The Margin Gap: Part II

On the long road back toward sales levels rivaling the best years in the industry, are similar profit levels still available? Where will we find profit?

By Scott Sedam, Contributing Editor | June 24, 2013
margin gap_home builder

Part 2 in a series. Read part 1 here.


Month by month, the housing economy improves, despite the continual pundit-sourced predictions of illusory gains and dead-cat bounces. As gross sales rise, however, one of the greatest fears is that builders will go back to the old-used-to-be practices where volume can cover a multitude of sins. During the go-go years of 1991 to 2006, almost everyone made money building homes, yet the greatest returns accrued from the land play. The amount of money left on the table boggled the mind. This begs a critical question: On the long road back toward sales levels rivaling the best years in the industry, are similar profit levels still available? We now face increasing shortages in both labor and materials with land and lots scarce nearly everywhere, a result of the near-shutdown of the development industry during the recession. Where will we find profit?

Coming out of the downturn, builders are almost universally behind the curve hiring personnel to match increased volume levels. Everywhere I go both field and office staff are at best overworked and, at worst, stressed to unhealthy levels. At this point, the traditional approach to lowering overhead by loading more work on fewer people is not even worth a discussion. And if you are looking to play hardball with suppliers and trades to get reduced prices in the face of shortages in this market, I won’t even wish you luck. So where do we turn? In my April article, “The Margin Gap—Beyond the Usual Suspects,” I introduced Survivor Homes, our friends struggling along with a 10-percent gross margin and desperately seeking solutions (see Pro Builder, April 2013). We walked through the usual factors impacting margin, including sales price and bid cost, and found nothing that stood out in a major way. 
Survivor represents an extreme case for sure, but as we went on to explore in the article, even a healthy, profitable builder pulling down a 25-percent gross was missing tremendous profit opportunity in the realm of process loss. Our quick analysis in that issue revealed at least a quarter of all builder costs are tied up in process waste and, if you ask my colleagues at TrueNorth who have spent the past seven years embroiled in this issue, that estimate is quite low. For example, the great majority of product waste measured by rework materials and waste haulage from the site is produced by process deficiencies. Yet the source is never attributed as such. If you are still skeptical consider that, in industry after industry where process waste has been measured extensively, the figures run from a low of 30 percent to as much as 80 percent. Twenty-five percent is, if anything, a low estimate.
An aggressive pursuit of process waste is one of those conundrums that appear quite simple on the surface yet often is difficult in practice. The measurements are not that challenging in and of themselves. The big obstacle is culture, ultimately the domain of senior management. When you ask your people to begin measuring things they did not track before, most of your employees do not leap at the opportunity. More tracking appears to be additional work and, as mentioned above, no one has extra time. This pursuit will happen only if senior management buys into using process measures as a vehicle for revealing additional profit. Here are some examples that have proven fruitful.

Schedule Metrics 

More than 20 years ago, I concluded that the best schedulers are the best builders and the best builders are the best schedulers. My work with more than 200 builders has only reinforced that. Schedule works in profound ways to increase margins. First and most obviously, a well-conceived and well-managed schedule brings order to the naturally chaotic process of home building, and chaos means waste and cost. One of Dr. W. Edwards Deming’s great lessons was that to improve a process, you have to first stabilize it. Be honest, would any critical outside view of your current process describe it as stable and predictable? Despite the proliferations of software and web portals for suppliers and trades, the majority of work in home building is still done via phone call often only a day or two prior to the required need. That effectively precludes any hope for those who actually build our homes to operate efficiently, and the excess cost is passed on, buried in their overhead. The next time you hear one of your people declare that an extra trip or rework that should not have been necessary does not count “because they do not charge us for it,” put him on Porta-John duty for a week. Tell him what he is cleaning is better than his thought process.
The first step for measuring schedule is to measure each house by the actual results—the only thing that matters. When asked about build schedule, so many builders quote what they have on paper, not the actual facts. There are many local terms and practices that may impact how you break this down, but establish your own schedule milestones to look something like this:
1. Signup to Release
2. Release to Foundation Start
3. Foundation Start to Frame Start
4. Frame Start to Dry-in with Mechanicals
5. Dry-In to Finish/Complete 
6. Finish/Complete to Close
Now, track every house and watch carefully. Where is the variation and how does it differ by site, product type, trade, or field manager? With good metrics, your processes will talk to you and show you profit bleeding onto the ground. There are many potential variables here, especially between steps five and six. Many builders schedule a full two weeks between when the home is supposed to be finished and actually closing. If so, you need to create a phase and track that as well. 
There is another impact of schedule that most builders know, yet seriously undervalue. That is the impact of each day on the absorption of overhead and other fixed cost. Most builders use a figure ranging from $100 to $250, but that number actually runs as much as $500 to $600 per day per unit if the saved days are used for building additional product—something that most builders are in a position to do these days. Previously, I devoted an entire article to schedule (See “The Gospel of Schedule,” PB, March, 2011) and I suggest you start there and spend some serious time evaluating yours. If you want to focus on the one single factor that will force most other systems and processes to improve along with it, marshal your entire organization to go after schedule.

