Purchasing Power Plays

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A war is brewing, and you could get caught in the middle of it.

July 01, 2002

 

At Village Homes of Colorado, Scott Sinelli and Cheryl Schuette are unsure whether Denver’s sixth-largest builder should follow that market into large-scale turnkey operations.

A war is brewing, and you could get caught in the middle of it. The good news is there’s not just danger here but opportunity as well.

Volume-based discounts on locally purchased materials and labor and national buying programs with major product manufacturers are centerpieces of the operations model for the publicly traded national home builders, who believe that squeezing costs out of their mass-production processes creates the competitive advantage that fuels the growth Wall Street demands.

Growing larger — and seemingly more belligerent — each day, the behemoths are agitated over turnkey purchasing practices, especially in the West, that give their trade contractors purchasing authority over the materials they use and products they install. The trades submit bids for each builder’s work in a package that combines materials and labor. The builder never sees those costs separated.

In California, 90% or more of a house’s hard costs, including lumber and framing labor, are now packaged in turnkey bids. The big guys are never happy when cost control is out of their hands, especially when direct costs are spiraling up at an alarming rate in the hot housing markets of California, Arizona and Nevada. They’re about to do something about it.

Alan Laing, vice president of e-business at Pulte Homes: “Going forward, the concept of manufacturer-direct purchasing and separation of labor from materials will be a centerpiece of our strategy for supply chain management. We will buy our materials separate from labor, and we’ll try to buy from a manufacturer whenever possible.”

Mark Hodges, K. Hovnanian vice president of operations: “There’s a real sea change in the industry as the large national firms move away from project-by-project bidding toward more unit-based pricing methodologies. Our strategic planning committee just ratified our companywide commitment to unit-price-based costing. We aren’t necessarily going away from turnkey operations. We just have to know exactly what we’re paying for materials and labor individually. If it makes sense to buy through the trades, that’s fine. But it’s absolutely critical that we get unit pricing and also move to just-in-time delivery of materials.”

Paul Dodge, Centex vice president of purchasing and distribution: “This is very significant. We have to manage our costs. There are double-digit advantages that can accrue from sharing cost information on the 25,000 homes we build each year all across the country. How we buy is completely separate from knowing cost. There’s more than one way to skin a cat, and this is not going to happen overnight. But more of our business will go to those trades who share that information.”

Smaller Is Better?

For smaller builders, watching such massive firms gobble up land and market share is enough to trigger sweaty palms and heart palpitations. The prospect of national Giants’ muscling trades to dismantle current labor practices in their markets might add a case of hives. Life is never simple in a war zone. But it can be brimming with opportunity.

“The trouble with the big public builders is that they really make their money by developing land, not by building houses efficiently,” grouses Colorado-based management consultant Chuck Shinn, president of the Lee Evans Group. “There’s a 10% to 15% savings there for anybody who can separate materials and labor, and you don’t have to be a national to do it.”

Shinn says turnkey operations are much more common among big builders than small ones. “Most small builders buy materials and labor separately. Only mechanical trades are turnkey in the Midwest, South and Northeast. Builders there have relationships with the local lumberyard and other distributors. The price they pay may be closer to retail, but at least they know what it is. They do a lot of customization and need the ability to price those custom changes fast. Unit pricing in a database can give them that flexibility. All that most small builders need to do is develop a database. We’re trying to bring our clients together to share that information from around the country.

“Turnkey operations are moving east from California, where they originated because that market is willing to pay for the builders’ sloppiness on costs,” Shinn says. “They can sell anything they can get built, at ridiculously high margins, so they just say, ‘What the hell, we’ll turnkey it.’ They spend their time looking for land and entitlements instead of managing costs.”

The movement of turnkey across the country from the West is not good news, Shinn says. “Phoenix, Las Vegas and Denver are now mostly turnkey, and it’s no coincidence those markets are dominated by big builders. Chicago is about 50-50. It will not be a good thing if this becomes a national trend. It’s 10% to 15% that’s automatically added to hard cost. The trade puts a markup on the materials, and most of the trade’s cost is tied up in how fast crews can get in and out of a job site. So trades, especially framers, waste materials to move faster. You wind up burying those variances where you can’t see them anymore. We broke up materials and labor for a client in Florida and saved 15% immediately.”

If a small builder achieves savings like that while everyone else is accepting turnkey purchasing and prices, it might grow into a big builder pretty fast.

