Profit Centers, Capital and Responsibility Accounting

Themes and questions Mike Vorster and I explore in this episode:
- Technology and the value of simplicity
- Should equipment be a profit center? 
-  How often should rates be recalibrated?
- Importance of competing profit centers
- Capital Modeling
- How can responsibility accounting impact your equipment fleet?
Story: Importance of measurement: learn to fly by instrument

Chapters

• 0:00 Intro
• 0:38 Technology and Value of Simplicity
• 7:02 Internal Champions & Costing - Boot Camp Story
• 10:50 Costing and the Making of Construction CEO's
• 16:00 How often should rates be calibrated?

Transcript

Michael Kelley: 0:05

Welcome to yellow iron black smoke, your podcast for engaging conversation on construction equipment Economics and Management. I'm Michael Kelly, your host. In today's episode, Mike Forster and I have a far reaching conversation about core values and simplicity and the Silvertrek equipment boot camp. The six month boot camp a hands on approach to the CEMP way, outlines four of the most important concepts from Mike's rebuilt book, construction equipment, economics, version two, be sure to check out the book at his website at CEMPcentral.com. ------ Hello, Mike. Go ahead. We're now recording. We'll jump straight in. Everybody who's listening, we jumped straight in, we started talking, everything was so interesting. We didn't even get to an intro. And he started telling stories. So go ahead, Mike, continue on

Mike Vorster: 0:53

That story that we were thinking we were talking about something that I read many, many years ago that said, a successful technology disappears. And if you think about it, it's very, very true. Because if a technology works, and if it technology succeeds, then it sort of becomes second nature. Okay, blocking cars, switching cars on and off making a cell phone call. Think about the technology that's involved in a cell phone call. It's unbelievable. But it's disappeared. And so we just go for it. We don't even think about it.

Michael Kelley: 1:31

That's right. And the unsuccessful technologies, or at least the ones that are not yet successful, they get in your way. Yes,

Mike Vorster: 1:40

yes. And then there's a dimension to that as well, I was I was walking one day through this sort of currently the hallways in a company, and upon the ball up on the walls with a normal sort of mission, vision, goals, statements and things like that, that we see a lot of I was looking at this statement of the company's values. And amongst its values was a thing called simplicity, simplicity, we value things that are simple and robust. Period. Okay, so I went in, and I saw the, the CEO, and we're, you know, we were bantering around, and I said to him, you know, I noticed that you have a value called simplicity, I see a lot of values. And I've never, ever seen a company that expressly states a value called simplicity. And he smiled, and he looked at me and he said, you know, it's strange that you notice that, because of all the values that we pay most attention to. And of all the values that we struggle with most is the value called simplicity. He said, because we have discovered that nothing that's complicated, extends beyond the tenure of its original champion. Knowledge take that nothing that's complicated, extends beyond the tenure of its original champion. So you I have a really cool idea. It's complicated. We are its champions, we champion that idea in the business. And we keep that idea alive. Our jobs change, we get promoted, we leave we do whatever it is, everybody else looks at this thing and says, you know, that's Mike's complicated idea. It's way too complicated. I'm not gonna do it, and it dies. And so he said, we have noticed that anything that's complicated, does not survive the tenure of its original champion. I think that's another one of those kind of wild statements.

Michael Kelley: 3:39

I think that's fascinating. Because I do that all the time. I have just a wonderful idea. It must be wonderful, because I came up with it. Right? That's what that's what I originally think. And then I come to the silver track employees, there's 21 of us now, right? So we're not a big company. We're not like talking hundreds of people. And I say this is a great idea. Everybody can see it. It's just it works really well on the whiteboard as I draw boxes and arrows. Right. And I I'm all excited about it. So I work with the developers or the accountants or however it is for the first first couple months. And then I say, Okay, you guys got this, finish up the implementation, I'll come back to it, I get go on to the next big project, or whatever it is, I come back six months later, and it's still right where we left off. I'm like, Well, what happened here? And so much of the time, I would have to go back and look. But so most of the time, it's not they're failing to get it implemented. It's that I'm the original champion. And it was a complicated idea. And so in order for me to if it's truly a good idea, which it might be Maybe, maybe not, if it's really a good idea, then the work of the original champion to actually get it integrated, is to reduce the complexity down to a few simple points. Yes, yes.

Mike Vorster: 4:56

What do I say you know, simplify doesn't mean Simple, right?

Michael Kelley: 5:01

Because that company that you're talking about, I'm sure he uses a cell phone. Yeah, that cell phone is anything but simple.

Mike Vorster: 5:07

Yep. But come up with a reporting system, or come up with a costing system or any organizational approach that's complex, it might work very, very well, it might give you something that some other way won't give you. And it's just too complex for folk to run with, once the original champion has kind of removed their insistence on on it being part of the of the organization. You know, buddy of mine said one day, he said, change will never happen until the change of the status quo exceeds the pain of the change,

Michael Kelley: 5:45

change the status quo that sees the pain of the change. Now, interesting, well, that's kind of cynical, it's kind of cynical, don't people don't don't, is the only pain that that motivates people to change.

Mike Vorster: 6:00

I think it's the pain of the status quo that motivates people to change, okay. And so, you know, if the pain of the change means you've got to do something that's difficult and complex, the pain of the status quo has got a fairly high before the pain of the change eclipses.

