Where Did My Profits Go? How Do I Get Them Back?

Transcription

1 Where Did My Profits Go? How Do I Get Them Back? A Summary of a Talk Given by Charles C. Shinn, Jr. National Association of Homes Builders 51 st Annual Convention January 27, 1995 About this time every year homebuilders across the country are analyzing their end of year financial statements to determine: "Where did my profits go?" and "How can I get them back?" Typically the homebuilder looks only at part of the profit equation; that being the volume sales, the sales price his product line can command in the marketplace, and the increase in material and labor prices. These issues are highly impacted by external factors over which the builder has little control. I continually hear comments like: "Interest rates increased this year causing my sales volume to drop off during the last quarter of the year." "I am in a very competitive market with lots of pickup truck builders who don t know how to price their product so I can t get an adequate price to generate good profits." "Several national builders came into my market this year and they were buying market share with discounted pricing." "Lumber and drywall prices increased, and labor costs increased due to a tight labor market which caused an erosion of my profits." Focusing on these items normally results in the comment, "This is the best I can do in my market, it just will not allow me to make good profit margins!" With this statement the builder is defeated. Homebuilders generally do not believe they can obtain a 10% or better net profit before tax in their market. They tend to become volume oriented with the assumption that the only way to increase dollar profits is to increase volume, which does not increase the rate of profitability. Homebuilders need to focus on the items that are within their control to generate optimum profits. Where the builder can have the greatest impact on increasing his profits is in the expenses and cost components of the profit equation. The homebuilding industry is generally very inefficient. A well run profit oriented homebuilder can make superior profits in almost any market and under any market condition. Obtaining optimum profits requires the development of a profit strategy and the balancing of four components: sales velocity, sales price, construction costs, and operating expenses. Builders who have undertaken the efforts to follow the recommendations outlines in this presentation, typically have been able to increase their net profitability before tax toward the target of 10% to 12%, and a number have reached superior net profitability of 15% to in excess of 20% before tax. During the last 25 years I have been analyzing homebuilding organizations and their profitability. Throughout his period, the profitability before taxes on homebuilding

2 operations has been between a loss to 7% with an average of approximately 3.5%. In my opinion this profit margin is very low for the financial risk homebuilders undertake and the cyclical nature of the industry. As management consultants and educators for the homebuilding industry, the Lee Evans Group has developed financial targets for homebuilding companies that would generate a 10% to 12% before tax profit. We have developed these targets to guide in determining where builder operations are losing profits. These financial target ratio breakdowns are based on NAHB s Chart of Accounts as presented in Accounting and Financial Management for Builders, Remodelers, and Developers, Third Edition. For clarification of what costs are included in each classification you should refer to this publication. Exhibit 1 presents the typical range of homebuilder expenses or costs represented by each classification and Lee Evans Group targets. PRICING THE PRODUCT Generally, I assume the market place sets the sales price and the builder can only marginally modify the price within a range acceptable to the market place. However, I find there are a number of pricing issues that can increase profitability. 1. Profits are treated as a Residual. The market establishes the price it will pay for a home. The builder starts with a set of plans and set of specifications to determine the cost of construction through competitive bidding. Profits become the difference between what the market will pay and the costs of construction. The builder forgets that costs do not create value. A. Determine the market sales price for each home. Deduct your target profit from the market sales price. Next deduct the land cost and the operating expense allocations (indirect, financing, marketing, and operating) to determine the amount of money available for direct construction costs. (See Exhibit 2) B. Develop target direct construction cost budgets for each job cost classification. Design, specify, and estimate toward the direct construction cost classification budgets. (See Exhibit 3) Reconcile the Market Basis and Cost Basis Proposed Sales Price. Builders frequently will determine the cost of construction and lot cost and apply a markup rate to determine sales price. Costs do not create value! If the market does not accept the cost based pricing the builder will not realize adequate sales velocity, and will establish some type of discounting program to bring the sales price back in line with what is acceptable by the market.