Paul Dodge, Centex vice president of purchasing and distribution, sees “double-digit advantages” in sharing cost information.

Art’s Answer

Former PB Builder of the Year Art Rutenberg, who co-founded U.S. Home Corp. in the early 1970s, operates his Clearwater, Fla.-based franchise network of small builders on the very unit-pricing basis the national builders now seek so desperately.

“There’s different pieces here,” the 75-year-old housing legend says. “The national builders buy a few things direct, but not much. So do we. Their centralized purchasing departments arrange rebates and model home discounts for the local divisions. We’ve done the same thing for our 28 local franchise holders. What we do that helps our franchises most is provide line-item purchasing and computerized cost comparisons across our full network of builders for all 80 house plans we build. There’s more money in that, by far, than in any of the national purchasing stuff.”

Combined, the Arthur Rutenberg Homes network builds 650 luxury detached homes a year for about $275 million in revenue. That’s enough volume to get the attention of national manufacturers. Around Florida, the franchise holders cross swords with Giants such as Lennar and Toll Brothers but compete mostly with small, independent custom builders. “We give our franchisees software tools that allow them to see the costs every other franchise pays for the same items, in very convenient ways,” Rutenberg says. “Nobody has the time to do line-item comparisons for every house you build if it isn’t automated. On drywall, for instance, we get a price per board, not per house. Even on electrical, where we have to bid the whole house, we bid the absolute base house and then have line items for every conceivable option and upgrade.

“If it’s highly automated, line-item purchasing is less work. Without it, if you sell a house five times and customize it each time, you have to give the electrician five sets of plans and bid each one separately. We bid it once — the standard plan — then give the electrician automated reports that give him just the changes. Since he’s probably seen most of them before, he’ll already have prices for much of it. What normally takes him two hours to bid he does in 10 minutes.”

Sales Job

How does Rutenberg sell the trades on his approach?

“We have to do a lot of explaining to get them to be open-minded,” he says. “But when they find out how much less time they have to spend in bidding and administration, they come around.”

Information is a powerful tool for the trades as well as the builder. Unit pricing allows the builder and trades to work together in true partnering relationships to build efficiency into processes.

“We darn near have to teach our trades how to work with us,” Rutenberg says. “But the ones who master it stay with us because they know we don’t mind that they make money, and they know we don’t want to churn trades. We can say to the trade, ‘Here’s $228,000 worth of work, broken down by every line item we’re going to buy.’ We show his bid price on the left and our target on the right. Where the target is lower, the trade knows the target is realistic because it’s based on real costs in other Florida markets. We only ask for a lower price when we’re getting it somewhere else. And if there’s a best practice involved, we share that with the trade.

“Toyota has a saying that the first price they pay a supplier is the highest they will ever pay. From that point on, they are working together with that supplier to bring those costs down. That’s the premise we’re operating on. Partnering is a word that’s been thrown around our industry for a decade. But this kind of information can make it a reality.”

The Personal Touch

This approach plays to another strength that local builders, large and small, have throughout the country: personal relationships. That’s one the national builders have a hard time matching, and the bigger they get, the more trouble they have.

Northern California builder Keith Christopherson will close 270 detached homes this year in markets north of San Francisco and a fledgling operation in Sacramento, where he competes with national public builders in first and second move-up product lines. Christopherson Homes is exactly the size national builders describe as an endangered species, one that cannot compete with their buying power.

Asked to calculate the impact of the nationals’ purchasing advantage, Christopherson says it’s “about 5%” but also offers that it doesn’t scare him.

“Except for appliances, carpeting and cabinets, it’s still a local business,” he says. “And when we talk to the vendors, especially trades, about dealing with the nationals, they tell us they get jerked around on their pay a lot, and they don’t have any relationship with the builder at all outside the business. That’s a weakness we can exploit.”

Christopherson Homes throws a catered party every year for all its vendors, complete with a live band, and celebrates every model opening with a catered barbecue for everyone who works on the project. “We also have a group of trade contractors serve on what we call the trade advisory group that looks at problems and opportunities to improve operations from every angle,” Christopherson says. “We have a catered lunch for them once a month.”

Aside from keeping caterers busy, these events build personal relationships and give Christopherson a look at the national builders from the trades’ perspective. “Trades will talk to them because they have that volume, but they don’t trust them to build their companies around that business,” he says. “The fixation on the bottom line scares them. They fear a lower price could take the work away instantly. Continuity is also a problem. The turnover in public companies destroys any chance to build lasting personal relationships.”

