Quietly Re-Thinking Out Loud

As part of an online discussion/debate regarding the validity of a a Capacity Based Markup system (JLC-Why the PROOF System is Illogical) Allan Edwards of Allan Edwards Builder; Houston, Texas presented me with the "challenge" to show how a Capacity Based Markup system (aka PROOF) could be used to "Price a house".

As a challenge, I will list the following 16 categories from the 200 or so on my estimate sheet. These are broad categories of cost. Maybe you can explain how, using PROOF, you would price out this house. Land $400,000 Arch $20,000 Permits $10,000 Foundation $70,000 Framing $100,000 HVAC $20,000 Electrical $20,000 Windows $40,000 Drywall $20,000 Millwork $100,000 Paint $40,000 Tile Mat $20,000 Tile Labor $20,000 Insurance $20,000 Loan interest $40,000 Realtor Fees $60,000 Total Cost $1,000,000. Some of the cost are material and labor from subs (turn key), some are material only, some are labor only, some are soft costs. All work is subcontracted. Assuming these were all the costs associated with building a house, what price would you stick on it and what method would you use? Also, overhead is about $30,000 per house.

Well to answer the question in new home construction, especially with a spec home, I wouldn’t use PROOF or any other markup method for that matter to "Price" a home. There is a subtle but important difference between "Pricing" a home and "Costing" one.

In Pricing a home there are other Value considerations that don’t necessarily appear on a balance sheet. A home also has intrinsic value based on just where it is being built and even how it is situated on it’s lot. A home costing 1,000,000 being built in my neighborhood in Katonah NY would be worth considerably less than the same exact home built 1 mile away in the Mt Holly neighborhood or 2 miles away up on Girdle Ridge near Caramoor. there are other factors that effect a homes price too such as noise (how close the highway or airport it is), the school system the house is in etc . Indeed building that same exact home 5 miles to the west of where I am in Somers or Yorktown NY the house would be Priced less.

In a May 2002 Professional Builder article Pricing Opens the Door to Profit management consultant Chuck Shinn was quoted as saying:

“Buyers decide what they are willing to pay for a house,and they base their decision on the value they see in the product, not on the builder’s costs. If you buy land poorly and build houses inefficiently, cost-based pricing can lead to over-priced houses that won’t sell. We still see that a lot. But today we also see underpricing because cost-based models don’t take into account the constant movement of supply and demand in the marketplace or the escalating value of a location.” (my emphasis)

But the article also goes on to say

Shinn, president of the Colorado-based Lee Evans Group, estimates that 80% of builders use cost-based pricing formulas. Sometimes they work, he says, but only because the prices fall, by chance rather than design, in the range where the market sees value. Shinn counsels that a better approach is to find the product the market favors on a particular site — through diligent market research — and the price the market will pay for that product, even before closing on the land.

So if your building a spec home it a better approach to take a Top-Down approach to pricing based on the intrinsic value the home and land have to a potential buyer and work backwards to see if you can then build that home for a cost that leaves you with the Gross Profit you need and the Net Profit you want to generate. It’s a business strategy also known as Target Costing.

But putting those Pricing considerations aside we’ll look at the project from a Bottom-Up (cost-based) perspective.

I’m not at all sure at all why Allan put the challenge to me in the way that he did. In the discussion of any Markup System whether it’s a Traditional Volume Based Markup system such as Walt Stoeppelwerth, Michael Stone or Alan Hanbury advocate and talk about or a Capacity Based Markup system (aka PROOF) such as Irv Chasen, Ellen Rohr, David Gerstel and I advocate the discussion at it’s core roots is about how Overhead gets allocated. In Allan’s challenge to me he has already allocated overhead to the job (although we don’t know for sure just what method he used).

However if I was the builder and wanted to cost this house I would do just what I described in my post #15 in that discussion:

If I’m a builder and I’m generating $3000 dollars in Business Operational Costs (aka Overhead) per week ($156,000 per year) and I want to look at my business through a Capacity Based (PROOF) Markup System I can plan to recover that overhead a couple of different ways.

If I build 6 of pretty much the same house in a year I can take that $156,000 and divide it equally among the 6 houses. So with each house I should expect to recover $26,000 of my company’s Overhead costs. I would then take the Direct Job Costs add to that the $26,000 and since I’m not taking a salary out of that Overhead I would then also add whatever I wanted to make personally on to that sum.