3 EXHIBIT 1 TARGET RATIOS FOR HOMEBUILDERS Target Typical Sales Cost of Sales Land (Market Value) Hard Cost Gross Margin Indirect Construction Costs Supervisory Salaries & Payroll Burden 1.5 Warranty 0.6 Other (Truck, Equip, Const., Office, etc.) 1.4 Finance Expense Interim Interest 2.0 Points, Closing Costs, Fees 2.0 Marketing Expenses Sales Commissions Internal Brokerage Commissions Advertising 1.0

4 Model Home 1.0 Other 0.5 General Administrative Expenses Key Person Salaries Accounting & Computers Other (Rent, Insurance, etc.) Net Profit EXHIBIT 2 MARKET BASE AVAILABLE CONSTRUCTION COST BUDGET Factor Budget Sales Price ,500 Profit ,340 Land ,900 Financing ,780 Marketing ,170 Indirect Construction Costs ,580 Warranty General & Admin ,380 Total Direct Constr. Costs ,750

5 EXHIBIT 3 PRELIMINARY DIRECT CONSTRUCTION COST BUDGETS TOTAL DIRECT COST BUDGET ,750 PRELIMINARY Plans Permits & Fees ,565 PREPARATION Excavation Foundation ,325 Steel Waterproofing ROUGH STRUCTURE Lumber-fram & Trim ,105 Trusses Stairs Winds & Sliding Drs ,830 Front Door Garage Doors Framing Labor ,720 Fireplace Gutters & Dnspts Roofing ,195

6 Masonry ,085 Utility Connections FULL ENCLOSURE Plumbing ,100 Heating ,260 Electrical ,290 Telephone Insulation ,220 Drywall ,875 INTERIOR FINISH Interior Trim ,705 Painting ,645 Cabinets Counter Tops Wall Tile Shower Drs. & Mir Hardware Appliances Electrical Fixtures Vinyl Flooring COMPLETION Carpet ,805

7 Finish Grade Final Clean Com. Labor & Clean Miscellaneous Cost base pricing needs to be reconciled with market based pricing, which is determined by market research, appraisals, and comparative analysis. Marketing must agree it can sell the house at the agreed price and production must agree it can build the agreed price. (See Exhibit 4) Account for Historical Direct Construction Cost Slippage Typically in pricing homebuilders do not consider the historical unbudgeted construction cost (fill-in material orders, subcontractor extras, rework and corrections, etc.) These direct construction cost variances can add up to a substantial amount of lost profits, if they are not accounted for during the pricing process. A. Develop a method to determine your historical direct construction cost slippage through variance analysis and tracking. B. Revise your sales pricing to allow for your historical slippage rate. Treat slippage as expense items is to be deducted from the market sales price prior to determining what funds are available for direct construction costs. Direct construction cost slippage is treated the same as operating expense allocations as outlined above. Account for Subdivision and Site Specific Expenses Frequently, builders develop standard construction cost budgets and do not modify these budgets for site specific or subdivision specific costs. When these costs are not considered in the home pricing, they create lost profits. A. If the site specific or subdivision specific costs create value sales price can be adjusted to cover these costs with the appropriate margins to cover operating expenses and profit. However, a number of these types of costs do not create added market value. B. Site and subdivision specific costs that do not create market value must be accounted for in the pricing process. As an example: In a subdivision one third of the sites will require deep foundations. These foundations will cost an average of an additional $3, each. No additional value is created by deep foundations. To account for this subdivision specific cost is the pricing of the houses, each home in the subdivision specific cost in the pricing of the houses, each home in the subdivision should carry a subdivision burden of $1, You can either treat the

8 $1, added burden as we did with the direct construction cost slippage or increase the sales prices for the houses to be sold in the subdivision by the $1, plus the appropriate margin. In either case the pricing will cover the added cost incurred for the deep foundations. EXHIBIT 4 STANDARD MODEL PRICING FORM COST BASIS DATE Targeted Rate of Profit: % (From project and/or company business plan) Overhead Rate % (Avg operating expense rate over past 3-6 Months or rate in your company budget) Required Margin % (Sum of rate profit plus overhead rate) Finished Lot Cost $ (From Land Development Cost Budget) Direct Construction Costs $ (From Job Cost Budget) Total Estimated Direct Costs $ (Sum of Lot Cost plus Direct Const. Costs) Mark-up Rate 0. (1.00 minus the Required Margin Rate) Minimum Selling Price $ (Total Direct Costs divided by Mark-up Rate) RECONCILIATION TO MARKET COST BASIS MARKET BASIS Price $ (From Above) Adjustments to costs (Explain each item) $ Price $ (From market research and comps) Adjustments to price (Explain each item) $

9 Total $ Total $ Adjusted Total Costs $ (Total Direct Costs less adjustments) Mark-up 0. (From above) Adjusted Min. Price (Adj. Costs Divided by mark-up) $ Adjusted Market Price (Initial price plus Adjustments) $ (The above two numbers must agree) V.P. Construction V.P. Marketing Estimator Anticipate Construction Cost Increases and Develop a Strategy for Increasing Sales Prices Too often the increase in sales prices are reactionary to cost increases in a catch up mode. This causes major erosion of profits for builders with a high proportion of pre-sales. Builders should develop a strategy to increase sales prices in anticipation of cost increases. Generally, the reactionary price increases are substantial, and unannounced, causing a major reduction in sales velocity. A. Analyze the cost increases that occurred during the last year by comparing your job cost reports at the beginning of the year to the job cost reports at the end of the year.