Despite all the publicity public builders garner with their national purchasing and supply chain initiatives, Christopherson says trade relations remain the critical element in the cost/value equation for his products. “We are all turnkey, and we don’t even ask what the trades pay for materials. We know when the market’s hot they will try to raise prices, just as we do. What we measure very closely are quality and service. We know we can make more by cutting two weeks out of cycle time than by cutting a few bucks out of direct costs. Asking trades what they pay for materials is like a customer asking us what we pay for cabinets.”

Randy Moylan, director of construction at Gibraltar Homes, says personal relationships are a small builder’s best defense against big builders’ purchasing power.

Big Trades One reason turnkey purchasing is so prevalent in California is that in many cases power resides on the side of the trades. Many trades in that state are huge, larger than even the biggest California builders. It will be difficult for even the national builders to wrest that control away. “The trades we use are much bigger than us,” says Olson Co. principal Mark Buckland, who isn’t necessarily betting against the nationals in a showdown over splitting materials and labor costs. “As long as the market is hot it will be hard for them, but volume does create leverage. When we have a lot of units coming up in the next quarter, we see that suddenly the prices we’re quoted on turnkey jobs are better.”

Even outside the West, not every builder believes turnkey buying is a bad idea. In some cases, especially for small builders, turnkey makes sense because the trade contracting companies are larger and can get a better price for materials and products. “It can also lift the administrative burden and liability of materials ownership from a small builder,” Atlanta-based management consultant Mark Schickner says. “A small builder might have to add a person to the payroll to administer purchasing, schedule deliveries and prevent theft. If the trade doesn’t have responsibility for materials, how likely will it be to cut a small builder any slack if there’s a snafu in delivery or a shortage when the materials shipment arrives?”

Gibraltar Homes in Sarasota, Fla., fits the case Schickner describes. The firm will build 40 homes this year for $16 million in revenue. Most of its homes are highly customized. Gibraltar director of construction Randy Moylan often uses turnkey contracts to achieve better materials pricing. “We do both turnkey and unit pricing, but when we do turnkey we always know exactly what we’re paying for materials. If I can negotiate a contract that’s close to what I’d have to pay for the materials myself, I prefer to go turnkey.

“The trade can often get a better price. For example, on concrete, I may pour 40 homes a year, but my concrete trade contractor is pouring 200.”

Gibraltar buys framing lumber and trim materials direct. Drywall, cabinets and roofing are turnkey.

Moylan worked for a large national builder and learned to do unit pricing in that environment. Like so many others, he says personal relationships are a small builder’s best defense against that purchasing power. “When I have a close, personal relationship with a trade and we share information on costs, I have confidence in that person to do the buying if there’s a reason to go that way.”

Denver’s Dilemma

Village Homes of Colorado is No. 104 in PB’s current Giants rankings, on 541 closings for $175.2 million in 2001 revenue. It is the sixth-largest builder in Denver. Village is also well-known as an innovator in supply chain management, an original partner with Pulte Homes in U.S. Build’s Denver pilot program for direct purchase, shipment and delivery of some plumbing and HVAC products to several projects. Yet even Village is struggling with whether to follow the Denver market into large-scale turnkey operations.

“We’ve always bought materials and labor separately,” vice president of home building Cheryl Schuette says. “It’s only recently that we’ve gone to turnkey purchasing. We started doing turnkey foundations 18 months ago. But the bids are certainly higher than what we budgeted when we were buying direct.”

Part of that arises from Denver’s notoriously expansive soils — trade contractors must now shoulder the risk for what might turn up underground. “We’re paying for the trade’s insurance,” Schuette says.

“The bids were pretty shocking to us,” purchasing director Scott Sinelli says. “But when we look at it carefully, it’s not as far off target as we thought. Still, we have so much historic data from our buy-direct days that it’s hard for us to be as blissfully unaware as builders who don’t know what they’re paying for labor.”

Village tried one turnkey framing job with less-than-satisfactory results. “We’ve yet to decide to do it again,” Sinelli says. “If we can train our trades to use materials better, we believe we can buy lumber more efficiently direct.”