Michael Kelley: 6:18

That's, that's true. And sometimes there might be a disagreement about how painful the status quo is, the accountants might say, this old accounting system is fine. And the CEO or the project managers might be like, the status quo was anything but fine. I don't have any idea where we're at.

Mike Vorster: 6:34

Absolutely, absolutely. And, and, of course, you know, we, we live with the pain of the status quo, when retirement is within such.

Michael Kelley: 6:48

Sure, sure. It's not the time to be job hopping. So, so that's interesting, though, that what you said about the simplicity, because the in the internal champions, because last week, Thursday, Friday, we got together for the first of four in person events, here in Vancouver, Washington, just south of our office in battleground. And we did the first of the boot camp equipment boot camp. This is for people who use VISTA by viewpoint that they sent two people each to this boot camp, we learned about, specifically the know your costs portion of equipment management in on and we spent Thursday on theory, and we spent Friday on implementation. The those 10 people were the internal champions of the equipment process. And what was interesting was that when I, when we put this together, we set this out, we assumed that these companies would send their equipment manager and maybe an accountant. But in no three of the five cases they sent the chief executive, the CEO, the CEO came to the class and is one of the one of the principal Movers. And then the other two than the other two, it was people equipment manager and finance manager. So I was surprised to see how much executives were actually there in the room. I thought we would be calling calling them at after the fact. But that didn't happen, which I'm very pleased about. That the executives are taking so much notice of equipment management that they're saying, this has to happen. We talked about knowing your cost and getting getting an effective costing system put together so that they have budgeting so they have good costing and marrying up the level of detail on the revenue side versus the cost side, which was a big portion of what we did Friday and Friday afternoon, especially on everybody's so they can look at their equipment, revenue and equipment costs. It was it was absolutely phenomenal two days I just those those kinds of meetings, when I get together with people and talk about their equipment, you can tell these people really, really, really care about yellow iron. Yeah, and

Mike Vorster: 9:04

wide iron and white on and off highway fleet and their own highway fleet. Right. You know, kudos to the folk. Kudos to the CEOs who came because they're really understanding the importance of that. And I think the importance of what we're talking about is, knowing your costs, knowing your costs in general, knowing your costs relating to equipment. I think the importance comes perhaps in two, maybe three dimensions. The first dimension is that if you run five or six jobs and equipment is a substantial portion of your activities, then the equipment account is the biggest job in the company. And the equipment account is going to be handling more money, more money more, more money is going to be handled and transactions made inside the equipment account than in any one of the individual jobs. So it's it's a, it's the biggest job in the company, okay, and then the equipment account has got another characteristic. And that is it goes on year to year to year, it doesn't end like many jobs do.

Michael Kelley: 10:15

Right? You can't, you can't you don't get a breather, really, because it just continues to go.

Mike Vorster: 10:22

No, you can't wrap it up and process your, your your completion and process your outstanding invoices and claims and come up with a number. You know, when it's all done, because December the 31st rolls into January, the first and the years just roll on to one another. It's a big and important job. Okay. The second dimension, which is kudos to the to the CEOs is that most CEOs have probably come through the construction, end of the business, there are very few equipment managers who become CEO, okay. And as they come through this, the construction end of the business, they've cut their teeth, and they've been trained, and they've grown up in Job Costing, and then estimating projects to completion and then managing their project whips and then all those good things that happen when you when you manage a project. And they have very little idea about how all those know your cost things are implemented inside of the equipment account. Yep. And in many, many ways, and one of the things I struggle with a lot is that know your costs inside of a job, or a project is exactly the same as knowing your costs inside of your equipment account. Okay, you've got to set up your budgets, you've got to collect your actuals, you've got to put your costs into phase codes or principal cost types for equipment. And we know how to manage cost at the job level. But frequently, because of their background and training, are knowing your costs in the equipment account and at the fleet level is something that very few CEOs have hands on experience with. Okay. And so kudos to them for getting close to loving and understanding something that that they haven't had hands on personal experience with. That's a great, great attribute for them and a great pity for our business.

Michael Kelley: 12:40

One of the one of the things that came up right away, Thursday, first thing in the morning, and then we and then we hit it again after lunch on Thursday was about the rate structure. And of course, we know that we're charging, we want to charge a rate to the jobs. And because I was talking about knowing your cost, and I was and I was really interested in in building them a smoke alarm. I you know, that was really what I'm trying to do here is I told them that really what we have to do in your company is we have to attack utilization, we have to attack reliability, we have attack fleet age, those are the things we really need to do here. But before we do that, I told them, we're going to build a smoke alarm to say, do you have a problem or not. And that's what knowing your cost really is, is a smoke alarm for one of those three things were likely for one of those three things. So we've talked about that. And so we avoided the talk, I steer the conversation away from the dual rate structure and how we handle utilization because that always comes up right. And, and but we did talk about establishing the rates in the first place, which often come from most of the time come from the historical costs on a class of equipment. So we look at the historical cost over a period of time, we say is this likely to change in the future? Yes, no. And then we establish a rate that we charge the jobs, regardless of method that's going to get us so that the our next 12 months is going to cover the cost and we're going to break even on this rate class, that would be ideal anyway. And so the question you have I said, Well, you know, 12 months and do this, and I said, Well, why 12 months? And it was an interesting question, why 12 months? What? Why not more often? Why not? less often? what's the what's the correct frequency of that? And then on top of that, they said, well, Michael, what's the process that we should go through to establish these rates? Like, do you have like you have a checklist for us, Michael, we didn't fully leave the questions unanswered. Luckily, I don't have to be much of an expert as they are already experts. And so you know, with those 10 people from these five different companies, we actually were able to get very far answering this question, but I'm curious, what have you seen here on this? What is the normal interval? What is what is the process you see on this when you're sampling rates to charge the jobs

