Titanic Homes had been known as a strong, profitable volume builder for years, but emerging from the housing crash, things began to go wrong. Sales rose considerably as profit dropped and several key players left for other firms. Titanic’s banks and investors weren’t happy. The president, Ed, called my firm and declared his intention to get to the bottom of it, and soon two of our TrueNorth team members were on their way to help. We quickly discovered that what Ed really wanted was an outside professional to confirm the notion already firmly entrenched in his mind. His take? Ed believed Titanic’s managers simply weren’t cutting it and were allowing suppliers and trades to run roughshod over them.
After applying our process with suppliers, trades, and internal staff, a pattern about the margin loss began to emerge. There was nothing wrong on the surface with the managers’ sales, cost, or profit projections at the start of their houses, yet 90 percent of them failed to make plan margin. Why? Where did Titanic’s margin go between contract and close?
The Home Building Iceberg Known as VPO
As we puzzled out the source of loss, it was clear Ed had no mind to hear the truth from his own people, so we convinced him to run one of our week-long Lean Process implementations. First, we prepared suppliers, trades, and the builder’s “LeanTeam” in advance with the right questions and clear, straightforward instructions. Then all 23 suppliers and trades came in for meetings over three solid days, one company at a time. Each testified in their own words, recounting their experiences, backed by examples, about the good, the bad, and the ugly of working with Titanic. In this case, the feedback ran mostly from bad to ugly. It was one of the most painful weeks we’ve ever seen a builder team go through, but also potentially one of the most educational and beneficial.
Given this is the third in my series on the nightmare known as the VPO—variance purchase order—you shouldn’t be surprised that VPOs lie at the heart of this particular builder’s problem, although VPOs were really just the symptom of deeper issues. Like the proverbial iceberg that sinks ships, a huge number of problems lay beneath the surface. Yet Titanic’s visible numbers were clear. An inordinate amount of work done on the homes took place under VPO.
AS A GOOD RULE OF THUMB, ADD AN OVERHEAD FACTOR OF 50 PERCENT TO ANY CALCULATION OF VARIANCE. ALMOST NO BUILDERS INCLUDE THIS REALITY.
Most builders will budget 1 percent to 2 percent of “hard costs” (aka “house costs” for many builders) for a VPO “do-not-exceed” target. Some do better, some worse, but let’s pause for a word of clarification about hard costs/house costs. On a percentage basis, hard costs tend to run 50 percent plus or minus 5 percent of the house sales price in typical markets, depending on local land and development costs. Mathematically, when land costs run up, that number artificially pushes down the house cost percentage. There are markets where finished lot costs are so high that house costs as a percentage can be pushed down to 40 percent or even lower, having nothing to do with efficient purchasing and construction practices. We see this in particularly hot East Coast and West Coast markets, but it can also happen in urban markets well away from the coast.
One of the most amazing scenarios is found in the Canadian market known as “GTA”—the Greater Toronto Area. There, a combination of demand, scarcity, and regulation can increase lot cost to 50 percent or more of the finished home price, making the hard-cost percentage look fantastic. In other markets though, particularly in the South, land is relatively cheap, and house costs may look artificially high on a percentage basis. Truth is though, by house cost percentage alone, you have no idea. Thus, beware of comparing numbers with any builder whose land price is substantially different from your own. The only way to sensibly look at these numbers is to use variance as a percentage of house costs/hard costs, not as a percentage of sales price. Yet a variance of 1 percent on a house cost of 60 percent will mean very different total dollars than a variance of 1 percent on a house cost of 40 percent. Again, comparison is tricky stuff.
For Titanic Homes, the suppliers and trades that participated in the Lean Process told Ed what his own people and hired-gun consultants had also desperately been trying to tell him: Titanic’s processes were broken, and the one most symptomatic of a long list was VPO. Nearly every supplier and trade brought it up, including the continual problems with inadequate specifications, incomplete plans, design changes after start, late change orders from customers, etc., etc. In short, Ed had positioned Titanic Homes as a high-volume custom builder while trying to operate internally as a production builder.
Distilled from 30 years of working with more than 250 builders in five countries, we can offer you this irrefutable law: Builders can have as many plans, elevations, options, and selections as they want—even custom options—if, and only if, they have the systems, processes, and trained staff to handle them with no disruptions to schedule or personnel, and that includes suppliers and trades. Stop there and consider the question: Can you measure up to that standard? If so, you are one of perhaps 5 percent of the builders in the U.S. and Canada that can. Titanic Homes wasn’t even close.
Hey Home Builders, What About Overhead?
