Scenario: Times were good for Barry Builder Homes. Sales were at an all-time high, with four houses under construction, three more houses under contract, and strong leads for three more. At his current level of production, Barry wouldn’t be able to complete the houses he had committed to for the year ahead. Yet last week, when Barry reviewed his latest quarterly report, he was astonished to see that his gross profit margin had plunged from 22% to 15%, and his net profit had dropped from 8% to 5%. At this rate, he’d make the same amount of money he made last year, and he was working a lot harder. What was going on?
Solution: Just because sales are up, demand is high, and prices are rising doesn’t mean that profits are following suit. Profits are based on dollar volume multiplied by profit margin, and if the profit margin falls, you’re working harder for less money.
Some of this is beyond Barry’s control. His costs for engineered lumber and OSB had nearly doubled over the past year. All his contracts were for a fixed price, and Barry had to absorb the additional costs. Normally there was less lag time between contract and completion, but the increased workload plus the limited availability of good subcontractors had pushed lag time beyond the safety margin.
The shortage of subcontractors also pushed up the cost of labor. Subcontractors had to pay their employees more to ensure their loyalty. And the subcontractors felt that if the builders were making more money, they should make more, too. In addition, subcontractor scheduling delays had added additional overhead and construction financing costs.
Barry wasn’t just a victim of circumstances, however; he had a hand in causing his problems. Buoyed by the prospect of increased sales, he’d raised the salary of his office manager by $5,000 and had promised his superintendents an additional bonus. He’d purchased the new truck he’d been putting off for the past few years, bought a new computer system, and redecorated the sales office.
One of the most troubling circumstances for Barry is the effect of fixed-price contracts that get pushed further and further into the future. It’s hard enough to predict costs six months ahead, but beyond that puts too much risk on the builder. When a builder gets that far out into the future, he should consider adding a material-cost escalation clause to the contract based on current price estimates. If prices go up (or down), he can adjust the contract price accordingly. This allows the builder to spread the risk for cost escalations that are beyond his control while still offering a fixed-price contract for the work. Some buyers might resist, but when a builder has more work than he can handle, it’s one way to weed out marginal purchasers.
In addition to keeping his own eyes on the bottom line, Barry needs to keep his employees’ eyes on it as well. He should base salary and bonus escalations on profits, not on sales volume. Not only does this protect the builder, but it focuses the attention of all employees where it belongs—on the company’s financial success. If they are tied into a profit-based bonus system, they may actually resist overhead expenditures that could reduce those profits.
During good times, builders should be careful about taking on more work than they can handle. Not only does this increase their risk of increased delays and overhead, but it can lead to employee burnout from the increased workload. Employees who have more work than they can reasonably handle are more apt to make expensive mistakes and are less likely to catch their mistakes when they are made.
It’s a common fallacy to think that a rising tide lifts all boats. If the boat has a leak, then it’s sinking whether the tide is going in or out. During good times, builders need to be especially careful that they don’t become lackadaisical about profits. What might be a bad habit when the market is strong can be fatal when it turns south. In good times or in bad times, profit margins should be monitored religiously and protected vigorously. It’s great to make hay while the sun shines—but don’t get sunburned while you’re at it.
Al Trellis, a co-founder of Home Builders Network, has more than 25 years of experience as a custom builder, speaker, and consultant. He can be reached at altrellis @hbnnet.com.