Mike Vorster: 14:59

well, Come to the expertise thing, you know, asking the right question is a real expertise. And that's what you were doing when you were with those folks as you were asking them the right question, which caused them to review what they were doing and to think. Okay, so I think it's very true that many cases, the success of a senior executive depends on their ability to ask the right question, more than on their ability to give the right answer. Because the folk doing the work of the folk in the trenches, so to speak, they the folk who give the right answer, the chief executive just ask the right questions, and then sort of make sure that the answer is acceptable, palatable within the realms and likely to succeed. The skill of asking the right question is a is a very important thing. So this question about how frequently do we adjust our rates or my preferences to say, do we calibrate our rates? Okay? Because, you know, we have the rates, and we have now experienced with those rates, and it's now a matter of calibrating those rates, so that it said that our budgeted cost, which is, what the rate is, matches our actual costs, which is the experience we gathering, we gathering experience with actual costs, and we comparing it with our budgeted cost. And what's strange, again, to come to this thing about the difference between construction and equipment, you know, we do Job Costing, and we measure performance on the job site. Because we want to collect that experience, and feed it forward into estimating and calibrate the custom productions that we use in our job estimating process and in our job management process, because the estimate becomes our budget or very close to the estimate becomes very close to our budget. But yet when it comes to equipment, we are also collecting experience. And then we must take that experience and feed it forward into our equipment estimating process, which is our rates calibration process, specific answer to your question, I like to see companies who review and calibrate their rates at least annually, in exactly the same way as when the job is finished, we were talking about the fact that jobs have the cycles, but equipment has a 12 month cycle. When the job is finished, the years budgeting process is finished. And we start establishing the budgets for the new year, which is the same as establishing the budgets for the new project. We will calibrate those rates, and think seriously about how to change those rates as we establish new benchmarks, new budgets for the year ahead. Okay. Now, if you've got a big and complex fleet, and you've got a lot of rate classes, you're going to be calibrating budgets for a lot of different machines and different rate classes. And it's going to be a major operation. So what I see a lot of successful companies doing is they take their support equipment fleet, and say, let's have a look at our support equipment. And at the end of this summer's end of this quarter, we're going to review everything relating to support equipment, and we're going to establish new budget benchmarks perhaps for the year ahead you in our support equipment, and then in our production equipment, and then in our on highway fleet, do a portion of the fleet every quarter, but issue a new Red Book, if you like, on an annual basis.

Michael Kelley: 19:02

Gotcha. So so we we've we've worked through these different you know, categories of equipment or sets of categories. And we've gotten by and perhaps even, this is what the rate is going to change to it was you know, we had 105 now we've calibrated it now it's going to be 106 It'd be great if it was that small of a change anyway. And we've we've set that out we've gotten buy in from the operations team we've got the buy in from the estimating and we've gotten ultimately buy in from the executives and now that might sit for three months because the the new rate book comes out at the end of June but we've done this we've done this at the end of March

Mike Vorster: 19:43

yeah and that's why I suggest that you start with the with the the more rats and mice fleets, the stat the the non production equipment, the standby equipment, the support equipment, the message boards, the hours Lighting plants, the conex boxes and all those sorts of things right here. And then in the, in the quarter immediately preceding the, the implementation of the new Red Book, you do the stuff that really counts, and that's most likely to be the yellow production on.

Michael Kelley: 20:20

Okay. Yeah, there's there was one company in particular that came to boot camp that had included in their rate calculation, the cost of capital and, and they had an interesting comment that they said, they tried to make their rates 2020 perfect 2020 vision, that's what they said. So that means that meant to them that their rates included 20% return on investment. So they included a cost of capital in there as 20%, they chose 20%. And they said that their rates should be able to beat rental companies in their area by 20%. So they're saying 20% return on investment included in the rate that they're charging your jobs. And still, that rate, even marked up such as it is, would be the external rental rates by 20%. And so they they include this rate in the cost of capital. And of course, what that means is that, since they're including the cost of capital, that their equipment budget doesn't net to zero. It's actually a profit center. And it seemed, it seemed to me like Well, there's, there's some, there's some problems there. If we if we start having multiple profit centers, to all of the different sections of the business, right, there's some things to think about here. When you're setting those rates, if you're really trying to get down to a zero difference in your equipment budget, or like in their case, they're trying to get down to a 20% return on investment dollar figure at the end of the day. And the argument and the valid argument, I would say, there's an Hey, we don't want to post office mentality. We want we don't want this to be we don't want the equipment department to become a bureaucratic post office that's just trying to you know, cover costs, set budgets. And if we don't, if we don't, you know, the user to lose it budgets, right, we got to spend this money or the budget is going to disappear next year. And they said, We want this to be an entrepreneurial, we want them to feel like they can actually do something to make this happen. But of course, now it feels like that you're starting to put the equipment department a little bit at odds with the with the job cost department because every every dollar they get is coming away from the operations guys.

