How Well Is Your Company Really Run?

Establishing metrics to compare company, division and project performances is difficult. There are so many variables that determine profitability - and so many excuses by those whose teams are less profitable. Metrics need to be simple to calculate, but they also should include adjustments for external factors truly out of a team's control. The most extreme example of an external factor might be a hurricane, but the most significant external factor affecting benchmarking these days is the significant appreciation in home prices. Adjusting for appreciation is easy.

Which team deserves the biggest bonus - the team with a 14% pretax margin or the one with an 8% margin? The answer seems simple at first. However, what if the team with the 14% pretax margin experienced a 20% increase in home prices in its market from the start to the end of its project, while the team with the 8% margin experienced no appreciation? Assuming the company does not freely enter and exit markets based on expected appreciation/depreciation, which team leader deserves the promotion? Whose operations are more efficient?

To establish effective metrics for operational performance, consider taking unanticipated home price appreciation out of the equation. To conduct the exercise, you need three things:

1. Your company's financial statements
2. A financial analyst
3. A leader who can help the analyst focus on material issues only

The Excuses
Let me get this out of the way upfront. Every benchmarking exercise I have been involved in has had excuse-makers. First are the bean-counter types (I can say that because I was a CPA many years ago) who cannot see the forest for the trees. They usually point out nitpicky things that affect pretax income by insignificant amounts. Then there are the poor performers (and most of them know who they are before the exercise even starts) who point fingers of blame everywhere. Typical excuses and appropriate responses are:

The list can go on and on. If the excuse was completely out of the team's hands (such as the hurricane), did not affect everyone in the industry (through rising insurance costs, for example) and affected pretax margin by more than 0.5%, I would adjust for it. Otherwise, let it go.

Establishing Your Company's Metrics
The first thing you want to do is determine how well your company is performing. To do so, download this simple spreadsheet, which looks like this (the numbers used for illustration are an average of four of the largest builders in the country):

The four large builders averaged an 8.6% pretax margin after deducting all costs of homes sold, operating expenses and interest expenses. Hopefully, your firm is performing even better.

What would have happened if home price appreciation had been less than anticipated from the day you bought the land until you the day you signed the sales contract? For the large builders, each 1% change in revenue changes the pretax margin by approximately 1%.

Comparing Division Performance
I know I'll get a few e-mails on this touchy subject, especially from my friends in Southern California. Accurately comparing division performance involves understanding each company, so the topics below are general in nature. However, my intent is to help your firm more rigorously compare the performance of its divisions.

If you are a large builder and don't wish to take the time to gather all the data on a project basis, you can use metropolitan area appreciation statistics and your average days of inventory to estimate the appreciation in each market. Resale home price appreciation by metropolitan area is available for the National Association of Realtors. You also might want to perform this analysis with no allocation of corporate overhead so you can avoid the inevitable argument that corporate allocations always create.

Is your San Diego division being run better than your Denver division? Before adjusting for appreciation, I am sure it appears that way. However, prices are up 21% in San Diego over the past year, while prices are up only 4% in Denver. If you were anticipating 4% appreciation in both markets, then subtract 8.5% from the revenue number in San Diego (one-half of the difference between the two markets, assuming an average time of six months between land acquisition and home sales contract) and see which division is being run better. Before making final conclusions, allow the team in San Diego to pile up the excuses and adjust for ones that are significant and reasonable (e.g., the increase in subcontractor costs) and then make the comparison again. If Denver's team now looks better, you need to ask why. Is it managing expenses better? Is it getting more done with fewer people? Could you be making even more money in San Diego?

Comparing Project Performance
To compare project performance, you will need two more facts:

1. Your targeted average selling price when you acquired the land
2. The actual average price

If you anticipated average base selling prices of $300,000 and actually achieved $318,000, then the market appreciated 6% to your benefit. Of course, your staff members will tell you that their efforts were responsible for some of the increase. To placate them, you can use the average appreciation in your market during that time, as previously mentioned. More accurate measures of market appreciation are available from DataQuick and First American Real Estate Solutions if you are willing to pay for more detailed information.

If your average price was 6% higher than actual, and you made the average 8.6% profit margin, what does that say about the performance of that project? Using the spreadsheet, you would have made only a 2.8% margin if the unexpected appreciation had not occurred. Is that acceptable? The next step would be to determine what happened and how you can avoid the same pitfalls in the next project. You might uncover unnecessary expenses incurred because the project was performing so well that there was little scrutiny on the expenses.

Use this methodology to compare division or project performance, and you will find out which teams are performing the best.

About the Author John Burns publishes three free Building Market Intelligence e-mails each month: U.S., Local and Strategic. He helps real estate executives develop and execute strategic plans, conduct market research and maximize profitability. More information is available at www.realestateconsulting.com.