Arizona Homebuilder

The Three Components of Profitability

By Mike Rudd

In today’s homebuilding/construction environment, market conditions are forcing business owners of every size to take stock of their businesses and assess key employees’ contributions and expense, marketing and sales effectiveness, changing customer demographics and credit restrictions, financial stability of subcontractors, and critical bank and supplier credit relationships. The decisions made from this assessment in regard to these and many other factors will determine the ultimate survival and profitability of the company.

Regardless of the strategic direction taken to mitigate the economic and market conditions, the end result must generate a profit. Profitability is not dependent on any single factor; it is determined by the continuous interplay between revenue, operations, overhead, and measured by a correctly designed accounting system.

More specifically, determining a profitable price point for a spec home or establishing a competitive bid for a custom project requires an understanding of all the costs of acquisition, development, construction and carrying cost. The above, combined with the ability to correctly calculate and apply overhead and utilize breakeven, will assure a full understanding of all costs, establish a profitable selling price and minimize the risk involved.

Further, profitable operations depend on motivated employees who take ownership of their work. However, since employees make seemingly small decisions every day that can have a substantial impact on the builder’s financial health, business owners must ask regularly, "What do I need to know?" and "When do I need to know it?

Starting Point: A Correctly Designed Chart of Accounts

The accounting function is fashioned around the previous two questions. Relevant, timely and accurate information is represented in the Chart of Accounts, which serves as a road map of operations. The chart begins with revenue and breaks it down into specific project; spec, custom, re-model, etc., and should include change orders and custom services. The gives builders the ability to track sales efforts and assure they are expended in the most profitable sales.

Second is Cost of Good Sold (COGS), which rises and falls with revenue. It can include in-house labor by function subcontractors, permits, materials, office rental, temporary utilities, equipment rental, sales commissions, etc. Third is indirect overhead. These are costs associated with the building projects and services that must be allocated across all revenue activities, such as sales and marketing wages, showroom and marketing expense, model expense, equipment repair, fuel and consumable supplies.

Fourth is General and Administrative (G&A). These are overhead items that occur with or without building activity. They include bank fees, interest, lease expense, contributions, depreciation expense and office expenses. A properly designed Chart of Accounts using reports expressed in percentages and dollars to measure results enables the builder to quickly identify any areas that are not performing up to stands and to allocate overheard correctly in the pricing process.

Establishing a pre-determined profit requires careful analysis of the company’s revenue streams, COGS and overhead expense. These numbers form the basis for a financial roadmap that dictates direction and pace with benchmarks to be followed. With profit budgeted into the process, the business owner can make continual and incremental adjustments to operations and track profitability.

Profitable Work or Just Busywork?

Customers who demand difficult project schedules or unreasonable pricing structures, or embarking on a project to "cover some overhead" consumes capacity, limiting the ability to work on projects for customers who are willing to pay a fair price for quality and service. Accepting marginal or unprofitable projects simply for revenue’s sake strains not only capacity but working capital as well, thereby creating a cash flow shortage. Eventually, the company is compelled to extend vendor payments, increase its line of credit or secure expensive bridge loans. With building capacity tied up in unprofitable projects, there is no opportunity to take on profitable ones. The company literally "grows itself out of business" in an ever- increasing downward spiral.

The solution is to understand the project’s true cost, accurately apply overhead and establish a profitable price point or bid and motivate salespeople to sell profitable projects through a compensation program that pays higher commissions for sales with the healthiest gross margin while providing little or no reward for sales that do no meet certain minimum standards.

Holding employees accountable is often an elusive endeavor. First, all employees need to clearly understand exactly what is expected of them and when. In addition, profit-based incentives applied to the factors that employees can control are the best way to ensure that profitable activities are carried out. Simplicity is the key. When all employees clearly understand how and why their actions and those of others around them have a direct positive or negative effect on their bonus pay, they become more accountable. Shared responsibility is the motto.

Second, the shared reward is dispersed based upon each employee’s position within the company (e.g., a manager with 10 years’ tenure takes a larger share than a six-month worker). Finally, incentives, measured both positive and negative, should be paid frequently enough to maintain morale yet not so frequently as to cause undue administrative strain. However, if incentives extend too far into the future, the excitement and momentum wear off.

Simple Secrets of Success

When business owners have a game plan and controls in place that tell them what they need to know when they need to know it, they can change the course as needed without interrupting the forward momentum. The pieces of a winning game are a clear understanding of the difference between profitable and unprofitable projects, a correctly designed accounting system, clearly defined work performance requirements, and employees who are motivated to take ownership of their work. That’s the way to fulfill promises to customers and propel the business to a whole new level of success.

Mike Rudd is a Project Manager for IPA and IBA. IPA and its related companies provide comprehensive business consulting services and business valuation services to companies in the U.S. and Canada. He can be reached at (847) 495-6786 or www.ipa-iba.com.