Mike Vorster: 22:26

Yeah, sad, gets down to the sort of DNA of the way we review business. And the thing that drives and motivates a lot of people. And that is a situation where, you know, salesmen succeed, the cost of sales, okay? In other words, you've got them in quotes, make a profit. Now, we'll get to the 20%. And we'll get to the ROI thing a little bit later. But I think that is a philosophy that says, do we set up our rates so that our equipment account does nothing other than recover costs? Or do we set up our equipment rates so that our equipment account makes a little margin? Okay, over and above everything? Well, let's go back to the business of setting up our jobs and our job accounts. We sincerely hope that we set up our jobs and our job accounts so that they make a little bit of margin. Right, right. Right, because that's we want to be in the business where sales exceed the cost of sales. And that difference between sales and cost of sales is, is the margin. And so the the construction folk construction operations, folks in our jobs are accustomed to sales exceeding the cost of sales by thing called margin. Now, with regards to equipment, many companies have a cost recovery mindset with regards to the equipment and say that the equipment account, we will set the rates up so that this job called the equipment account, it targets zero margin, because we make our margin by digging holes in the ground and laying pipe or laying asphalt or whatever it is, we make our margin on the work we sell our customers. And the equipment is just the tools we use to make those that makes those margins. And our whole charge out mechanism is just a way to get our equipment costs as clean and as neat and as raw and as breast down as possible into our job costs. So the whole charge up mechanism is a way of getting equipment costs into the job cost once they're in the job costs. We have the cost of sales and you see exceeding our cost of sales. So That's one mindset. And what happens there is those guys will mark up the equipment when they change their estimated net cost into their bid price. And so the equipment will carry a markup as part of the jobs markup, and that markup will be recognized at a job level. So that's the kind of equipment is a cost recovery center mentality. The other mentality says no, when we set our rates, our equipment rates, there will be a margin in those equipment rates. Because for equipment sales has got to exceed the cost of sales as well. All right. And we want to give the folk who are responsible for the equipment budgeting process, we want to give them what what I call the respectability of profits. Yeah, because yeah, like to work in a, in a world where sales exceed the cost of sales. Right? Now those guys have got to be really careful when it comes to marking up their estimated net cost to turn it into their bid price, right, because there is a little margin in their equipment, estimated net cost. And so if you reach the level where you mark up, and I hope almost everybody has, where you mark up labor materials, contractors, subcontractors and equipment differently, then when you mark up the equipment portion of the of your estimated net cost, you should mark it up very much less. Because indeed, at a job site level, that estimated net cost doesn't carry much risk. And it also carries at a corporate level some margin already. Sure. So do it. Now the question, so some companies do it, and they do it very successfully. And that is there is a margin in the equipment, we give the equipment guys the opportunity to get the respectability of profit, return Mark markup equipment. When we mark up our equipment in the bid, we recognize that it's got a margin in it already. Yep. Now you've got this, the operations guy says, well, equipment departments profit center, we're a profit center. Now we're competing profit centers. Yeah. And that can introduce some bad behaviors. Okay, especially if there's bonuses involved. Never ever calculate at risk compensation, when part of the calculation includes an internal charge out transfer price, because then that transfer price becomes part of the incentive compensation calculation, and you run into terrible troubles. Okay. But this business of competing profit centers is, you know, we all want to win, okay, and you've got playing a game called make a profit on construction, I'm playing a game called make a profit on equipment. And the armwrestling is the most elegant way of describing what's going to go on in the, in the business. Exactly. If you really scratch me, I'm not a fan of establishing an equipment account as a profit center. I think it should be established as a direct cost center. And I think that the equipment account, and the call equipment operation is to manage experience and recover the true cost of the fleet. Okay, we make our business out of money in construction, by producing completed work safely on time, to the required quality and on budget. And if you're going to put a little margin in your equipment account, know about it, talk about it, have it on top of the table, not as a fudge factor in the in the system. And have everybody recognize that the jobs make 17% marginal margin, that's the job. Expected margin. And the equipment account makes 5% expected margin. And I'll help you make your margin You helped me make my margin and we play this whole thing on top of the table. Right?

Michael Kelley: 29:26

Right. Yeah. So it's an interesting thing because you can you can start to skew. You've mentioned it briefly with your estimating. If you start marking up your equipment, your equipment, budget or equipment account, say you know that 5% you just mentioned, and now it's not just your cost but you have 5% on top of that, top your costs. And so now what would have been 100% as marked up to 100 sorry, $100 per hour is now marked up $205 per hour when you send it over to your estimating system. Well that if you mark it up first From there, so you just say, well, we have one margin across the board and wire margin, we're expecting on this job, we're going to try to get 10%. Right? So So we've marked up, let's just say 10%. At the tight market, we're gonna mark it up only 10%. That's good. So we've taken this 105, we multiply that by point, by point one, we get to $10.50, we mark that up. Now we've marked up the markup, right? So we're at 100 and$115.50, that we're actually selling this to the customer. And, and, and the problem there becomes now if it really is a tight market, and you've marked up the markup, that you're, you end up in a situation, you could end up in a situation where you lose the equipment heavy work, because your competitors aren't using the same markup. And so you don't have 10% markup on your equipment as a company you have, the number would change, but basically 15 and a half percent markup, in my example, on on that particular equipment. And if your competitors are only marking it up, 10% there's a chance then that you lose that work on accident, on accident Really?

