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The Art of Benchmarking

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Leadership

The Art of Benchmarking

With no financial benchmarks, small volume builders often repeat the same mistakes. Here are tips for targeting a bigger profit, without selling out.


By Matthew Power, Senior Contributing Editor February 28, 2006
This article first appeared in the CB March 2006 issue of Custom Builder.

Sidebars:
Six Steps Forward
Are You Average?
The Midas Myth
Inside The Small Builder Universe

Even artists have to eat. Consider Michelangelo, the famed 16th Century sculptor. "Through astute investment and strict management of his finances," one biographer notes, "he provided for his entire family (his father and four brothers) and died a millionaire."

Most custom builders have nurtured the first part of Michelangelo's gift — his creative vision — but few take the second seriously: his business savvy. Why? Because, according to Emma Shinn, CPA and vice president of the Lee Evans Group in Denver, they share a common delusion.

"They think they are so different from everybody else that management concepts won't work for them," Shinn says. "But the same concepts will work — and make their jobs easier. Time and again, we see them putting effort into areas that are leaking profits."

In other words, the first step in tuning up your business is quieting the artist's voice, and acknowledging that your business can be quantified in a way that will help you reduce redundancy, trim waste and have more time for other things. At the same time, you'll be putting yourself in a league above your local competitors.

"I'd say about 1 percent of small builders have some sort of [benchmarking] system in place," says Shinn. "I think part of it is that they're all terribly scared of numbers."

She explains that while most custom builders already keep track of a lot of accounting numbers, they don't mine them for information. They take expenses such as the cost of site supervision, real estate commissions, warranties, and just "throw them into the same pot of soup."

Tracking Pays

Brad Simon, co-owner of Cottage Homes, a small building company in Salt Lake City, Utah, has something most custom builders don't: years of experience working for a big production builder. Simon's experience working for Woodside Homes, a company that builds 5,000 homes a year, taught him some key accounting skills. That knowledge still applies, he says, now that he builds only six to 12 homes annually.

"This year, we will save about $120,000 in financing costs alone," Simon says. He attributes that savings to his use of detailed accounting.

"The national builders track everything," he says. "Custom builders track nothing. I was giving a seminar about this to a bunch of custom builders, and one of the guys went back to his hotel room and tracked his sales for the year.

"He came back to me and said, 'You know, I went a whole year without making a sale. I'm never going to let that happen again."

That lack of a handle on planning and expectations, Simon notes, creates a lot of unnecessary stress for small volume builders.

"I'd say only 20 out of every 300 people in one of my seminars do a monthly finance statement," he adds. "Without that, how are you going to analyze your expenses? It's a benchmark for what you know you can do next month."

John Barrows, a custom builder and remodeler in East Hampton, N.Y., says that many custom builders simply don't know how to apply accounting principles to their business.

"This business is weird, because we own part of what we're manufacturing," Barrows says. "If it's a spec house, you own it until the day you sell it. If it's a custom home or remodeling, you can't simply expense the whole thing. So you end up having to document the job by cost code, or phasing in costs."

He adds, however, that this process is not as daunting as it sounds. Most of the hard work of figuring out what to track has already been done by the NAHB and accountants who specialize in home building, such as Emma Shinn.

Taking Account

The NAHB, with Shinn's help, has created something called the chart of accounts (COA), a list of financial ledgers aimed at helping builders track day to day accounting. This chart marks the first — and probably the simplest — step toward financial benchmarking.

The COA is available for free on the NAHB Web site. As Barrows points out, however, the chart is a catch-all. Many of the categories don't apply to custom builders. Fortunately, the NAHB has done much of the winnowing work already. Builders can download a Microsoft Excel version of the COA specifically for small volume builders.

One caveat: Before custom builders end up frustrated by this more complex method of accounting, it helps to understand the principles behind the COA. Emma Shinn explains:

"Typically, the only reason custom builders have accounting is so that lenders will help them — and to pay taxes," she says. "As a result of those goals, they set up the accounts in ways that are not meaningful. They have no clue what the balance sheets tells them.

"But to lenders, the balance sheet is very important," she adds. "The lender is looking at the ability of the company to repay loans, measured as a ratio of your current assets divided by your current liabilities."

