The Art of Benchmarking

Even artists have to eat. Consider Michelangelo, the famed 16th Century sculptor. "Through astute investment and strict management of his finances," one biographer notes, "he provided for his entire family (his father and four brothers) and died a millionaire."

Most custom builders have nurtured the first part of Michelangelo's gift — his creative vision — but few take the second seriously: his business savvy. Why? Because, according to Emma Shinn, CPA and vice president of the Lee Evans Group in Denver, they share a common delusion.

"They think they are so different from everybody else that management concepts won't work for them," Shinn says. "But the same concepts will work — and make their jobs easier. Time and again, we see them putting effort into areas that are leaking profits."

In other words, the first step in tuning up your business is quieting the artist's voice, and acknowledging that your business can be quantified in a way that will help you reduce redundancy, trim waste and have more time for other things. At the same time, you'll be putting yourself in a league above your local competitors.

"I'd say about 1 percent of small builders have some sort of [benchmarking] system in place," says Shinn. "I think part of it is that they're all terribly scared of numbers."

She explains that while most custom builders already keep track of a lot of accounting numbers, they don't mine them for information. They take expenses such as the cost of site supervision, real estate commissions, warranties, and just "throw them into the same pot of soup."

Brad Simon, co-owner of Cottage Homes, a small building company in Salt Lake City, Utah, has something most custom builders don't: years of experience working for a big production builder. Simon's experience working for Woodside Homes, a company that builds 5,000 homes a year, taught him some key accounting skills. That knowledge still applies, he says, now that he builds only six to 12 homes annually.

"This year, we will save about $120,000 in financing costs alone," Simon says. He attributes that savings to his use of detailed accounting.

"The national builders track everything," he says. "Custom builders track nothing. I was giving a seminar about this to a bunch of custom builders, and one of the guys went back to his hotel room and tracked his sales for the year.

"He came back to me and said, 'You know, I went a whole year without making a sale. I'm never going to let that happen again."

That lack of a handle on planning and expectations, Simon notes, creates a lot of unnecessary stress for small volume builders.

"I'd say only 20 out of every 300 people in one of my seminars do a monthly finance statement," he adds. "Without that, how are you going to analyze your expenses? It's a benchmark for what you know you can do next month."

John Barrows, a custom builder and remodeler in East Hampton, N.Y., says that many custom builders simply don't know how to apply accounting principles to their business.

"This business is weird, because we own part of what we're manufacturing," Barrows says. "If it's a spec house, you own it until the day you sell it. If it's a custom home or remodeling, you can't simply expense the whole thing. So you end up having to document the job by cost code, or phasing in costs."

He adds, however, that this process is not as daunting as it sounds. Most of the hard work of figuring out what to track has already been done by the NAHB and accountants who specialize in home building, such as Emma Shinn.

The NAHB, with Shinn's help, has created something called the chart of accounts (COA), a list of financial ledgers aimed at helping builders track day to day accounting. This chart marks the first — and probably the simplest — step toward financial benchmarking.

The COA is available for free on the NAHB Web site. As Barrows points out, however, the chart is a catch-all. Many of the categories don't apply to custom builders. Fortunately, the NAHB has done much of the winnowing work already. Builders can download a Microsoft Excel version of the COA specifically for small volume builders.

One caveat: Before custom builders end up frustrated by this more complex method of accounting, it helps to understand the principles behind the COA. Emma Shinn explains:

"Typically, the only reason custom builders have accounting is so that lenders will help them — and to pay taxes," she says. "As a result of those goals, they set up the accounts in ways that are not meaningful. They have no clue what the balance sheets tells them.

"But to lenders, the balance sheet is very important," she adds. "The lender is looking at the ability of the company to repay loans, measured as a ratio of your current assets divided by your current liabilities."

Shinn explains that current assets in home building refer to things that will be converted into cash within 12 months, which would typically include works in progress — unfinished homes and remodeling jobs.

"One thing a builder can't afford to do is lose his ability to borrow money," Shinn explains. "If you lose that, you're dead. The other ratio is the debt to equity ratio. That's important because it refers to the risk the lender has. It determines whether you can borrow more money."

The chart of accounts, Shinn explains, clearly breaks out these ratios — at the same time separating expenses and income into neat categories that builders can use to make detailed comparisons over time: Welcome to benchmarking.

"If you don't have this system, you'll never know why you did well (financially) on one project but not another," Shinn says. "Was it because I had a real estate guy? Was it my crew size? You need to keep the classifications really, really clean."

Shinn says that setting up your accounts for the first time primarily involves rearranging your budget (assuming you have one) in a coherent fashion — fitting them into six well-defined areas (see sidebar on page 52).

"You want to set up the chart like a timeline — so that it follows your construction sequence," she explains. "You do it in the same order you actually build a house — not alphabetically, like so many builders."

"By comparing numbers on a month by month, year by year basis," Shinn notes, "you can now see if you've been efficient in every area."

For a custom builder to judge his success, he will need some targets for efficiency. One good place to start is NAHB's "Cost of Doing Business Study" survey. The NAHB compiles the data in the book using its own COA ledgers, so builders can make an apples-to-apples comparison of the typical income-to-expense ratios for a home building business of a particular size.

Emma Shinn has developed a book that offers a similar set of target ratios — based on measurements taken in the field. Put simply, ratios refer to the percentage of overall expenses used for a specific aspect of running a custom building company.

"For example, we set an operating expenses target of 3.5 percent of sales revenue. Then you can set your own target — where you want to be. You may be running a 6 percent construction costs ratio, but next year your want to bring it down to 4 and a half percent."

Using this accounting system, she says, builders can identify where they spent their budget. For example, a builder may find that he has too many supers in the field.

"Now all of a sudden you can see where you've been inefficient," she says. Are you being efficient in buying land, financing, sales and marketing and your office? Where can you plug the profit leaks?"

"Even if you don't want to do it yourself, you can hire someone," adds Simon. "It's not going to kill you to pay $1000 to have an annual financial report done. It's a progressive process. Each year we do it, we save more money — primarily by moving money from bank to bank (to get better terms).

"Most custom builders don't even know how long it takes them to build a house, but without knowing that, how can you know whether to send a framing crew to a new job or not? We wear a lot of hats, but you have to know your own business."