After years of poring over builders’ numbers, I have developed a series of benchmarks that custom builders can use to measure their success. Because operations vary among builders, your numbers may differ from benchmarks within individual categories, but when it comes to the bottom line I strongly believe that all custom builders should be striving for net profit from operations of at least 10%. These are the benchmarks I believe will help you achieve that.
Gross Profit Benchmark: 21% to 23%. For custom home builders, gross profit is defined as sales less direct construction costs (commonly considered “sticks and bricks”). For homes built on a cost-plus basis I recommend including more than sticks and bricks in costs billed to the customer. However, for benchmarking purposes use only direct construction costs to compute your gross profit.
Custom builders who use outside salespeople to sell their spec homes and/or carry the construction loans for their customers need to obtain a gross profit closer to 25% in order to cover these added costs. Over the years I have seen custom builders who work in the same marketplace report gross profits that range from single digits to over 30%. The characteristics that distinguish the builders with high gross profits: They are not afraid to ask for margin, and they have systems in place to control job cost variances.
As markets get tighter many builders have the tendency to ask for less margin than they need and deserve and often cut their gross profit targets. Strong custom builders do not cut their margins in lean times. They sharpen their sales skills and sell the benefits of their company. A builder who cuts margins has to produce more volume in order to hit net profit targets. A builder who is doing $4 million in volume at a gross profit of 22% would have to produce $5 million in volume at a gross profit of 16% in order to make the same $800,000 in gross profit.
Operating Expenses Benchmark: 11% to 13%. In order to achieve 10% net profit from operations, a custom building company that produces gross margins in the range of 21% to 23% must keep its operating expenses between 11% and 13%. Total operating expenses will increase for custom builders who build and sell spec homes, have their homes sold by salespeople other than the owner, or carry construction loans for their customers.
Operating expenses include four major components with the following benchmarks:
- Indirect construction expenses: 3% to 4%. For management and benchmarking purposes, costs relating to construction but not identified to a specific home are reported as indirect construction costs. These costs include construction supervision (2% to 3%), warranty and service (.25% to .50%), and other indirect costs (.50% to 1%). Construction supervision should include the total compensation of your superintendents and project managers even if the superintendent is working on a single home. Since most custom builders do not have separate in-house personnel to handle warranty and service costs this category should include expenses paid for warranty material and trade contractor costs. Other indirect costs include compensation for estimating, purchasing, and design team members. Custom builders with an in-house design team may have slightly higher benchmarks in this area.
- Sales and marketing expenses: 2% to 3%. The largest component of sales expenses within a custom building company is advertising and marketing, which should range between 1% and 2%. Included in this amount is maintenance of the company’s Web site. If all sales are made by the owner, a custom builder can maintain its sales and marketing expenses below 2%. For builders with inside sales agents or for those who pay fees to outside agents, this line item should be increased to include sales expenses of 2.5% to 3%.
For spec homes, it can be beneficial to look at a benchmark representing contribution margin. At my firm, we define contribution margin to be gross margin less commissions and concessions. A good benchmark for contribution margin for spec home sales is in the range of 20% to 22%.
- Financing expenses: 1%. Since custom builders typically get paid as they build the home, the company should be able to operate on customer draws with financing expenses only including interest on notes for fixed assets or on a working capital line of credit, keeping their financing expenses below 1%. For custom builders who build spec homes or maintain construction loans for their customers, for management and benchmarking purposes we recommend looking at interest as an operating expense not a direct construction cost. Financing expenses should include interest during the construction period (interim interest) as well as interest on finished inventory (interest carry from completion to sale of a spec home). Interest on lots held for construction should not be included as financing expense. Until construction on the home begins the interest carry on the lot should be included as part of the cost basis of the lot. Financing expenses should increase to between 2% and 3% for custom builders carrying construction loans.
- General and administrative expenses: 5%. The largest component of general and administrative expenses is the owner(s) compensation and the company’s financial and administrative personnel, which should range from 3 to 3.5%.
As we navigate through 2008 I challenge all of my readers to strive toward hitting the benchmark for net profit of operations of 10% or better. In future articles I will share strategies to achieve these target margins even in a slow market.
Steve Maltzman, CPA, is president of SMA Consulting in Redlands, Calif.My firm has developed a card that highlights suggested benchmarks to remind builders of their financial goals. If you would like a financial benchmarking card, please e-mail me at smaltzman@smaconsulting.net.