Another way I could look at it is I figure I’m going to put in 2000 hours working building houses each year. I’m going to build six houses in a year but they aren’t the same house and are going to require different amounts of my time.

House 1 will take 410 hours of my effort.
House 2 will take 210 hours
House 3 will take 320 hours
House 4 will take 270 hours
House 5 will take 290 hours
House 6 will take 500 hours

So figuring each hour of my time essentially generates or accounts for $78.00 of Overhead ($156,000 divided by 2000 = $78) I need to spread that $156,000 respectively amongst those houses so I get:

House 1 @ 410 hours accounts for $31,980 of Overhead
House 2 @ 210 hours accounts for $16,380 of Overhead
House 3 @ 320 hours accounts for $24,960 of Overhead
House 4 @ 270 hours accounts for $21,060 of Overhead
House 5 @ 290 hours accounts for $22,620 of Overhead
House 6 @ 500 hours accounts for $39,000 of Overhead

And like the other example you take the houses Direct Job Costs add on the respective Overhead charge and then add to that what you want to make on the house.

That said reverse engineering the $30,000 Overhead allocation that Allan gave me I probably would have figured that that house would consume 384 to 385 hours or 19.23% of my company’s capacity.

My recommendation for Pricing the house would be as follows:

Direct Job Costs + Overhead Allocation + Consideration for The House’s Intrinsic Value = House Price

$1,000,000 + $30,000 + Consideration for the The House’s Intrinsic Value = House Price