10 COST OF SALES B. Chart critical construction cost categories such as lumber, framing, drywall, etc. (See Exhibit 5) C. Analyze national and local market trends and talk to subcontractors and suppliers to determine anticipated cost increases and their timing. D. Determine the amount of anticipated cost increases and develop a strategy to increase your selling prices to cover these cost increases. For example: The anticipated cost increases will be 4% this year. To account for this cost increase, sales prices shall be increased 1% at the beginning for their prospects. Cost of sales consists of land and direct construction costs (labor and materials). It does not include such items as construction supervision, interim financing, or sales commissions as we frequently find in many builders reports. 1. Land Costs Generally, the cost of land is not a major problem for homebuilders representing from 16% to 25%. The problem we do not find with land is that it is frequently understated. Builders that hold land, develop land, or have purchased land from R.T.C. at below market prices should treat land as a profit center and transfer the land to the homebuilding operation at builder retail. (The price a builder would pay for the land at today s fair market price) Too often builders mix up land profits and homebuilding profits. Builders in high land cost areas and custom homebuilders may have land costs. In these situations, they should try to keep the combination of land and direct construction costs within the target cost of sales ratio. For example: If the cost of sales target is 70% and the land cost is 25%, the builder should make every effort to keep direct construction costs to 45% of sales price. 2. Direct Construction Costs Normally this area represents the greatest potential for increasing profitability. Not only do direct construction costs represents the largest classification of homebuilder costs, but these are variable costs (costs that change in direct proportion with changes in construction volume). For example a $100 reduction in fixed costs creates a $100 increase the marginal rate of profitability for each unit of production. So, the $100 reduction in direct construction costs for a house sold 50 times increases the marginal rate of profitability for each unit of production. So, the $100 reduction in direct construction costs for a house sold 50 times increases profits $5,000. Because of the nature of direct construction costs it is very important to continually monitor, control, and reduce this cost component. The attack on direct costs has many fronts. A. Get rid of your Bad DealsGet rid of your Bad Deals. Eliminate bad deals and standard plans that do not generate

11 appropriate gross profit margins. Bad deals normally are a major source of lost profitability. One bad deal can wipe out the profits from several good deals. Conduct gross profit analysis for each of your homes. For the homes yielding low gross profit margins analyze why they are not performing adequately. Redesign, respecify, and/or reprice your adequate gross profits, eliminate them from your product line. One method of analyzing standard plans to improve gross profit margins is to conduct a comparative job cost classification for your best gross profit generator. Using these percentages calculate the amount that should be spent in each classification for your poor gross profit producers and compare these calculations with the actual costs. This profit producers and compare these calculations with the actual costs. This comparison will highlight the cost classifications causing your loss of gross profits. B. Analyze Standard Specifications. This is probably one of the most productive activities to undertake which can produce immediate improvements in profitability. Develop the practice of "zero" base specifications, instead of the normal practice of starting with the current level of specifications and continually adding to it. Strip your standard specification down to the basics and conduct a cost/benefit analysis of each item to be added back into the standard specification, will your customer be willing to give you an appropriate return? Builders having gone through this exercise, have lightened up their home specifications and increased their gross profit margins. Items once included as standard and given away are now options or upgrades generating the appropriate margins. C. Do Not Over Do a Standard Feature. Watch how much of a standard feature you offer. I see this problem everywhere. The builder is told, "the competition is offering three piece crown molding, chair-railing, oak hardwood flooring, tile entries, Corian counter tops, oak turned picket handrails, fireplaces, etc. We need to offer these items to be competitive." D. Eliminate Waste and excess Material Usage. Everything that ends up in the trash pile represents lost profit dollars. However, this is only the tip of the iceberg. Police diverted materials, extra materials installed for no purpose, excess materials being stockpiled.

12 1. Make sure all excess materials are returned for credit and documented back to estimating and accounting to guarantee correction of the estimate and credit is obtained. Conduct variance analysis of all fill-in orders and extra work orders to determine the cause for these variances. 3. Inventory material deliveries and implement a program to eliminate back orders and substitutions. Conduct "as-built audits" to make sure the materials were used as intended, and instruct workers in the proper use of materials. E. Implement Value Engineer, Use of Alternate Materials, and Material Savings Techniques Just by changing the method of framing corners and tees from the standard three stud method to the use of ladders can save over 50 studs for a standard 1000 square foot home. 1. Analyze each of your plans to determine its construction efficiency. Look at the number of corners, the use if 2 foot modules, roof pitches, engineering of the floor system, etc. Continually look for new and alternate materials. Open up line of communication with your suppliers and subcontractors.

