Texas is an interesting example where instead of a corporate income tax, it has a franchise tax calculated on gross margin. So Texas builders take out construction management, design, estimating, finance costs—everything they can—above the gross margin line. This formula lowers gross margins, thus reducing taxes, but cross-company comparisons are now out the window. As another example, national builders often take out at least a percentage of indirects, as well as the sales and marketing expense, before calculating gross margin, while privates usually do the opposite. Care to compare?
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.
The Margin Conversation
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?