After running the entire operation through the reality filter—no tears allowed—Titanic ran a very conservative estimate of 6 percent of hard costs as extras after the initial contract for house and options, less than half of which actually showed up on VPO line items. At that point, it was merely an estimate because the measurement standards were so poor. Many costs that should have been classified as VPO were buried in other accounts, such as “Losses and Replacements,” “Winter Conditions,” or any other handy account with a surplus. We even saw late charges pushed into “Model Maintenance” in the sales budget, and no one in sales had ever noticed! Many other charges were written off as favors, paybacks, or deals to be made up in the next project. And, more often than we’d have believed, attempts by suppliers and trades to get paid for extra labor and material were simply ignored.
Believe it or not, it gets worse. How many builders, when calculating variance, factor in the overhead costs generated by VPOs? How much time, both in the field and inside the office, is spent on supervision, costing, design change, and all of the paperwork required to handle VPOs? We’ve found a good rule of thumb is 50 percent of whatever you book as extras. Start there and work through some specific examples in your own firm to come up with your factor. Don’t be surprised if you find it’s even greater than 50 percent.
So, in our “typical” $300K production home in a typical market, let’s keep it simple and say we have 50 percent hard cost, or $150K. A strong builder will try to run no more than 1 percent of hard cost as variance, in this case $1,500. Given everything that can happen or go wrong in the course of building a house over three to five months, outside, with 30 to 45 suppliers and trades and as many as 500 folks involved, $1,500 sounds pretty impressive. Now I refer you to my first two Professional Builder articles this year on this topic: “Welcome to Your VPO Nightmare,” and “The Variance Measurement Quagmire—the Nightmare Continues.”
In those, we explored the many pitfalls in measuring and how one presumably small issue of a missing item on site can mushroom from a single phone call costing perhaps 15 minutes to a 50-step fiasco with a true cost exceeding $1,000. Just how many of those do you have per unit? That’s $1,000 of cost that’s never accounted for. At Titanic, this activity in total consumed half the time of the entire purchasing and estimating staff combined.
IN THE FINAL ANALYSIS, VARIANCE COSTS ARE A CULTURE PROBLEM, AND CULTURE IS SET BY LEADERSHIP.
This “VPO iceberg” sank Titanic Homes. Our team is very good and we tried every imaginable way, but we couldn’t get Ed to accept responsibility or reality and address the problem head-on. The fact is, as big as the problem appeared to be above the surface, what lay beneath the surface was so daunting Ed couldn’t deal with it. There was no discipline whatsoever in managing plans, specifications, bid packages, start packages, design center offerings, or the cut-off dates for options and selections. Consider that idea of what lies beneath the surface ... What’s wrong upstream that results in VPOs during the construction process? VPOs are, in reality, just the symptom of all the problems at the source.
10 Upstream Requirements to Eliminate Variance
I hope that some of you now wonder if perhaps that low VPO percentage you brag about isn’t quite reality, and just maybe you should give this a closer look. As I am driven to say so often in my columns, you can’t solve your VPO problem by threats, memos, or declarations from the supreme command. You must challenge every single thing you do upstream, everything that lies below the surface that results in variance costs during the construction process, whether or not those costs are properly documented—and don’t forget the overhead. Those upstream requirements include:
1. Purchase land right with early determination of product type and requirements.
2. Insist that architects and engineers produce plans that are efficient to build and conform to standards of Lean Design with fully detailed construction drawings.
4. Provide sufficient time and talent to prepare 100 percent complete bid packages with all specifications including plans, construction details, elevations, options, and scopes
5. Provide sufficient time and talent to produce 100 percent complete start packages with all specifications including plans, construction details, elevations, options, and scopes of work.
6. Make sure you have fully trained field supervision to continually manage all aspects of the construction process and to maintain the schedule.
7. Cultivate a well-developed stable of strong suppliers and trades to implement all elements of the construction process.
8. Offer well-conceived, fully costed (with overhead) options and selections with input from design/architecture, sales, the design center, purchasing, construction, and warranty.
9. Have mutually developed, fully agreed upon cutoff dates for options and selections—with sales, the design center, purchasing, and construction all signing off.
10. Ensure senior management is responsible for maintaining discipline in all of the above processes.
A failure in any of these 10 results in variance cost, one of home building’s biggest robbers of profit. In the final analysis, this is a culture problem, and culture is set by leadership. What should have been a company-changing learning opportunity for the entire Titanic Homes team was lost due to Ed’s failure of leadership.
In the next article in this series, we’ll dive deeper into culture, lay out a specific step-by-step approach to reduce the costs of variance, and outline a simple but powerful process your team can employ to get to the bottom of your most vexing VPO problems and eliminate them. But get started working on these 10 factors—the less visible elements that result in VPOs. Your process, your people, and your profit margins will thank you.