There are five key numbers, or key performance indicators (KPIs), in a residential building company's financials that builders should be aware of on a quarterly basis.
The analyses should be conducted quarterly because most residential building companies generate less than $10 million in revenue a year, and their claims can be six to seven weeks apart, which means their monthly income can be a little volatile. So it makes sense for builders to look at their financials quarterly rather than monthly when comparing to the previous period, or the same period last year.
Of course, if builders don't calculate their work in progress accounting adjustment (WIPAA) each month, then their financial reports are not going to make too much sense to anyone, no matter how frequently they are reviewed. That means calculating the work in progress accounting adjustment figure each month is the first number that builders must know in their financials.
The next KPI to review is revenue. It's important to look at the numbers quarterly rather than monthly, because revenue can easily get distorted by the time that invoices are sent to clients. However, over a 90-day period of time, things tend to even out, so it’s important for builders to to look at their revenue and compare it to their budget, last quarter’s revenue and the revenue for the same period last year. That helps with taking seasonal fluctuations into account.
Gross Profit Margin
This is a builder's gross profit, which is the revenue from their projects less the cost of sales relating to their projects, as a percentage of their total revenue. A lot of builders confuse this with markup, which is different, so it's important to understand the difference. The benchmark for custom home builders is 25% margin, which is a 33.3% markup.
Builders should check their gross margin every quarter and compare it to their target gross margin, last quarter’s gross margin and their gross margin for the same period last year. By doing this, builders will see how much margin they are actually getting out of their jobs compared to how much margin they are adding to their jobs when they price them. And that may be a bit of an eye-opener for many builders, especially if they are not achieving the industry benchmark.
Fixed Expense Ratio
Fixed expenses are any costs that cannot be directly attributed to a project; things like, rent, administrative staff and software costs. On its own, this figure does not mean too much — unless it’s higher than the gross profit figure.
The way to look at fixed expenses is as a percentage of revenue, which is known as the fixed expense ratio. The benchmark for a residential building company is 15%, which includes the owner's salary at market rate and a healthy investment in advertising and marketing of around 3% of revenue.
It is possible to artificially lower this ratio by either not drawing a salary, or by investing very little in marketing and advertising. So those are the two key areas to look at closely when builders calculate this number and compare their building company to others in the industry.
Net Profit Margin
Finally, it's important to review net profit margin, which is the profit remaining after accounting for all of the project costs and fixed expenses and then calculating it as a percentage of the total revenue. If builders do not take a salary and instead draw a net profit of what the company makes as income, then their building company isn't really making a profit, it’s just breaking even. And that's a very risky situation to be in, because after a few quiet months, these builders might be out of business.
The industry benchmark for a custom home building company is 10% net profit margin. A well-run building company will operate between 10%-15% net profit depending on where they are in their growth cycle and market conditions. Unfortunately, most custom home building companies are not achieving double digit net profit margins because they are focusing on revenue rather than margins and ratios.
A professional builder should look at all five financial KPIs in order to understand how well their building company is doing, rather than just focusing on the bank balance. To learn more, download the Professional Builders' Secrets To Increasing Margins checklist. This checklist helps builders:
- Understand the difference between markup versus margin.
- Understand the difference between the cost of sale versus fixed expenses and why it’s critical to factor this into a pricing strategy.
- Calculate fixed expenses as a percentage of revenue.
- Determine the exact net margin a building company needs in order to be profitable.