A step-by-step process to determine a meaningful and useful purchasing ratio
Purchasing is at the center of any home building business. As a purchasing professional, you are expected to possess a high degree of business acumen and know your operation’s costs so you can be a good steward of the company’s financial resources.
But how do you really know if you’ve made a good deal? Certainly, the competitive bid process is an indicator, but you can more precisely determine if your costs are in line by knowing your purchasing ratios—a deeper, more accurate dive into what you typically pay for specific materials and labor.
There are many types of purchasing ratios. The two most common are trade cost as a percentage of vertical construction costs, and commodity cost drivers as a percentage of the finished materials you use to build your homes.
The Trade-Code Ratio
A purchasing ratio based on trade codes is one I use a lot. Trade codes are the aggregate costs for each trade category (foundations, framing, electrical, etc.), ideally broken down into four buckets:
• Material quantity at a SKU level
• Material cost at a SKU level
• Labor rates
• Standard labor hours to perform the scope of work for each labor rate.
That level of detail isn’t always possible, so do the best you can. Obviously, if you haven’t already mapped your cost codes to their designated trade codes, you’ll want to do that before you run this report.
Steps to Determine a Trade-Code Purchasing Ratio
Here’s a step-by-step process to determine a meaningful and useful trade-code purchasing ratio.
Step 1: Run a report
Run a trade-code report for all of your floor plans and their elevations, as well as all of the communities within each market you serve.
Step 2: Sort the information
Sort the trade-code report information by product type (single story, two story, attached, detached, etc.) and specification level (first-time buyer, move-up, luxury, active adult).
This step is critical for comparing costs across similar product. The cost per square foot for a condo unit will be very different from that of a large, luxury, single-family detached home. Simply knowing the difference is of little value; the real value comes when you compare multiples of each product type and across communities and markets at a trade-code level.
Step 3: Set up worksheets
Set up a separate worksheet for each product type. In a perfect world, you will have several communities of comparable specification levels for each type, as the simplification and standardization (or not) of your specifications will come to light. How many different specifications do you really need for each product type and buyer profile? I know builders that use different specification levels for each of their communities, as if they’re building those homes for the first time. In reality, they’re throwing all of the knowledge from a previous project of the same type out the window and starting over with each new community. That’s inefficient ... and dumb.
For those of you with the discipline to standardize specifications across each of your product lines, your purchasing ratios will be both easier to calculate and more meaningful.
Step 4: Divide costs
In each product type worksheet, divide each trade-code cost by the square footage of each plan.
Use the rows in the spreadsheet to designate the trade code. For example, electrical labor in one row and electrical material in another (if you don’t have your costs broken down into that level of detail, just use your turnkey cost). All of your vertical construction costs should be categorized to a trade code.
Purchasing ratios shouldn’t include land. The amount of land on a lot will affect your landscaping, final grade, flatwork, and other costs, so try to group similar-size lots together under the same specification.
Step 5: Calculate average costs
Within each worksheet, calculate your average cost per trade-code row. Also, calculate your minimum and maximum costs in each row. You can use conditional formatting within Excel to highlight the cell that’s the highest cost or the lowest cost in a given row. You now know your cost range from least to most (or vice versa), as well as the average cost at a trade-code level for each product and specification.
Step 6: Analyze results
Analyze the results. There will surely be some aha moments where you can’t easily explain why a cost is particularly high or low, exemplifying the limits of a competitive bid process. Sure, you went with the lowest qualified bid, but did you still pay too much? Knowing and referring to your purchasing ratios would have been a good start for evaluating future bids.
Other Uses for Purchasing Ratios
Purchasing ratios also are good for determining target costs. For instance, look at your highest cost for each trade group within each product/specification and dig into the details to see if there is a valid reason why that is.
If there’s no clear reason, reach out to the trade and ask for their help in getting the answer. You may realize (as I have a few times) that the contract had a typo and neither the builder nor the trade realized it until someone dug a little deeper.
Another great use of purchasing ratios is in creating pro formas.
Suppose you are looking to buy a piece of land and need to quickly turn around a vertical construction cost pro forma. Having your current ratios on hand will make quick work of the task. Simply use the worksheet that most closely mirrors the product/specification level you intend to build on the land, and the pro forma should be easy ... and accurate.
Here’s another way to use them: As you conduct due diligence into the potential acquisition of a competitive builder, comparing their purchasing ratios to yours will help you understand the opportunities for cost reduction once the deal is done.
Keep your worksheets handy and, ideally, on shared online or cloud-based platforms, such as Microsoft SharePoint or OneDrive, or on Google Sheets, among others, so you can access them from a laptop or mobile device wherever you are. In value engineering meetings, design studio meetings, and design charettes, purchasing professionals are often asked what something would cost, so having the ratios at your fingertips is time-efficient and helpful.
Better Evaluate Bids Using Cost-Drivers Ratios
Another useful purchasing ratio is the percentage of a given raw material’s cost in the cost of a finished good, also known as a cost driver.
Commodity lumber, copper, steel, etc., are all examples of cost drivers. Knowing the ratio of their commodity cost to that of a finished good’s cost will help you better evaluate bids as commodity prices go up or down.
A trade will always let you know when the cost of a commodity goes up, but how do you know that the full increase was justified if you don’t have a good purchasing ratio? In addition, how often does a trade call you with a price decrease? It does happen, but it’s rare. If you have a trade that comes to you with a price decrease, hang on to them.
To create a reasonably accurate raw material cost-to-finish-cost purchasing ratio, reach out to your trades, distributors, and manufacturers for help, and talk to as many trades as possible—both those that currently work for you and those that want to. The more data the better, as you will want to average the numbers you get from all the different sources.
Once you have the data, find an index that tracks the commodity cost driver. Maintain an open dialog with your trades to keep things current—especially when commodity prices fall—and be willing to adjust your price when those costs go up.
The job of a purchasing professional is to be a good steward of the company’s financial resources. Purchasing ratios can help you get the best cost up front and can assist in making sure that those commodity price–driven cost increases are not inflated.
It will take some work to calculate and maintain your ratios, but the return on the time you invest will be significant.
Access a PDF of this article in Pro Builder's January 2020 digital edition
- The Strategic Power of Purchasing: Climbing prices are shutting out some potential buyers, but savvy purchasing can help offset pressures exerted by market conditions
- The Center of Home Building: Purchasing: Is Purchasing at the core of your operations? If not, you’re leaving money on the table, and lots of it
- The Pros and Cons of Group Purchasing: Is a GPO right for you?
- 10 Elements of the Total Cost Model to Purchasing: Home builders that adopt the total cost model to purchasing and operations are guaranteed to save in the long run. Follow this road map to get started