13 Implement material saving techniques such as plywood diaphragm headers, ladder corners and tees, cutting crutch studs out of 14 material, etc. Adequately communicate the material savings construction techniques to the workers. Gain Control of Construction Slippage Determine your historical level of direct construction cost slippage. This represents lost profitability. 1. Document all fill-in order and extra work with variance purchase orders. Develop a strategy for reducing the amount of variance. Determine the cause of the variance and the action needed to be taken to eliminate the variance in the future. Maintain and chart variances by their cause. Improve Estimating and Purchasing Procedures Inhouse detailed quantity survey estimating instead of competitive bid management and formal purchasing systems can reduce direct construction costs by 2% to 4% or more. 1. Develop a unit price database and have the subcontractors bid units instead of jobs. Conduct detailed quantity survey estimates documenting the units of

14 material and labor required to build the house. Implement formal purchasing procedures with written purchase orders. OPERATING EXPENSES Operating expenses consist of indirect construction expenses, all financing expenses related to the homebuilding operation (land financing expenses should not be included), all marketing costs including sales commissions, and general and administrative expenses. Total operating expenses should be kept at about 18% 1. Indirect Construction Expenses This classification includes construction personnel salaries, wages, and payroll burden; field offices and temporary facilities; construction vehicles and equipment; maintenance of housing inventory; and warranty. These expenses normally get out of line because of over staffing in the field with superintendents, assistant superintendents and laborers; not enough sales velocity per subdivision to support the expense burden needed to maintain the subdivision; extended construction schedules; and poor construction quality standards and control which causes rework and warranty problems. A. Monitor Staffing Levels. Continually monitor your staffing levels in the field and maintain a balance with your volume of sales. B. Adequate Sales Velocity. Maintain adequate sales velocity in each subdivision to support at least the minimum required level of indirect construction costs. C. Construction Schedules. Maintain your construction schedules and continually work toward reducing the amount of time required to construct your homes. D. Develop Quality Standards. Develop quality standards for each of the trades. Implement the quality standards through training of the superintendents and subcontractors, and the development of quality checklists. Financing Expenses Included in this classification are interest on notes and mortgages, interim financing and closing costs and fees. To reduce financing fees and interest rates being paid, the amount of unsold housing inventory being carried, extended construction schedules, and the amount of points and closing costs being paid for the purchase. A. Obtain revolving construction lines of credit. B. Balance the level of unsold inventory being carried to the sales velocity. C. Maintain construction schedules.

15 D. Control the amount of points and closing costs offered purchasers. Sales and Marketing Expenses This classification includes: internal sales and marketing salaries and commissions, sales office expenses, model home maintenance, coop commissions, and advertising and sales promotions. Builders typically have a hard time controlling their marketing expenses. The area typically causing problems are advertising and promotion, internal sales commissions structure, and model home expenses. A. Monitor the effectiveness of your advertising and promotion program. B. Develop target advertising and promotion programs. C. Establish a public relations program to obtain editorials which are more effective than advertising and less costly. D. Balance the number of model homes with the number of lots in the subdivision, and make sure the homes modeled are high gross profit producers. Builders frequently have too many models. E. Decorate models to sell houses not win awards. F. Develop a variable referral program with specific objectives of what percentage of your sales will come from referral. General and Administrative Expenses Included in this expenses classification are: owners, officers, and office personnel salaries; office expenses; computer and office equipment; vehicles; travel and entertainment; taxes; insurance; and professional services. Generally, when this classification exceeds the target of 4.5% it is a signal of over staffing, departmentalization and layering of management. Small builders will have greater General and Administrative Expenses because they need to cover their salary and basic operating expenses with low dollar volumes of sales. SUMMARY A. Watch the staffing levels for clerical and middle management. During periods of sales growth it is very easy to add staff. B. Instead of adding requested additional staff, analyze your management systems to make sure they are efficient and effective. C. Analyze your information systems, your approval processes, workloads, and number of handoffs. D. Make sure your company does not become top heavy. Invest in systems before hiring more staff. During the next several months as you analyze last year s financial statement and ask "Where did my profits go?", do not just look at the external forces impacting your

16 company. Analyze your internal operation, how you are pricing your homes, the direct construction costs that can be eliminated, the staffing of your production operation, the way you are spending your advertising and marketing dollars, and your staffing levels in the office. Normally there are a lot of profit dollars laying around internally in the homebuilding company. All we need to do is to look for the dollars and take action. Good Luck!