Mike Vorster: 31:16

Well, Michael, I really, really do hope that the number of companies that do a flat markup of estimated net cost as they calculate their bid price, I really hope that number of companies is very, very small, because you have to mock up library equipment materials and subcontractors differently. Because your confidence about the cost and the risks associated is very, very different. If you work if you mock up labor equipment, materials and subcontractors by the same percentage, you're going to end up getting a lot of work in high risk labor markets. Yeah. Exactly. And you're going to end up doing a you know, you're going to you're going to end up marking up let's imagine your flat markup is 12%. At the job level, you're going to mock up subcontractors 12%, which is which is ludicrous. Because there's no, there's very, very little risk associated with the knowledge of the cost and the performance of the work.

Michael Kelley: 32:23

Okay, that you're contractually pass the risk off.

Mike Vorster: 32:26

Yeah. So that's why I get to this business of saying that I really hope the number of companies that have black markups, regardless of the mix of labor equipment, materials and subcontractors in the estimated net cost, I hope they're getting fewer and fewer and fewer. Okay, right, right. But let's swing back to this ROI markup thing. And let's, again, explore this thing called communication and understanding. Now, when we communicate and understand a markup at a job site level, we say it's 12% of estimated net cost. And everybody understands that, if I'm going to mark up my rate 20% return on capital, very few project managers will understand what 20% return on capital means. Sure. And so again, I think if you're going to mark up your rates, because you're going to run your equipment account as as something that's going to make margin like your jobs. I think your language should be clear and simple. We're going to mark up our rates 15%. Okay, why we're going to mark up our rates 15%? Well, 15% is what we need for the risks. 15% is what we need for the for the return on on equity that we've got in there. 15% is, is for all for all the same sorts of things that we have 15% on the job sites markup. Now just tie up capital, why do we Why do we not have return on equity, or capital locked up on the job site in the difference between, you know, over claims and under claims and receivables and all those sorts of things? Why do we not include that when we look at job sites? Okay. I think one needs to be very clear and very clear in this business, of how of our expectations with regards to the degree to which sales must exceed cost of sales. Because that is bottom line. What, what motivates us.

Michael Kelley: 34:38

It's an interesting point, because project managers and estimators understand markup on costs. They deal with that all the time. they very rarely deal with the kinds of things that you're talking about weighted average cost of capital, right, and you start to talk about the cost of financing versus the cost of equity in the business. Right. And you have you have these different things. What Then you know that the equipment because I can get return on investment any day of the week, at least in this market right now, because the banks are throwing money around, right? All I do is I say, I'll buy one excavator myself, I'll go and borrow the money to buy 99 other excavators and my return on investment is easy to make, easy to make. Because but but that's not that's not, that's not what we're really talking about here. What we're trying to what we're trying to this particular company is trying to do with their 2020 vision idea is that they're trying to make it so that their company, culture, inside the equipment department is entrepreneurial, that they're trying to find ways to save money rather than make money, even help the company make money overall, rather than just trying to cut costs all the time. Right. That was that's the main mindset. But I think that that conversation, that language that they use is important, is it easily understood by the project managers isn't easily understood by the best meeting team so that we don't, we don't start having separate understandings of this same concept within one company that can happen super easy.

Mike Vorster: 36:09

That's happened super easily. And I think that simplifying the language said, it's understood, and so on, and so forth. Really, really, really, really helps. Let me share this with you, that is to go back to one of the oldest performance metrics and ways of measuring company performance that I know of anyway. And that's the thing called the DuPont model. Okay. And, as in the chemical company, as in the chemical company, because they pioneered it in the in the 30s. Okay, 1930s. Okay. And I would encourage our listeners to find out and, and look at it a bit and understand it a bit. But what it says in its basic form, is that you need to look at both a profitable use of capital, and the efficient use of capital. Now we spend a lot of time talking about profit on turnover, we spend very little time talking about turnover on capital. Now, if you're a heavy grading company, the your turnover ratio between your turnover, your annual turnover, annual contract revenue, and the capital that you've got tied up in your business is, is pretty low. All right. industrial companies and general contractors that have concrete mixes and cranes or concrete mixes and, and very little else, that turnover on capital is huge, because most of the capital they've got tied up is in this week's payroll and receivables. And so their turnover on capital is very high, which means that their profit on turnover can be relatively low. Because of course, profit on turnover, multiplied by turnover on capital is profit on capital. Okay. Whereas if you're a heavy grading company, your turnover on capital, you're going to be lucky if you're going to get to maybe do an attack Tad, if you're, if you're using a lot of other people's money, and those sorts of things. And so your profit on turnover has got to be relatively high to make your 20%. If you're making a if you want to make 20% on your capital, and you making a 7% profit. All right, you got to have a turnover capital of three in a very heavy and a heavy grading company will struggle to get there. Okay, yeah. So we're looking at the profitable use of capital as well as the efficient use of capital. Right.

Michael Kelley: 38:53

If this is the DuPont, you said, it's the DuPont analysis or the DuPont model.

