In my last article I introduced several financial reports that custom builders should be using to manage their companies. Armed with an operating budget and a system to collect timely and accurate data, the nine-column income statement, which can be produced by most accounting systems, is one of the reports that should be regularly reviewed.
The income statement (also referred to as a statement of earnings or profit and loss) is a summary of the revenue, expenses, and net income or loss of a custom builder’s operation for a specific period of time: a month, quarter, or year. Net income or loss for the period becomes part of the balance sheet by increasing (income) or decreasing (loss) the owner’s capital. Your income statement should compare your actual results with your budget as well as monitor the percentage relationships that the various expense categories have to revenue.
In addition, the income statement should include both a summary and detail report. The summary report highlights the major revenue and expense categories. The upper part of the income statement should include revenue from building activity, costs related to building activity, and gross profit (sales less cost of sales). The bottom portion of the income statement should reflect the major operating expense categories: indirect construction costs, sales and marketing, financing, and general and administrative expenses.
The detailed report should provide further detail into the main revenue and expense categories and include all accounts within the company’s chart of accounts. It will break out revenue and costs of sales by type of work performed (i.e., custom home on the buyer’s lot, custom home on the builder’s lot, spec home, and remodeling). In order to manage and not just watch the company’s profitability from construction activities I recommend that custom and small-volume builders use the percentage-of-completion method of accounting.
Proper analysis of the nine-column income statement will assist a custom builder in evaluating and managing the overall profitability of his business and identify areas of concern. A builder who manages instead of just watching compares the results to plan and has systems in place to take corrective action when variances occur.
Following is an analysis of Sample Custom Builders’ income statement for the five months ended May 31, 2007, highlighting areas of concern and suggesting possible corrective action items. The budgeted percentage of sales represents targets that I recommend as benchmarks for a custom building operation:
Looking at the top line (revenue) it appears as though Sample Custom Builders has had a strong month (recognized under the percentage-of-completion method of accounting), exceeding revenue by $200,000. However, net income from operations for the month are under budget. Looking further we notice that gross profit dollars were $4,500 under budget as a result of lower-than-planned gross profit.
For the month, Sample Custom Builders’ margins are 4% lower than planned and 3% less than the year-to-date budget. In order to get a handle on why margins (a.k.a. gross profit) are decreasing it is necessary to dig deeper into the company’s work-in-process report, which provides the detail behind the revenue and cost of sales shown on the income statement. In reviewing this report Sample Custom Builders noticed that margins for the Smith job (which was completed during the month) were only 10% for the month. When this job was estimated, Sample Custom Builders targeted a margin of 22% but throughout the job margins slipped until the job ended with a gross profit of 16%. The difference between the 10% margin for the month and the final 16% margin relates to the fact that through April the company recognized 80% of the revenue on the job at the target margin of 22%. When the job closed out in May at a 16% margin, the company had to reduce the margin recognized in previous months during the month of May.
A perceptive builder will dig deeper into the reasons why the margins on the Smith job slipped, asking three key questions: What did not go according to plan? Why didn’t it go according to plan? What can be done so this variance does not occur on future jobs? For the answers, the builder needs to review detail job cost reports that compare the budget to actual results broken down by detail cost codes (activities).
This report reveals that the costs of framing exceeded budget by 35%. To see why this occurred, the builder analyzed a detail job-cost report that included all of the activity posted to this account. Sample’s owner noticed this job used much more framing lumber than estimated. He also saw that framing labor exceeded budget. His next question: What caused the lumber overage? The answer provided the focus for his third and most important question: What can be done to minimize future variances?
