Financial Management - Part 3

In Financial Management - Part 1, we discussed the importance of setting up a solid accounting system to accurately measure what has happened in the past so we can make better decisions for the future.

In Financial Management - Part 2, we discussed the importance of:

• Long-term financial planning
• Setting business and personal goals
• Putting the above into a simple action plan
• Mark-up versus margin
• Time value of money

We also introduced Chris Smith, a 45-year old custom builder who has been in business for six years. Chris is looking for better — and less stressful — ways to be more successful and is convinced that careful planning is the way to achieve this goal. Chris has been taking classes from the local Home Builders Association. He has received guidance from a Certified Financial Planner (CFP), and Katherine, a financial and business management consultant.

Chris wrote out several personal and business goals and met with Katherine to review them. Chris's personal goals were as follows:

• Work fewer hours
• Take two full weeks of vacation
• Spend more time learning about personal and financial management
• Prepare a month by month personal budget

Chris and Katherine spent the remainder of the day creating a solid plan of attack for the future.

Chris walked Katherine through a typical day and it was apparent that Chris needed to overhaul his time management skills. Chris wasn't using any type of formal time management system nor did he have any formal organizing system. Chris typically kept track of to-do's, phone messages and appointments on scraps of paper.

The first thing Chris and Katherine decided is that Chris would take two classes within the next two months. The first was a time management class that cost less than $300 and the second was an e-mail system class taught at a local community college two nights a week for three weeks which also cost less than $300.

In the mean time, Chris was going to purchase a legal pad, calendar and phone message pad (with duplicate forms) from an office supply store and utilize them for the time being. Just getting more organized would probably knock off five to 10 hours per week of work. For tips on organizing work space, e-mails and phone calls, see the sidebars on pages 54, 58 and 60.

Chris had already picked out two weeks for vacation. Katherine had two pieces of advice. She said, "First, book all the travel arrangements now. If you spend the money ahead of time, you'll be less likely to back out of the trip later. Second, schedule meetings with your staff and key trades for the two days prior to your trip to let them know you won't be available and give them clear direction for the week you're gone. Make those meetings happen no matter what!"

Katherine told Chris she felt that blocking out two hours per week was impractical and probably wouldn't happen. The only way to successfully continue learning about financial management was to incorporate it into daily and weekly routines.

At Katherine's suggestion, Chris ordered two books on CD, The Millionaire Next Door by Thomas J. Stanley and William D. Danko, and Rich Dad, Poor Dad by Robert T. Kiyosaki and Sharon L. Lechter. Chris planned to listen to these books to and from job sites instead of making the harried phone calls that would probably cause an accident some day.

Katherine also suggested subscribing to some type of personal financial magazine and reading one article at the same time, every other day. "Small steps over a long period of time are always better than cramming a lot of information in short bursts," she said.

Katherine suggested that Chris spend this year concentrating on tracking where the Smith family spends their money. Chris was becoming better with the company's accounting system and decided to set up the Smith family accounting using the same program with Katherine's help. Katherine moved on to how she felt they should set up Chris's company budget.

Developing an operating budget can be a time-consuming process, but well worth the effort. An operating budget is one of the key elements in the planning process. It provides a builder with a basis for determining the appropriate mark-up percentage as well as targeting the amount of gross profit needed in the upcoming year to cover overhead and provide for a reasonable profit.

To really make the best of an operating budget it's important to not only look at sales revenues and expenses for the year, but also to identify estimated sales revenues and operating expenses on a month-by-month basis. This will make it easier to analyze financial results compared to budget and will make cash flow forecast analysis much easier as well.

It's important to obtain an understanding of your current business and what it will look like in the year ahead before you develop your operating budget. Take a look at both the internal and external factors that have an effect on your business. Look at the jobs you sold and produced. What type of work provided the greatest gross profit? Were you more successful in a particular part of town or subdivision? Was there a particular customer profile that was easier to work with? Is this a year that would be safe to build a spec home or two or would that be too risky?

Take time to also examine your internal resources and systems. Are you getting the most out of your systems and people? Review your successes and failures during the previous years and make sure you plan to capitalize on successes and take corrective action to avoid future problems.

Before detailing your operating expenses, set some basic goals on the number of homes and/or dollar volume you would like to produce in the year ahead. Establish a target net profit you would like to make for your company. Net profit should be after paying yourself a "reasonable" salary for the work you perform for the company. Strive for a net profit between 7.5 to 10% of anticipated sales volume. Be realistic when it comes to increasing closings or sales revenue significantly in one year. It's very unlikely that you will be able to successfully increase revenues from $2,000,000 to $20,000,000 or increase net margins from 2 % to 13% percent in one year. Setting unrealistic goals will only lead to disappointment.

The best way to start your budget is to review your current year's activity on a month-by-month basis. Identify fixed expenses (those that won't change with volume) and plan for possible increases. Examine variable expenses (expenses that will vary with changes in volume) and link these expenses to your targeted sales goals.

