Financial Management - Part 4

Financial Management - Parts 1, 2, and 3 discussed the importance of setting up a solid accounting system to accurately measure what has happened in the past so better decisions can be made in the future. Previous articles in this series have also stressed the importance of long-term financial planning as well as setting business and personal goals.

This series showcases Chris Smith, a hypothetical 45-year old builder who has been in business for six years. He is looking for better, less stressful ways to be more successful and has been carefully setting goals, planning, and budgeting over the past several months. In this installment of the Financial Management series, Chris reviews his budget for the upcoming year.

When most builders think of an operating budget, they immediately start to think about how much they pay their supers, estimators, etc. They also think about how much money they'll spend on computers and software. As shown in Chris Smith's budget, an operating budget is much more than just expenses.

Some builders wonder why they constantly miss their first quarter numbers. Most of the time it's because they start the budgeting process too late in the year or wait until January of the current year.

There is a wait time from when a house sells to the time it closes. If a budget isn't in place prior to quoting delivery dates to customers in the following year, then the builder winds up missing the boat.

Sales in the late third and fourth quarter don't affect the actual year. Rather, third and fourth quarter sales affect the following year. It is important to plan ahead to know how many houses will need to be sold for the remainder of current year to make the numbers in the first and second quarter of the following year.

A number of builders find themselves on a roller coaster ride each year because they don't plan early enough and therefore they start the year out in the hole. The same builders sell and build in a rush to make their numbers; often sacrificing margin and quality as well as increasing the stress levels for everyone involved. These builders get so busy that they don't have time to budget for the next year until "things slow down."

This sort of practice becomes a self-induced problem in January because the ball was dropped while the team was busy building. It's a vicious cycle and it makes it extremely difficult to run a home building business.

An easy way for a builder stop the vicious cycle would be to plan out a sales, starts and closings budget for 18 to 24 months. This practice allows the builder to have an eye on potential slippage in any of the three critical drivers and avoid the ups and downs of the roller coaster.

The residential construction industry is pretty straightforward. There are five key drivers, which include:

• Sales
• Starts
• Closings
• Customer service
• Customer satisfaction

Sales, starts and closings can make or break a builder in the short-term. The remaining drivers — customer service and customer satisfaction — can make or break a builder over the long-term. This article will focus on sales, starts and closings.

For builders that work on a completed contract method of bookkeeping it should be apparent that one has to close a home to earn money. To illustrate the concepts discussed in this article, a completed contract method of bookkeeping will be used.

The tables on page 48 show Smith Builders' five homes in backlog from the prior year's sales, plus five homes projected to close in the upcoming year. One home is a planned spec home for the local Parade of Homes put on by Chris's Home Builders Association.

Once closing projections are in place, it is best — and easiest — to work backward to set up sales and starts projections. Chris, for example, has an average build time of 18 weeks. With the 18-week build time in mind, the $330,000 home projected to close in September has to start sometime at the end of March or in early April. (If the house is not started during this time, the chances of it completing on time diminish.) Chris knows that the average time from sale to start is about six weeks so to start the home by late March; he must have it sold no later than the end of February. Knowing these critical dates helps avoid the sell it/build it cycle.

Chris found budgeting for his full time superintendent to be quite simple. He looked at last year's actual expenses, added the raise he plans to give her and adjusted the benefits according to anticipated increases. He also budgeted for her truck allowance, small tools and warranty costs based on the total spent in the prior year and increasing based on the increased volume.

The Table below shows the new addition Chris is hoping to make this year — an estimator. Chris hoped he could hire a top-notch estimator for about $50,000 per year. Chris also added the additional payroll taxes and benefits cost starting in February. The addition results in an increase from $1,250 to $2,500 per month.

At 4.46%, total budgeted indirect costs as a percent were slightly higher than the industry target of 3–3.5%. However, Chris realized he would get economies of scale as he grows the company. He won't need to add another superintendent until he plans to close 15 to 20 homes. He may not need to add another estimator until he is building considerably more homes.

For the next few years, Chris has found he wouldn't need to spend much more money than he currently planned for indirect costs, but he'll be able to close at least five to 10 more homes. His costs as a percentage of sales would drop considerable in future years.

Also, Chris knows that he has few production systems in place and almost no estimating systems in place. With a slower build pace this year, he could work with both employees and begin to implement systems to help streamline and improve the building process adding to the bottom line or saving Chris personal time he desperately wants to get back.

Finance expenses were going to be minimal in the coming year, but as is seen on page 50 Chris thought ahead on three points:

• More volume equals an increase in interest on construction loans.
• With the show home Chris planned to build for the Parade of Homes, it would be quite possible to have to carry the home for a few months, so he budgeted for interest on finished inventory in September, October and November.
• A new expense for the upcoming year would occur if Chris decided to his home office into a small office space outside of the home. Chris learned from other small businesses to expect a lot more start up expense with a new office, so he planned on potentially borrowing at least $25,000 for a new phone system and furniture and any other potential new office expenses. Then he increased interest on notes payable in the same month he was hoping to move into a new office.

Chris's total finance expense falls well within the typical range of a builder his size at 1.04%.

Chris — having a strong sales background — is able to avoid paying a great deal of sales and marketing expenses. Much of his work is coming from referrals from previous buyers and job site signage. He did budget in realtor commissions in November for the sale of the parade home he is budgeting to close that month.

As seen on page 50, Chris's total expenses for sales and marketing are extremely low at only .75% of sales, compared to industry benchmarks of 2–3% of sales for a builder his size (It's fairly common for larger builders to budget 5–6% of sales to sales and marketing). He knows that if sales slow down, he may have to increase his marketing budget or work with real estate agents to sell more homes.

However, for the first time, Chris realized that he was in great shape for the coming year. He was already sold out through May and has three solid leads and four weeks to close at least one of the three leads to ensure a June closing. He was feeling more control and therefore even more confident in his ability to raise his margins.

By the time Chris started budgeting for general and administrative (G&A) expenses, he was feeling like a pro. He convinced his bookkeeper/administrator to work full time instead of part time starting January 1. He also had a good lead on an office space with good street exposure for about $1,700 a month that would be available starting in April.

As seen in the Table on page 54, Chris even budgeted for depreciation expenses with an increase starting in April in relation to new office furniture, phone system and some computer expenses he planned on purchasing.

Chris's total G&A was much higher than the industry target of 4–5% of sales, but his total expenses were only budgeted at 14.03%, which left him a potential net profit of about 5.75%. That would be an increase of not only 2.75% from the prior year, but also a little more than $100,000 more in profit. As an added bonus, he has the potential to work fewer hours and improve performance with the additional staff that quite possibly will shore up some of his weaknesses.

Just like the indirect costs, the G&A won't have to increase much more in the near future until he reaches at least 15 to 20 homes. At $5–7 million in revenue G&A falls well within the 4–5% range.

There will always be room for improvement, but until achieving high gross margins, a builder should spend most of his time increasing sales prices, lowering direct costs or a combination of both. Gross margin is everything.

Chris is all set on paper, but in the next few articles, we'll see how he did in reality by analyzing his income statement, budget versus actual. We'll also look at some cash flow statements, and look at his balance sheet as well as some performance ratios.