Purchasing Metrics

Over the past two decades in home building, purchasing underwent a partial metamorphosis into supply-chain management with the intent of reducing cost to increase margin. In the end, most of those efforts degraded into yet another version of the old beat-down as supply chain in the eyes of most suppliers and trades became better known as supply pain. Yet anyone who studies industry outside of home building knows that we’ve only scratched the surface in terms of building truly productive purchasing models. The vast majority of builders purchase on low bid alone, while others are hamstrung by old, ineffective relationships they can’t seem to escape. I previously wrote about how builders need to establish a comprehensive list of criteria for both selection and ongoing evaluation of suppliers and trades and actively use them. In addition to bid price, these criteria need to cover elements such as schedule adherence, quality, warranty response, participation in product and process improvements, and worker compensation factors, among others. My advice is to use that as a starting point and develop your own list of selection and evaluation criteria. Your metric is adherence to those criteria. Get the criteria right and track them. Then you’ll have not simply a measure of margin contribution but a lead indicator, and those are in short supply.
As we discussed in the previous article, variances can be extremely misleading. Yes, track them, but do it with your eyes wide open. So what else do we measure? One of my favorites is the ratio of variance purchase orders (VPO) to purchase orders (PO). This metric is tied to variance, of course, but the ratio is more revealing because it provides a better indication of how well your systems and process are in control. A perfect world would see zero VPOs, so the percentage of work done under PO would be 100 percent. Doing 10 percent to 20 percent of work under VPO is not unusual, and I have seen builders with as much as 30 percent of work performed this way. High numbers here are a prime indication of chaos in process and systems, and margin always suffers. There are two ways to measure this ratio, by item—the actual number of VPO’s issued—or by dollars. They tell you different things so I recommend you measure both. The bottom line, however, is that each additional percentage of work done under VPO is a margin-eater, no matter how you calculate it. Fix it and find more margin.
Another purchasing/estimating technique I learned 25 years ago from Mike Rhoads in Chicago is engaging in a round of mutual comparative takeoffs between the builder and the key suppliers and trades. First, you need your own takeoffs for at least the major components, including foundation, framing, all mechanicals, drywall, and roofing, among others. Do more if you have the capability. Then sit down with your favorite suppliers and trades and compare numbers. If nothing else, accuracy and understanding improves, and that reduces the chaos. Yet every time I participated in these exercises, costs came down as well. Make this exercise a requirement for each new plan that comes out. No exceptions—if you lost the capacity to perform these takeoffs, get it back. Track this process and watch your margin improve.

Building Site Metrics

There is a book to be written here and therein lies the problem. It is easy to get so deep into job site trees that the forest is no longer visible. You can spend so much time measuring that you never get anything built. The goal is to devise a system of metrics that parallels what a good doctor does. She could order up every possible test—and each of those is a metric—and learn a lot. Then you’d die from the tests. Instead, depending on what she is looking for, she picks a dozen or so tests that are the best indicators. They don’t measure every single thing, but they measure the most critical markers. You get these right and the rest follows.
Checklist systems can be problematic. They are so exhaustive that pretty soon they become mere paper games. Challenge yourself to measure the fewest possible things in a house that tell the biggest part of the story. Having said that, I do strongly recommend a few ongoing measures that the vast majority of you do not perform now. When was the last time one of your field managers checked a load of concrete for temperature and slump rate? Guess what? Your suppliers know you don’t check either. So just how close to tolerances do you think he will be? Do you randomly check—actually count—quantities of incoming loads of lumber and engineered wood? You’ll be surprised at how much variance you find and it all represents waste in some form. You are making an impression on your suppliers that you care, of course, but even more important is what you are teaching your own people. You are training them to care about these details every day, and that concern will be reflected in margin.
One more factor that is normally judged only as a cost yet serves as a revealing measure of process efficiency is site waste removal. I wrote an article about how to go after that last year (see “Less Waste, More Profit,” Pro Builder, September 2012). So determine your baseline, set up your measurements, and attack it. I guarantee if your waste removal drops 50 percent you will receive a visible bump in your gross margin.


Design Metrics

There are three critical techniques you need to be a permanent part of your design process, and all have shown to pay off in increased margin. First, establish a set of design standards for both architects and engineers that clearly delineate your goals and expectations. For example, you want them to design to even lengths wherever humanely possible. You want baths that work with standard cabinets. You never want to see a 12 foot 2 inch x 12 foot 2 inch bedroom again. Direct them to meet every code, plus the customer code, but nothing more. You want plans designed and engineered that are both totally cool and completely cost-effective. So spend some time, establish your design and engineering standards, and insist on compliance. 
Second, get your suppliers and trades involved all the way back at the black-line/conceptual stage, then at several additional points through the design process and through construction of the model. Make this collaboration standard procedure and insist on it. Track it. Finally, each house gets fully detailed, site-specific plans. The technology today makes it so simple that there is no excuse not to do it. This practice simplifies the schedule and eliminates the margin killers—mistakes, rework, and phone calls for clarification. 
Note that although we focused primarily here on process factors that enable cost reduction to increase margin, the savings also can be used to generate more sales. In the toughest times, most savings will be applied to the builder’s bottom line, but we have seen some builders use savings to reduce sales price or add features and options to increase sales velocity. Nice to have choices like that, isn’t it? When we began, we talked about a builder struggling at 10-percent gross margin and a much more successful one pulling down 25 percent. Yet both were after more profit and habitually looked in the wrong places. No one suggests that your traditional financial and accounting measures are not important, but to find all the profit, you need to see with new eyes and measure process at key points along the way. That approach will show you where the losses really are and the true opportunities lie. Psychologists say new behaviors that are strongly reinforced become permanent rather quickly. Watching your margins tick up as you apply these new process measures should be all the reinforcement you need.

Scott Sedam is president of TrueNorth Development, a consulting and training firm that works with builders to improve products, process, and profits. A senior contributing editor to Pro Builder, Scott writes about all aspects of the home building business and won the 2015 Jesse H. Neal Award, business journalism's most prestigious prize, for his commentary in Pro Builder. Scott invites you to join TrueNorth's Lean Building Group on LinkedIn and welcomes your feedback at or 248.446.1275.