Mike Vorster: 38:58

Yes. So there are lots of applications and and, you know, internet resources relating to the DuPont model in its various forms, because it's morphed around a lot. All right. It's a company I worked for in South Africa. We measured the capital invested on every project every month. And we took say that the left hand side of our balance sheet, or be represented with assets that were on the job sites, okay. Some of our jobs, the ones where we were running big fleets of motor scrapers tied up on a lot of our net pp. Other jobs where we were where we were using much less equipment intensive methodologies and things like that tied up less of our net pp. We measured turnover on capital on every job every month, and jobs that had a very, very low turnover on Capitol number. How to produce very high margins. In order to get the same result, return on investment, okay, return on investment result. Yeah. And so if you look at, if you look at if you look at your equipment account only portfolio, capital investments into your equipment account, return around capital in your equipment account is going to be very, very low. Right? And therefore, if you want to get a 20% return, you're going to have to make a margin on your equipment account.

Michael Kelley: 40:30

Yeah, exactly. Exactly. And then what's what's neat about that model, just glancing at it here, and from what I remember from, you know, my, my old college days, is that the incorporates the different ways that you can get money as well, at least a more sophisticated analysis do so that you can, you can look at things like borrowing money, and the cost of the cost of borrowing money versus the cost of your own of your own money, that you already have that kind of thing. So that's good.

Mike Vorster: 41:00

That's good. While I like an equipment account to be a straight cost recovery mechanism, I think that it's cool to give the equipment guys a respectability of profit. And what and therefore, I think it's cool to have a little bit of a margin in your recruitment rates. When you do that, be very careful how you're going to mark up your bids, because of course I rate is an estimate within your estimate.

Michael Kelley: 41:26

Right. And even you don't want to mark up your motor scrapers so much that you lose every single job that you ever bid from now on everybody scrapers.

Mike Vorster: 41:34

Yeah, yeah. And you know, another thing about this margin and respectability of profit, and so on and so forth. we're accustomed to, let's imagine that we have our jobs of as expected job margin of 17%. And the jobs come in at 1215, something like that. We say, well, tough job, it's three points, four points below margin, two or three points below margin, the guys are working like stink, and at least they start bringing in some money. Now let's imagine we set our margin at zero. And we come in four points below zero, you come in at minus four. Now the agony of negative well exceeds the ecstasy of a positive. Right.

Michael Kelley: 42:21

Okay. Especially, especially when it's unexpected. Or margin variances or unexpected growth, positive and negative rushes if you expect it, and you didn't do anything about it, then that's laziness. You're expected. But I've had people say that they said, I said, Well, it looks like your equipment account is negative. Yeah, but we expected that. Yeah, I'm like, Well, okay, let's have a different conversation then. Because I don't want to expect a loss.

Mike Vorster: 42:57

Yes, but then that loss is consolidated at a company level. And the guys who do that the guys who do that watch this very carefully, and I'm, I'm very close to a company that does that is they will budget for their, for their equipment account to make about minus one or 2%. And they budget for that to be part of the corporate overhead. All right, watch what happens, then you totally completely defuse this conversation about what you know, your equipment or guys that are fleecing us, your equipment, your equipment is a profit center. Our rates are too high. Okay, no, you're walking around, you know, in old shoes, and, and you're, you're eating in the low class restaurants because look, you've still got to get some subsidy out of our corporate level indirects Okay, yeah. Well, that shows you how how, what a deal we doing for you at a job level. Okay. So setting the setting the equipment account at a slight negative completely the fuses or does great things for this optics of you guys are making money on us, you know? Does it affect the cost? Not one single little bit? Because the cost is a cost is a cost, right? And in the end, all the pluses and minuses in these this responsibility center performance measurement game that we play, all those Profit and Loss all those gains and losses on internal transfer prices wash out and it's a difference between sales and

Michael Kelley: 44:51

cost of sales at the end, but but in the but what it does do. It seems to me anyway, this is just from you know, the few minutes Your answers, it takes away the teeth of or takes away the sting of the negative one now, where where if you budgeted for zero or at least you expected zero, and we can get into the difference between what people expect and what people budget later. But, but if you expect zero and it comes in at negative two, well, that should be agonizing. And it should outweigh the pleasure of a positive two, in my mind. But if you if you budget negative two, and then it comes in at negative two, then you're like, Okay, that's fine. And then how come when it comes budget magnitude comes in negative three? It feels like well, wow, you know, I mean, it's a little bit bad, but it's not terrible. Where the first, for anything below zero at first, is painful. Yeah.

Mike Vorster: 45:49

Zero is a very special number. Okay. Arabians that gave us that number? makes everything work, right. In fact, sometimes I ponder that about, you know, what the how they did this before they invented zero. Exactly. And zero is a very special number, and many things happen around zero. Now this company that I'm close to that has, you know, 300,000, expect there will be 300,000 out of about $6 million, with equipment costs that we will not recover from the job sites. Okay. Okay. the agony of turning that 300,000 into 400,000 is pretty high. Okay. And, and, and the feeling is that, you know, we've set it up. So out of 6 million, we are not going to recover 300,000 on through through our job charging mechanism, we are going to recover 300,000 by consolidating that directly into our corporate overhead. In other words, the corporate overhead for the equipment is 300,000. Now, that's probably the shop, that's probably the dispatcher, that's probably, you know, things which are and should be truly corporate overhead. Okay, that's, and so it softens a little of that, you know. So again, their attitude is, their style. And their philosophy is we recover from our job sites, as as close to the true cost of owning and operating the equipment as we possibly can. And we expect that there will be 300,000 out of, you know, there'll be 5% of that, that we that we want to recover. But that's okay. We will take that as a corporate indirect, that, of course, gives the CFO who's responsible for the corporate indirect, a real handle into the equipment account, because that any change in that minus 300 is going to happen is going to impact the corporate overhead recovery. regulation. Right. It's all measuring performance. It's all about measuring and motivating the responsibility centers in your organization. Right. Another subject, I would suggest that our listeners research and look a little bit is responsibility center accounting, which is as if not a more interesting subject and cost accounting, and certainly more interesting than financial accounting. Right? But what is responsibility accounting? It's this whole business of setting up the rules of the game so that everybody plays the game in a aligned constructive manner. Yep. It's all about alignment and motivation. I can tell you some guys get it. Very, very wrong. Some guys get it very, very right.