Shinn explains that current assets in home building refer to things that will be converted into cash within 12 months, which would typically include works in progress — unfinished homes and remodeling jobs.

"One thing a builder can't afford to do is lose his ability to borrow money," Shinn explains. "If you lose that, you're dead. The other ratio is the debt to equity ratio. That's important because it refers to the risk the lender has. It determines whether you can borrow more money."

The chart of accounts, Shinn explains, clearly breaks out these ratios — at the same time separating expenses and income into neat categories that builders can use to make detailed comparisons over time: Welcome to benchmarking.

"If you don't have this system, you'll never know why you did well (financially) on one project but not another," Shinn says. "Was it because I had a real estate guy? Was it my crew size? You need to keep the classifications really, really clean."

Aim for Improvement

Shinn says that setting up your accounts for the first time primarily involves rearranging your budget (assuming you have one) in a coherent fashion — fitting them into six well-defined areas (see sidebar on page 52).

"You want to set up the chart like a timeline — so that it follows your construction sequence," she explains. "You do it in the same order you actually build a house — not alphabetically, like so many builders."

"By comparing numbers on a month by month, year by year basis," Shinn notes, "you can now see if you've been efficient in every area."

For a custom builder to judge his success, he will need some targets for efficiency. One good place to start is NAHB's "Cost of Doing Business Study" survey. The NAHB compiles the data in the book using its own COA ledgers, so builders can make an apples-to-apples comparison of the typical income-to-expense ratios for a home building business of a particular size.

Emma Shinn has developed a book that offers a similar set of target ratios — based on measurements taken in the field. Put simply, ratios refer to the percentage of overall expenses used for a specific aspect of running a custom building company.

"For example, we set an operating expenses target of 3.5 percent of sales revenue. Then you can set your own target — where you want to be. You may be running a 6 percent construction costs ratio, but next year your want to bring it down to 4 and a half percent."

Using this accounting system, she says, builders can identify where they spent their budget. For example, a builder may find that he has too many supers in the field.

"Now all of a sudden you can see where you've been inefficient," she says. Are you being efficient in buying land, financing, sales and marketing and your office? Where can you plug the profit leaks?"

"Even if you don't want to do it yourself, you can hire someone," adds Simon. "It's not going to kill you to pay $1000 to have an annual financial report done. It's a progressive process. Each year we do it, we save more money — primarily by moving money from bank to bank (to get better terms).

"Most custom builders don't even know how long it takes them to build a house, but without knowing that, how can you know whether to send a framing crew to a new job or not? We wear a lot of hats, but you have to know your own business."

Case in Point
ABZ Homes Income Statement
Actual Ratios Target
Sales $5,345,500 100.0% 100.0%
Cost of Sales:
Land (lots) 962,190 18.0% 18.0%
Direct Construction Costs 3,207,300 60.0% 52.0%
Total Cost of Sales 4,169,490 78.0% 70.0%
Gross Profit $1,176,010 22.0% 30.0%
Operating Expenses:
Indirect Construction Costs $203,129 3.8% 3.5%
Financing expenses 187,092 3.5% 4.0%
Sales and Marketing expenses 347,458 6.5% 6.0%
General and Administrative 251,238 4.7% 4.5%
Total Operating expenses 988,917 18.5% 18.0%
Net Income 187,093 3.5% 12.0%

 

Six Steps Forward

Stop alphabetizing your budget! That's the advice of CPA Emma Shinn. To start using accounting as a tool, not an inconvenience, your expenses should be clearly divided into the a total of six categories and sub-categories.

  • Cost of land. Actual hard costs for land, not including closing costs, interest, etc.
  • Sticks, Bricks and Labor. This includes all material costs, plus labor (not including supervision).
    Next, divide the category of "Operating Expenses" into four subcategories.
  • Construction Costs (described in some references as "Indirect Costs). Add up all of your supervisory costs. These would include things such as pay for your superintendents, costs to rent a trailer, miles on your truck, utilities for the site, and cellphone costs.
  • Financing. This is primarily interest on outstanding loans for land or materials. Also, include closing costs, points paid for the buyer and other costs you used to make a deal. If you build on the owner's lot, this category could be very small.
  • Sales and Marketing. Many custom builders do very little marketing, but don't leave out anything. Include brochures, signs, real estate commissions, advertising, web site designs and maintenance. Also, if you paid a designer to work with a client, that fee would go here.
  • General Administrative Expenses. This section includes all salaries, office expenses such as supplies, lease and phone, plus equipment such as computers.

