The Margin Gap: Beyond the Usual Suspects

Survivor was a severe case, but finding builders full of good people operating with no better than marginal processes is common. So what’s that got to do with profit margin? Plenty. The data from more than 100 lean process implementations in residential construction show that more than a third of the total cost of a home is burned up in waste. Half of that waste is literally built into the product up front from design through purchasing—virtually all a result of poor process. Once under construction, at least half of the remaining waste also is due to process, with scheduling being the greatest culprit. Do the math, and you will conclude that at least 25 percent of the cost of building a home is tied up in process waste, yet this detail rarely comes up in the conversation.

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RELATED: Part 1 in a two-part series. Read Part 2 here

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I recently visited a builder with a gross margin of 25 percent, fretting over his need to get to 27 percent. He talked about expensive lots, excessive fees, material shortages, and rising labor rates—all the usual suspects and variables over which he had little control. But when I brought up his 110-day build schedule, a pure process issue that he could control, I got no response. Getting that schedule down to 90 days would provide the missing 2 percent in a heartbeat, but he did not see it. Our friends at Survivor Homes? They were operating with a gross margin of merely 10 percent.

The Survivor senior team asked which margin level was considered healthy, but direct margin comparisons are tenuous at best. Despite numerous warnings, people focus immediately on the raw number, not on the six or eight footnotes that often go with it. This approach is hard enough at the gross margin level, which usually is defined as sales minus land, improvements, and direct construction costs. Consider design costs. Some builders capitalize them to the balance sheet; some expense them above the gross margin line as part of house costs, while still others let this cost fall below the line in overhead.

Never forget that hardly anyone counts—or accounts—for costs in the same manner. During my nine-year tenure as a corporate vice president at a national builder, we were continually vexed by 30 divisions in the same company, supposedly accounting for things in the same way and by the same rules. Instead we found different costs were being assigned inconsistently to different accounts, making comparisons frustrating, at best. Now examine different builders with a wide range of business models, different tax codes, and using different accounting systems. You’re comparing apples to rutabagas.

Then try to equate builders who develop their own land to those who buy finished lots. Are they showing land profit in their gross margin and, if so, might they be unusually high or low due to unique factors or to an internal policy such as defining lot cost as a predetermined, set percentage of sales price? How about impact fees that vary dramatically across different locations? Is there rental income? Are there land or lot sales in the top line? How about old legacy lots that drag down the real returns on current product? The list is long, but understand that despite the “NAHB Official Chart of Accounts” there are no hard and fast rules on exactly what constitutes gross margin in home building. If you think the solution is to compare pre-tax net, then we encounter a whole additional round of complications, such as how much does a builder pay its executives. We all love playing the comparison game, but be very careful.

Given those warnings, here are some descriptive gross margin performance targets, plus or minus a couple of percentage points in each category:

• Subsistence 5%

• Survivor 10%

• Marginal 15%

• Solid 20%

• Strong 25%

• Exceptional 30%

• Extreme 35%

Over the years, you will find a few in the 40 percent neighborhood. That level is typically the result of an astounding land position in a remarkable market. One exception was the builder with the most highly-developed systems and processes I have witnessed, in a hot market. Other builders with comparable processes in merely good markets achieve more in the 30 to 35 percent range. For Survivor Homes, however, a reasonable target for the next year was 20 percent.

Survivor Homes needed to double its margin but how? There ensued a discussion centered on the usual suspects. How did Survivor compare to the competition with stronger margins? Did the competitors buy land cheaper than Survivor? Land development said no. Were competitors’ finance rates from banks and investors lower? The chief financial officer answered no. Did competitors sell like-sized homes at higher prices than Survivor? Sales said absolutely not. Did Survivor pay more for labor and materials than their most successful competitors? The purchasing director said they were “competitive.” Was this a hedge? Did Survivor have significantly more people to build in equivalent numbers, sizes, and types of homes? Most did not think so, although two new recruits from competitors cautiously dissented. They suggested some competitors had a higher dollar volume per employee—a clue?

Land cost is hard to get at quickly, so whenever we search for margin we immediately scrutinize material cost, labor rates, price increases, and consider trimming staff. This habit is so much a part of home building that a conscious effort is needed to fight it. Remember, we know that at least 25 percent of your cost is tied up in process waste. If there was a way to calculate and show line items for process waste, this exercise would be easy. Yet the margin gap is buried in a hundred line items across a hundred suppliers, trades, bankers, consultants, municipalities, attorneys, brokerages, and yes, even your own employees. Still skeptical? Consider just two process examples.

Let’s say you spend right at the NAHB-reported average of $1,200 per unit for annual site waste removal. A deeper analysis will show that number is conservative, but let’s go with it and assume you have the typical three-to-four dumpster pulls at $300 to $400 each. Grab some folks from design, purchasing, production, and warranty and go out to the field for a thorough dumpster dive, something you should do regularly. Ponder this. For each 2x6, half roll of insulation, 16’ of insulated duct work, 40’ roll of Pex tubing, and each and every piece of cardboard you paid money right out of your margin to bring it to your site. You’re now spending more to haul it away for burial. Every landfill you pass has a nice chunk of your profit buried within. So how do you get it back? Writing the memo won’t help nor will blaming the superintendents.

Here is the cardinal rule of home building—as goes the schedule, so goes the builder. The building schedule is process in its purest form, organizing and coordinating a wild dance of typically 50 or more suppliers and contractors assembling thousands of parts, made even more complex by variables of weather, traffic, and city inspectors, to name just a few. Building very often is a desperate attempt to bring order to an inherently chaotic process. Yet if you have witnessed how that dance can evolve into something planned, predictable, coordinated, and even occasionally beautiful, you know where so much of builders’ profit margins bleed out onto the ground every working day. You can squeeze your suppliers for cheaper materials and hammer your trades for labor concessions all day long, but that will never generate the returns of an optimized schedule managed with precision. Once again, the losses do not appear as a line item; they are buried in 100 lines, representing every component of the home-building process. To prove it with numbers, email me and ask for the “Saved Day Calculator” Excel template. Enter your financials, subtract just one day from your schedule, and stare in disbelief. The numbers are real, and they will soon drive you to put schedule as the number one route to margin improvement.

Most builder management teams are so deep into what they are doing, they miss the essential link between lost margin and process. If they do see the connection, most do not know the metrics that reveal process as the source of margin loss. (I will write about which metrics builders need to use in future articles). Ironically, suppliers, trades, and the builder’s own people at lower levels suffer no such illusions. As an astute trade blurted out in a lean session recently in Texas, “Muda rolls downhill!” Muda is the Japanese word for waste, which is exactly what those on the receiving end of bad process are buried in. Another term for Muda is “anti-margin.”