Michael Kelley: 49:03

It happened at silver truck that we got it wrong. About a year and a half ago, it was our responsibility. Accounting was we were asking individuals to to make sure that they were billable. a certain number of hours per week, right. When we tracked that had a little scorecard. We checked them our billable hours. And you know, it's like, oh, great, you know, this person has tracked this many billable hours, just this many billable hours, right? Well, the when we found out that we were doing it wrong. I mean, that sounds reasonable, right? I mean, we're we sell labor, we're a labor oriented company. So if we're not working on something that's tangible, and you know, we can't do it. And it's a little bit different than equipment. But in a sense, it's like it's like our utilization. Right? We're just being we have we have people where we have to be utilized rather than machines. But so we thought this is this would be great. In fact, a lot of it was influenced by my work with equipment that was like we have to talk about yields. What happened was that the behavior started to get weird. And this was with people that I respect and were doing, legitimately trying to do the best for the company. They weren't. This isn't like people who were actively trying to undermine anything. They started hoarding work. Because they were afraid they wouldn't make next week's utilization if they gave it to the developer, or the developer beside him. And so one developer would have idle time, the other developer would have too much work, but they wouldn't share because they're worried about next week's utilization so that the customer had to wait for no reason. Because of that, and then on top of that, they any flat rate jobs, we didn't, it was like, if they were working on the flat rate job, Well, great. And we weren't tracking whether or not they were progressing on the flat rate job. So as long as they're working on what we after a couple, three, four weeks of great numbers, and we looked in the products weren't getting done great numbers, projects weren't getting done great numbers, projects weren't getting done, we realized that the the behavior that we were asking for the behavior wasn't matching up to what we were asking for. And therefore we had to look at our responsibility accounting and say why. And it turned out that asking for utilization, specifically for humans, was the wrong thing. Because humans aren't pieces of equipment, human, it all of these people can actually make decisions on their own. It's difficult to have your your wheel loader make a decision. But it's easy to ask the human to make a decision. And they were making decisions that were going towards the responsibility accounting, going towards the scorecard that were at the detriment to the company at the detriment to the customer. customer first actually, which ended up to be the detriment to the company. I was in an interesting where we got that wrong?

Mike Vorster: 51:50

Absolutely. We we have since a very, very, from a very, very young age, been taught how to understand the game, understand the scorecard and play the game. This whole question of how you set up the scorecards, and how you measure performance inside of the business. And specific end equipment is just such a large and complex part of that whole puzzle of when we started off by saying that it's probably your biggest job. Okay, yeah. And then we continued, and we said that construction companies, and particularly construction CEOs are really good at setting up the game and setting up the scorecards for the performance of project teams, because that's where they cut their teeth. That's where that's the game they learned to play. And when it comes to setting up scorecards, and managing the equipment account, they don't have any personal hands on experience of that game. they've watched a lot of that game. And they've, but they and so the way the scorecards are set up at a project level is a fairly highly developed science. The way the scorecards are set up inside of the equipment account is is a relatively undeveloped science and the company you had there that said, we are experimenting with a 2020 scorecard that says 20% return on investment, and 20% below personal blow external rates. They, they setting up that scorecard. Other companies set up scorecards very differently, because this way is this whole thing is still being developed and still being built.

Michael Kelley: 53:41

And what I'm just I'm just so pleased that they're doing it differently. Because if everybody was doing it the same, then people like me, and you would learn nothing.

Mike Vorster: 53:50

Well, you know what my dad said, My dad told me, my dad said, you know, Rolling Stone, my dad and I must, but it should get us plenty of shine. And one of the opportunities I've had is to roll around the business a lot and spend a lot of time with the best and the brightest in the business, and pick up the shine and learn what they're doing and, and, you know, share my learnings with with other folk which is, which is really what it's what it's all about in the end. Yeah.

Michael Kelley: 54:23

Well, well, let's wrap up. Let's wrap up today. I know that we get when we get back together. We're gonna continue on on the book. I think we're on chapter four now of your new book. So So I look forward to that going through chapter four. Next time we get together told a story about the airplanes and your old boss that talk to you about flying blind. And I don't think we've talked about this on the podcast yet. And I think that everybody deserves to hear that story. And it's I think it's so relevant to what we're trying to do and what we were trying to do last week at the boot camp, because we're trying to we were trying to get them. Get them some where they could well tell the story, it'll make more sense.