Still, Village must think about what buying direct will be like if the rest of Denver embraces turnkey. And the U.S. Build experiment did not work for Village, either. “We backed away from it,” Village principal John Osborn says. “Our experience was hurt by our insistence on doing custom changes. U.S. Build doesn’t want a lot of tinkering with specs once they are online.”

With U.S. Build out of the picture, Village plans to go back to growing its own intrusion into the supply chain. “We have our own supply company that does half its business with us, half with other builders,” Osborn explains. That initiative is now centered around lighting and hardware lines, and Village will try to add fireplace boxes and HVAC equipment.

Village also has an “extranet” Web site that allows trades to log on to get scheduling updates and check the status of invoices, very similar to the Web technologies now under development in public Giants such as KB, Pulte and K. Hovnanian.

Like Village, Pulte has its own in-house intrusions into the supply chain. “E-Schedule” is an online scheduling tool that ensures that materials deliveries match trades’ scheduling in Pulte’s buy-direct approach. It now operates in five cities, with plans to add seven cities each quarter for the next 15 months. When it’s in every city, Pulte will expand it into every trade by the end of the first quarter of 2003.

Super Science

Pulte also has its own supply company. “Our Pulte Home Sciences initiative in Detroit will be adding a second plant in Manassas [Va.] this year that will buy direct, then distribute and redistribute products for the shell of the home, like structural insulated panels, foundations and floor trusses,” Laing says. “This is a facilities-based production model that enables different purchasing transactions that are manufacturer-direct. We’re buying plywood from Weyerhaueser and becoming our own distributor.”

Laing says all the national builders have too much capital invested in supply chain initiatives to ignore vertical integration and direct participation. “We’ll get in the middle of the supply chain because we can and because what we do creates value. The Pulte Home Sciences facilities are a beginning for us. We’ll get into foundation systems, especially for basement markets, exterior walls and interior steel partitions, eventually roofing systems — probably not conventional trusses, but rather some kind of structural insulated panel-based system that allows us to get HVAC systems in air-conditioned space for better performance.”

Laing says he is confident Pulte will win its fight to uncouple materials and labor. “Resistance from trades used to be a big battle, but it’s declining now. The trouble is that every market is different. But we are now organizing by product rather than geography. Instead of working on cabinets in the West, we’re now working on cabinets everywhere. It may be that we’ll still use three different vendors, but terms, conditions and pricing will all be understood from one end of the country to the other.”

Already, Village Homes of Colorado sees the impact of Pulte’s purchasing advantage in lighting products. “We tried to sell to Pulte from our supply company,” Osborn says. “But they have a national contract and a relationship with a distributor in town. We can’t match the price they get.”

Ultimate Buying Advantage

Dallas builder Bill Darling says he’s finding it increasingly tough to compete with Lennar’s mass purchasing, which supports its “everything’s included” home prices. “We shake our heads at what they’re able to include in the base price,” he says. “They build a nice house and put a lot into it. If you’re willing to live in the plans they offer, without making a change, we can’t match them. They’re turning the heads of some people today that two years ago would not have taken no for an answer on a custom change.”

Despite his buying power disadvantage, Darling says Darling Homes would compete with the national builders just fine if not for the cash land buys they use to gobble up prime locations. “Cash land buys and high-velocity inventory turns are their real advantage,” he says. “None of the public builders separate land and house as separate profit centers. If they did, it might not be a pretty picture.”

In markets with strong local land developers, personal relationships with local landowners often trump even that high card. Duffy Homes in Columbus, Ohio, will build 75 detached homes and 40 to 45 townhouse condominiums for revenue of $50 million this year, up from $36 million last year and $28 million in 2000 — all in direct competition with Toll Brothers, and with M/I Schottenstein’s Showcase Homes division lurking just beneath Duffy’s $400,000 low-price threshold.

Duffy builds from 25 detached house plans but customizes extensively. “We’ll do anything,” president Vince Kohler says. “We put the emphasis on relationships, especially with trades. Toll can beat our price if you want a big Colonial box, but they don’t finish ’em like we do. We have a Mercedes product compared to Toll’s Cadillac.”

Price is not the critical factor in selection of trades. “It’s quality and craftsmanship,” Kohler says. But the real key to Duffy’s success is land. The firm is a subsidiary of The Edwards Cos. That powerful local empire of patriarch Pete Edwards includes Edwards Land, which has the clout — and more important, the contacts — to place Duffy in the locations it needs to compete successfully with two large public builders.

“We let the people judge,” Kohler says, “and I think they are.”

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