Sedam-variance quagmire-quote 1-illustration by Allan Swart / 123RF

 

The same things happen to home builders measuring variance. Again, let’s start with the numerator. Exactly what do we count as a variance from the original “known and fixed” cost? If we’re purists about it, a variance is absolutely anything that’s not included in the original cost estimates for everything that goes into the house—labor and material. Someone breaks a window? Variance. Someone runs over a curb and cracks it? Variance. Scratches on a wood floor? Variance. Repair to a damaged shower liner? Variance. The same for a damaged countertop, an extra 3 yards of concrete, a square of shingles, or another load of gravel for backfill. Even at this seemingly simple level, there are issues that distort the picture. Maybe the sales rep for the window company is desperate to win your next contract and just replaces that broken window for free. The framer is a golfing buddy and he doesn’t charge you. The roofer says he has a square left over from another job and he’ll bring it over, no big deal. His guys have been really busy lately so he can just send them home early. But two of them have to make an extra trip to this house to finish tomorrow, which will slow down the next job. He’ll work it out because his dad started in business with your dad and “That’s just how we do things.” 

Great, right? What about the data you need for continual improvement? If it’s not reported, it’s not tracked, and if there’s a trend in shingles or gravel or any material or labor, how do you know how to respond? Short answer, you don’t. But the pressure to hide the variance is so great that you accept it. People always gravitate to the option of perceived lowest pain. From here, it gets way, way more complicated. How about the tile order that was coded wrong, has to be torn out, and the replacement rush-ordered and reinstalled? That’s going to look really ugly, but there is just no way to bury one that bad, right? OK, so you still believe in Santa Claus, too, and maybe it doesn’t happen in your company, but I guarantee that your folks know how to hide it assuming there’s sufficient motivation. 

How about late change orders? Is it fair to call them a variance when they’re usually the fault of sales or the design center or the boss who just can’t say no? Fair or not, it’s a variance, and you have to put it down. Maybe you can make up for it somewhere else. Of course you can. Categories such as “Losses and Replacements” or “Winter Conditions” are known as dumping grounds for all manner of variances. Short 10 sheets of OSB due to an estimating error? There’s extra money in Losses and Replacements to cover that, let’s call it “stolen.” You got behind on a couple of homes and the drywall stage was pushed back to December, resulting in $500 in extra propane? Winter Conditions handles it fine. If I had more space here, I’d love to detail the operation that buried a plethora of suspect items in “Model Maintenance,” which conveniently came under the sales and marketing budget. Or another operation that happily transferred most of the extras it took to get the house finished in the final two weeks into the warranty budget.

I could give you a hundred pages of examples, and I know right now your mind is already racing with those from your own experience. Step 1 is to get everyone to understand exactly what constitutes variance for every cost code, and that’s far more difficult than it sounds. Go through every example your team can conjure up. Ask: How do we count it? Where does it go? Next is to get everyone to agree to honestly report every variance. Every time. Burying any variance in the buddy network or with creative accounting tactics should be classified as a major sin. Subject to dismissal? Would this level of change be painful? Yes, but now consider the denominator of the equation, which is in many ways a bigger problem.

Manipulating the Denominator

I have threatened colleagues—only half in jest—that if I ever even semi-retire I will write a couple of books with rude titles. At the top of the list, sanitized somewhat for the reading audience, is “Screwing With the Denominator—the Legacy of American Business Accounting.” Give me the numerator as pure as possible and I can still significantly change the percentage by manipulating the base. The simplest way is to loosen up the budgets. Let’s sneak a bit more into concrete, gravel, lumber, roofing material, etc. Do the same with labor—heck, everyone knows those costs are up everywhere. 

 

Scott Sedam-variance quagmire-quote 2-illustration by Allan Swart / 123RF

 

Suddenly, my variance percentage looks a lot lower. And where do we cut off the house budget calculation? The best practice is to issue a house start package with every option selected and firmly priced by each supplier and trade involved. Building commences, and every additional cost beyond that budget is variance. That’s a radical change for many builders that allow selections way beyond the start date. How can you determine the base for those options? In short, you can’t. The good news is that it provides a few additional opportunities to bury additional cost as you go. “Hey Brad, that extra 50 feet of line set you need on Lot 42 because the compressor has to move to the other side? The customer on Lot 50 wants to upgrade to the variable-speed furnace with 21 SEER. Just give me a higher price on that to cover the line set, too, OK?” So, what’s the big deal with that? I’m going to let you ponder it. If you see all the consequences, you get it. If you don’t, then keep looking.

Just as with the numerator, I could provide a ton of examples of how to increase the equation’s denominator—the base. At the most basic level, do you calculate it as a percentage of sales price or as a percentage of house cost? There are strong arguments to be made for either, but as long as you decide how to do it for your operation and you do it consistently, you’ll begin to see the patterns as your systems and processes “talk to you” through their numbers. Be especially careful comparing your numbers to those of other companies or even those of other operations within your own firm because no one ever measures things the same way.

Denial

When all else fails, the last (and ugliest) surefire way to reduce variance is simply to disavow its existence. We cajole the supplier to replace the damaged material based on the promise of the next project. We lean on the trade to supply the labor based on our long-standing relationship. The worst example of all is the minimum $10,000 bill buried under every house in the U.S. due to wasted or otherwise unnecessary trips to building sites by suppliers and trades. At TrueNorth, we have the cold, hard data on this from more than 200 builders using more than 5,000 trades, so there’s nothing speculative about it. That is all variance, all waste, and it kills margin, yet it’s virtually never counted. From our data we know that suppliers and trades attempt to collect on these trips less than 10 percent of the time because “that’s just home building.” Meanwhile, purchasing typically pays about 10 percent of the ones they do receive. Do the math. The bottom line on this massive variance item is you only see 1 percent of it (10 percent of 10 percent). Ask yourself then: How will we ever learn to improve?

An author named Ron DeLegge II writing about the shenanigans on Wall Street said, “99 percent of all statistics only tell 49 percent of the story.” That also applies to home building, and the culture at building companies can dramatically affect the numbers. In a culture of fear, the numbers can never be trusted. Next month we’ll lay out a step-by-step model for establishing your variance calculation and, even more important, some concrete ideas for how to process the data and use it to improve both profitability and sanity for builders, suppliers, and trades alike.  

For a free PDF of Bridging the Margin Gap, with this and other articles on how to increase profit, email your request to info@truen.com.

President

Scott Sedam is president of TrueNorth Development, a consulting and training firm that works with builders to improve products, process, and profits. A senior contributing editor to Professional Builder, Scott has written award-winning commentary on all aspects of the business of home building and won the 2015 Jesse H. Neal Award, business journalism's most prestigious prize, for his commentary in Pro Builder. Scott invites you to join TrueNorth's LeanBuilding Group at linkedin.com and welcomes your feedback at scott@truen.com or 248.446.1275.

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