Mike Vorster: 55:05

Well, you know, I get ribbed a lot about telling too many stories. But I'm a strong believer that we learn by using metaphors. And we remember by telling stories, and I think stories is how our cultures and societies remembered in the days before everything was written down. Okay, but so thank you for the stories because I'm a great believer and a lover of stories. The story goes like this, I worked for a delightful guy by the name of Nick frontopolar, has long since passed away. And he'd been a hurricane fighter pilot in world war two in the North African desert, flew all the way up, Italy, flew the Berlin airlift and all those sorts of things. And I was on a job as a young project manager. in Malawi, which is in the center of Africa, I was building track, Bella sleepers and rails has a very, very simple job. And we had between Nick and I, we had a very simple, he came up and visited once a month, between he and I, we had a very simple sort of forecasting method. It said to me, how much are you going to earn and how much you're going to spend next month? And I tell him, just those two numbers, it come at the end of the month and say, How much did you earn? How much did you spend, I need either scowl or smile or whatever it was my beam. And we've done this for about a year he one day he said to me, he said, You know, you're pretty good at this. You get to estimates estimates and your numbers and your forecasts fairly right. And I don't bother about how you do it, but because it's pretty on track. He said, but there will come a day when you will build a complicated job. He said there come a day when you will fly more than a single engine airplane. Because if you fly a single engine airplane, remember who was American fighter pilot single engine, right? When you fly a single engine airplane, you can hear the engine and everything that goes on. He said you can see their eyes and the sky is blue, and their eyes in his flat. He said there will come a day when you will fly an aeroplane with more than one engine with some passengers in the back. And when having a disaster is a real problem. He said I would like you to learn to fly a job site using instruments. Because that's how it will get dark one day you will fly into bad weather one day. Not every flight that you fly is going to be visual flight rules. Okay, so I learned to fly your job by instruments. And so I said, All right, this is fine. And the next month he visited I had on the office wall one piece of graph paper along the bottom was time. And along the way. And along the y axis was miles attract late and I had a pin in this graph. And he walked into my office looked at this piece of graph paper with a pin in it and said are your first instrument. You now know how many yards of track meters of track you lay in a month? I said, Yep. I always knew that. He said, Yeah, no, but now you've got it up on the wall. And you're tracking it and tracing it your first instrument. And sometimes I think about that, and my mind boggles at the extent to which we now focus on flying by instruments, right? Because truly, the number of days in which we fly by visual flight rules on a large complicated project are pretty few and far between.

Michael Kelley: 58:45

Right. And, and I would say that, you know, in a time, like 2020 was, despite all of the uncertainty, there was a time of fairly easy money. It was a time where construction was relatively unimpacted unless you were in some of the areas that were actually shut down. But relative to the other markets. 2020 was a time where, you know, yeah, there was some cloudy days, especially for some contractors, but by and large, it was visual flight rules with blue sky, and the horizon was flat. And the so you could get by with gut feel on your equipment. You could get by within going to the auction and being like that looks like a good idea. All right, we'll figure out the financing later. Or, let's see, okay, we can do that. We'll figure out yeah, that's not a cat. It's kind of a it's it. This is our first Komatsu but you know what, we'll figure out how we can service that later. You can you can understand you can you can do that in 2020 and certainly in the years before to a large extent. But, but what what does lie ahead for people with large equipment foot fleets, we don't know of course always uncertain. And but we want to be able to be prepared and that's and that's where I don't want to make people afraid or anything like that. And that's why they go To do instrumentation, hopefully they're doing it because they're curious, they want to get better not because they're afraid. But we do want to be set up, if there is a downturn if if construction does start to tend towards like it was in 2008 2009, that we have very clear instrumentation. So we know what our equipment is actually costing us. So we know where the real zero is, when we're bidding jobs.

Mike Vorster: 1:00:26

Yeah, we can share about 2020 and the challenges of 2020 at length. But I think that there, there's a there's another reason why instruments and learning knowing to how to fly by instruments is critically important. And that is that in the complex world of today, and especially as the aeroplanes get bigger, and as we have more responsibility for the safe flight, the safe passage of our cooperation through the year, the ability to fly by instruments is required. And expected. When I walk onto an aeroplane, I don't sort of look left and say to the guy, Hey, can you fly by instruments? It's expected. And when when I when we negotiate with a bank or a bonding company, they don't look left and say, Hey, can you fly by instruments? Right? Because I guarantee you, if only 20% of your pilots couldn't fly by instruments, you're going to get no passengers coming in by your door. Right, exactly. Our airplanes crash occasionally. But you know, it's it's expected, it's expected. You know, the way to make money in construction is not to lose it. And you're gonna have a very successful company on low margins, if they've got very few, if any, losing jobs again. And that's the whole market, in my opinion of a of a, of a great business. Not that they can make money, but that they don't lose money. We're in we're in the age of accountability, and part of the age of accountability. And we're in the age of quantitative decision making. Even and the expectation is that we can fly by instruments. And by instruments more than one sheet of graph paper on the wall with a pin in it. All right, at least one sheet of paper on the wall with a pin in it.

Michael Kelley: 1:02:33

Right, exactly. That that's that's fine by instrument, but you're still in a single a single engine airplane. Yeah. Yeah. Well, great. Well, thank you for today. And we'll get back together, I'm sure soon. And we'll, we'll continue on on the book. I'm excited to continue reading the new revision.

Mike Vorster: 1:02:53

Well, I've got through to chapter 16. And that's as many chapters as the second edition is going to have. So it's now a matter of proofing and tidying. Well, great. We will be talking soon. Thank you, Mike. Not at all. Not at all. Pleasure. That's it for today, folks. See you next time.