It's "dangerous" to not understand the difference
The Association of Professional Builders has issued new guidelines for some of its members to heed in light of shrinking net margins amid a softened housing market.
Some 75% of small home builders now are operating on net profit margins of 3% or less, Russ Stephens (pictured), co-founder of APB, told Mortgage Professional America in a telephone interview. Juxtaposing that reality, a new report by New York University Stern School of Business found that the average builder’s margin among the larger building companies was almost 25%, which enabled those businesses to enjoy a net margin of 12.73%.
The upshot: Smaller building firms should emulate the studied group of larger firms to achieve higher margins, Stephens said. To accomplish that, the APB issued key guidelines to include:
- Understanding the difference between a builder’s net profit margin and its markup;
- Grasping the importance of investing in marketing in order to increase;
- Drafting a business plan.
And yet, Stephens noted, there are no guarantees for bolstered margins. While most residential building companies do not currently add 25% to their projects, he said, those that do will still not get close to clearing a double-digit net profit margin.
“That can be catastrophic,” Stephens said of builders working on lowered margins. “It’s important for the consumers to understand, as well, the difference between the market and margin because this is what goes in their contract.”
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He crunched the numbers to illustrate: “Typically if they’ve got a 25% margin on variations, that means the builder will mark up those variations by 33.3% to get a 25% margin. A lot of people do not understand that. It leads to a bit of conflict; it also leads to builders not charging the correct amount because builders that don’t understand mark up by 25%, which means they’re only applying the 20% margin. As you start going down the scale over a year working on a 20% margin and they mark up by 20%, that’s only 16.6%. Now they’re getting really, really close to their operating expenses. It’s a dangerous game not understanding the markup and margin.”
Some builders are averse to acknowledging they don’t understand the math, Stephens said, which is to their peril: “A lot of people don’t like to admit they don’t understand it, but a lot of builders, when you spend a bit of time and explain it to them, it can be a bit of a game changer for them.”
To further cut into the abstraction of finances, he provided an all-too-real scenario of the pitfalls of not understanding margins: “Although the benchmark, what the big companies are on, it’s all 33.3% for new construction, which is 25% margin. That’s pretty standard. But in small business, they don’t understand the margins are that high and because someone down the bar told them they should add 20% on their jobs, that’s what they do – without any proper research or understanding of their financials.
“A lot of builders are adding 20% to their cost of labor and materials. So, if they’re turning over, say, $3 million a year every month, that’s $250,000. So they look at that $250,000 and they think ‘I’m working on 20%, that’s $50,000 profit.’ But they’re not because the 20% was a markup, which was 16.6% margin. So this is really dangerous because when they don’t understand their financials properly, they think they’ve made $50,000 but they’ve really made about $40,000 in reality. And when they start spending that extra $10,000 they haven’t made – because it’s sitting cash flow positive in the bank account – this is where, over time, they get into trouble. So it’s a very important concept for them to understand.”
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A slowing housing market, challenging supply chain and labor shortage issues have combined to erode builders’ profit margins, Stephens told MPA. Moreover, APB’s own State of the Residencial Construction Industry report finds that smaller residential building companies are failing to charge the correct margin because they lack demand.
More sobering stats come from the US Bureau of the Census, which reports that the start of construction on new residential homes fell to 1.45 million in July – a 9.6% decline from the previous month. Consequently, homebuilders have an ever-important task ahead of ensuring they are pricing for profit by carefully calculating their net profit margins, Stephens said.
APB has also determined that allocating 3% of a building company’s total revenue to marketing and advertising is what enables successful businesses to enjoy 10% net margin due to a fundamental law in business, Stephens said. He added there is clear proof that margins are linked to marketing because of the fundamental law of supply and demand. When demand outstrips supply, he said, prices rise. And when prices rise, he added, margins also rise, and businesses become more profitable.
APB further advises building companies that use paid advertising to increase demand for their services are able to continually increase their markup until they reach the industry benchmark of 33.3% for new homes, resting in a 10% to 15% net profit margin. When it comes to profitability, Stephens said, it is imperative for builders to understand their financials and document a repeatable sales process while generating more opportunities than they actually need.