It's easiest to budget by building one giant income statement on a month by month basis projecting sales revenues and direct costs. Then use the four main income statement categories — indirect costs, sales and marketing, finance and general and administrative expenses to develop the expense part of the operating budget. Using the NAHB Chart of accounts is the easiest way to budget. Industry experts added just about every expense category possible for the industry and made it easy to develop a budget. See the sidebar on page 52 for an idea of what part of an operating budget might look like. Because operating budgets are quite detailed, we're unable to show an entire operating budget.

Following are some general tips on budgeting and tips for costs in each of the four main income statement categories.

Some of the main indirect costs include:

• Superintendent compensation
• Production manager compensation
• Estimators compensation
• Purchasing compensation
• Design & selection coordinator compensation
• Warranty expense
• Warranty personnel compensation
• Field office/storage expense
• Construction vehicles
• Depreciation-field equipment
• Other indirect expense

It's easiest to budget for your superintendents, assistant superintendents, production managers, estimators, purchasers, design and selection coordinators and warranty personnel as an overhead cost. If they are paid a salary, their costs will be the same no matter if you build 10 or 12 homes. Don't forget to include the related burden — payroll taxes, workers comp, health insurance and other payroll-related benefits given to your supervisory personnel.

Identify the gross wages and related taxes in the actual month they will be made (for example, for weekly payrolls you will have some months with 4 weeks and some with 5 weeks). For payroll taxes, budget for the time when your people go over the tax limits (for example, federal unemployment taxes are only paid on the first $8,000 of wages).

Some of the main sales and marketing expenses include:

• In house sales commissions
• Sales manager compensation
• Outside sales commissions
• Advertising expense
• Model home expense
• Buyers concessions
• Depreciation
• Other sales & marketing expenses

It's also easiest to budget sales compensation as an expense. Budget your house sales compensation for the same months that you have projected home closings. If you intend to pay split commissions, budget half at the point of sale and the other half at closing for example.

If you use model homes to sell, challenge how many homes are really necessary to meet your desired sales volume. Also, constantly challenge buyers' concessions. If you're meeting or exceeding your sales goals, why continue to offer them?

Review the results of your marketing activities during the past year. How many leads and sales did you get from newspaper advertisements? Did most of your leads come from referrals or from architects? Develop a marketing plan, which targets the activities you plan to pursue next year. Attempt to identify the month you expect to incur the cost. For example, if you plan to participate in a parade of homes budget for the registration fee in the month it is due and the out of pocket costs for the parade when you expect to pay them.

Some of the main finance expenses include:

• Interim interest
• Interest on finished inventory
• Interest on notes and mortgages
• Construction loans - points and fees

It's important to separate your finance expenses. Too many builders lump all costs into one catchall category. When you separate out the different types of points, fees, and interest, you'll be able to compare them to industry benchmarks.

Make sure to budget for interest carry on any finished spec inventory. It's easy to miss the true costs of standing inventory.

Some of the main general and administrative expenses include:

• Owner compensation
• Accounting and office compensation
• Profit sharing & bonuses
• Office rent and utilities
• Insurance
• Permits, licenses, and fees
• Vehicle expenses
• Personal property and real estate taxes
• Professional services
• Communications
• General office expense
• Computer expense
• Education, training, and travel
• Entertainment
• Dues and subscriptions
• Office depreciation
• Other G&A expense

Most of the above categories are self-explanatory. Challenge insurance rates. Make sure you read the fine print on the quotes or have someone else read the fine print for you. The best time to shop for insurance is when you don't need it.

Challenge communication expenses often. Phone plans change frequently and you need to make sure the business takes advantage of the best offers. Try to rotate hardware replacement for computers and servers so you don't have to replace all your hardware in the same year. Make sure that all software licenses are up to date.

After you have taken a first cut through your operating budget, sit back and examine the overall numbers. Add your targeted net profit to your operating expenses to determine the amount of gross profit you need for the year. Once you know the dollars of gross profit needed you can determine the mark-up you need to reach your goals.

For example, suppose you expect to produce five homes this year with an average sales price of $300,000 for total anticipated sales of $1,500,000. If you are looking to achieve a 10% net return, your targeted net income is $150,000. If your overhead for the year totaled $300,000 you will need $450,000 of gross profit (sales less direct construction costs — all costs not accounted for in your operating budget) to hit your goal.

To determine the markup you need, determine your targeted cost of sales by subtracting your target gross profit ($450,000) from your anticipated sales ($1,500,000). In this example, cost of sales would be $1,050,000. To determine your markup, divide sales by cost of sales ($1,500,000/$1,050,000), which totals a mark-up of 1.42.

If you see that the markup you must achieve to meet your goals is unreasonably high, it's time to go back and challenge your operating expenses. Have you built in capacity, which will be able to handle more volume? Will the market allow you to sell more than the five homes in your original plan? Make the necessary changes in your budget so that you can realistically meet your net income goal.

Evaluate your existing personnel. Do you have the right people in the right jobs? Will you need any more people either in the office or in the field to handle growth plans for the new year?

Challenge your benefit package. You may be offering some benefits (disability and life insurance, for example) that your employees really don't care about. If adding new people, make sure to budget for added health, workers compensation and other insurance benefits. You should also provide for increases in your insurance premiums when they renew.

In the next article, we'll review Chris and Katherine came to some of the final business decisions for the upcoming year.