Are You Average?

Wondering how your expenses and profits compare with similar sized firms? Stop guessing and apply some ready-made research to your financial expectations.

Typical New Home Cost Breakdown
Finished Lot 20–25 percent
Materials 25–30 percent
Labor 20–25 percent
Overhead/Selling 6 percent
Financing 2 percent
Profits 10 percent *
* all residential builders
The ratio of costs for building a new home has been fairly consistent, in recent years despite fluctuating labor and material costs. PERCENTAGES COURTESY OF THE NAHB.

The Midas Myth

You might think that by building more expensive homes you can make an easier buck. Think again.

Chuck Shinn, president of the Lee Evans Group, in Denver, writes frequently about the impact of a company's sales volume on its ability to turn a profit. Most recently, his firm analyzed data from 94 clients — builders who construct homes averaging in sales price from $98,000 to $3.2 million.

Shinn found no direct correlation of house price and company profitability overall among his clients. What he did find, however, is that within each price range, net profit varies quite widely. You may not want to bet on any one niche however. Even in the luxury category, almost a quarter of builders made less than 5 percent net profit. And one of the low-price leaders reported a 39 percent net profit!

Pricing: The Long View
Classification Price Range Avg. Price Avg. Net Profit
Low Price Leaders $98,000–$178,400 $149,000 8.86%
Mainstreamers $179,000–$230,000 $200,000 5.91%
Move-Up Pricers $230,000–$360,000 $279,000 8.39%
Laps of Luxury $362,000–$3.1 million $623,000 10.48%
Source: "Price Does Not Affect Profit," by Chuck Shinn, Lee Evans Group

Inside The Small Builder Universe

Both a builder and an academic, Mark Hutchings has conducted extensive research on the much neglected small volume side of home building.

A faculty member at Brigham Young University in Provo, Utah, Mark Hutching's work has begun to get the attention of custom builders. That's because much of his research lands squarely on their turf. What he has found confirms what people in the industry have known for years — that few small builders practice efficient management. Hutching's research offers builders a road map toward better profitability, by acknowledging that their yardstick for measuring success is incomplete.

"One of the findings that surprised us a little is that when you ask small firms to name the five things most important to their success, they begin to list off what I call warm fuzzies...things that are impossible to measure.

"Ask the same question of production builders and they will list off things like systems, and accounting."

In other words, he says, when it comes to business management, small builders are often their own worst enemies.

Management Matters: Secrets of Small Builders

In other research, Hutchings compared the profitability of small builders in the top 25 percent of profitability with those in the lowest 25 percent. Here are several of the strongest observations to come from that data.

  • Spec Pays Better. 40 percent of those in the upper quartile built most of their homes on speculation, while only 6 percent of those in the lower quartile built most of their homes on speculation.
  • Brokers Matter. 74 percent of those companies in the upper quartile had real estate brokers involved in their new home sales, while only 48 percent of those companies in the lower quartile had real estate brokers involved in their new home sales.
  • Higher Commissions Help. 58 percent of those companies in the upper quartile reported paying sales commissions of 3 percent or more on new home sales, while only 26 percent of those in the lower quartile paid 3 percent or more.
  • Land Ownership Matters. 56 percent of those in the lower quartile built most of their new homes on their customers' lots, while only 24 percent of those in the upper quartile built most of their new homes on their customers' lots.
  • Vagueness is Profitable. Those in the lower quartile tended to provide new home buyers with detailed written specifications for pre-sold homes more often than those in the upper quartile.
  • Patience is a Virtue. 64 percent of those in the lower quartile pre-sold most of their homes, while only 38 percent of those in the upper quartile pre-sold most or more of their new homes.
  • Meetings Can Cost You. Those in the upper quartile tended to have fewer formal preconstruction meetings with new home buyers than did those in the lower quartile.

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