by: admin

1. Lack of Skills and Experience
   Listed perhaps in an increasing level of importance
   1. Trade Skills This is pretty obvious to most contractors but perhaps because it is so obvious it is incredibly over emphasized with is just as dangerous as having no trade skills at all. Often contractors will think this area is the most important or the only thing that is important. Thinking that is often a huge fatal mistake.
   2. Project Management Many small contractors think because they execute small projects or have the trade skill to build a house they should just naturally be able to manage the project of building a house and that just not true. Project management is a unique set of skills unto itself.
   3. Sales Skills. Contractors need to have the basic customer relationship skills to understand what their clients want and how to respond to those needs. And of the basic sales skills contractors need to understand and learn how to close the sale.
   4. Basic Business Acumen & Financial Control Many small contractor business operation fail because managers do not integrate accounting and accounting practices to any kind of reasonable level in their business. By failing to do so, they suffer from the lack of financial control and consequently cash flow problems force the business to fail.
2. Insufficient Capital (Money)
   And that can mean anything from insufficient capital to market the business enough to get it rolling to not having the capital for a operational reserve (an OCRA account) to get you through a bad stretch or cash flow crisis. How many contractors even know how much money to even keep in an OCRA account (Operating Capital Reserve Account also sometimes referred to as a CYA account).
3. Poor Location
   Meaning your working the wrong business in the wrong market area. This doesn’t at all mean to survive and thrive you need to work in Beverly Hills or Greenwich CT but it does mean you need to tailor your product offering for the region you plan to work in.
4. Poor Inventory Management
   This means a couple of different things. In the management schools of Lean Thinking, Six Sigma, and the Theory of Constraints work-in-progress is considered inventory so having too much work in progress. That’s where you’ve paid for the materials and have put in you time or paid for your labor’s time but the client has yet to pay for it. People might say well that’s just a matter of keeping your Accounts Receivable to a minimum but it goes beyond that in that Accounts Receivable only represents the work that is completed and ready for payment and not the incomplete work that is in the pipeline.
5. Over-investment in Fixed Assets
   Renting shop space, buying an Altendorf table saw, Festool saws and drills and the brand spanking new truck while not having the profitable cash flow to support those purchases or leases
6. Poor Credit Arrangements
   Or no credit.
7. Personal Use of Business Funds
   Spending the businesses money on that boat you want so that you can go fishing. Real bad idea.
8. Unexpected growth or the Inability to Manage Growth
   Getting too big too fast and not having the infrastructure in place to support the growth
9. Competition
   Well there is not really too much competition in the building and remodeling market we been in for the past few years but who knows how long these flush times will last and even then you could always be blind sided by a good skilled contractor who has devised a better way to produce the same out you are only cheaper and faster or you could be blind sided by a gray or black market contractor underbidding you.
10. Mistaking A Business for a Hobby
    Woodworkers and and good cooks (restaurants are # 2 for having the highest business failure rate right behind contractors) may in fact be the most prone to this. We love our trades and would do them even if we were in another career field.
11. Asking Friends & Relatives for Advice
    They will more often than not tell you what you want to hear rather than what you really need to hear.
12. Asking Friends & Relatives for Money
    When things get tough the pressure they can put on you for their money can double the stress.
13. Mismanaging Money
    Paying too much or paying for things at the wrong time.
14. Poor Marketing
    Gets you caught between a rock and a hard place when your word of mouth leads dwindle or dry up in a tightening market.
15. No Business Plan
    Dwight D. Eisenhower once said: "In preparing for battle I have always found that plans are useless, but planning is indispensable."
16. No Understanding of Pricing
    Boy this is a big one in my estimation. This means understanding both the concepts of markup and overhead recovery and how to estimate at least semi-accuratly.
17. Inability to Plan for Transitional Periods
    What to do during the peaks and valleys when the work you do is seasonal or the peaks and valley of an economic cycle
18. Lack of Commitment
    Not realizing that running a business is a full time relationship that needs to be worked on to succeed.
19. Failure to Set and Revise Goals
    Out of the start gate you need a goal to head for but you have to be able change as the opportunities in the market change.
20. Inability to Develop and Monitor Financial Statements
    Not understanding what the bottom line you have to achieve can be deadly. I think every contractor has to understand and know precisely what their break even point is.
21. Inability to Balance Business & Family
    As the stress and needs of a business build up they compete for what is a finite resource. The waking hours you have available in a day so the two can very easily end up in competition to each other rather than complementing each other.
22. Underestimation of the Time Requirements
    This applies both to in the area of understanding and planning for the time a business owner needs to spend on the business house keeping, administration, and marketing as well as the understanding of the time requirements of the actual trade work.
23. Poor Internal Communications
    Poor internal communications between project sites and the home office plague many construction companies. Consequently, there may be little warning of project execution problems or financial difficulties. This can be anything from not having an actual phone connection from the sit cellular of land line to a company culture problem such as "shooting the messenger" where employees don’t want to tell their bosses the bad news because they’ll be punished for it. In most cases, it only takes one or two disastrous projects to bring down a company. Early warning is essential if corrective action is to be taken in time.
24. Poor External Communications
    Not talking to the customer.
    Or talking at the customer instead of listening.
25. Inaccurate estimates — Many contractors do not make a detailed estimate of their projects before they bid and some of them simply rely on past experience. They do not get the job because their bid for a project is too high and if ever they win one because they gave the lowest price, they also end up losing money because the price that they were paid for can never deliver the service that they promised. Having a detailed and accurate estimate for any construction job brings more confidence and increases the probability of getting a construction job.
26. Poor purchasing — Good material sourcing is a critical success factor in the construction business. Good purchasing is not just getting the lowest price but also involves quality and delivery. Looking at alternative materials and suppliers is a good strategy in trying to bring down costs.
27. Poor pricing decisions — Even with an accurate estimate, some contractors still would want to shave off their bid price just to ensure that they are the lowest bidder and would eventually win the job. Although dropping prices is a pricing strategy, it is most of the time not sustainable and should be looked at as a short-term strategy.
28. Poor quality control — A lack of quality procedures and control would only lead to poor workmanship. If this happens, the customer will not accept the job and will only result in rework and additional costs for the builder. Many builders have closed shop due to poor quality.
29. Unsafe construction site — An unsafe work site is an unproductive work site. Accidents at the work site affect costs, image and the overall morale of the workers. A responsible builder is one who makes sure that the work site is safe for the employees, customers and its surrounding environment.
30. Contract management failure A construction contract is a legal contract in which the owner agrees to use the services of the contractor and the contractor also agrees to provide the required services based on the agreed price and specifications.
    A legal failure is caused by poor contract management. It is the responsibility of the contractor to build to specifications but it is also the responsibility of the owner to pay the builder on time. The construction contract should detail all of the requirements on the project and both parties — the owner and builder — should fully understand these. When in doubt about contract interpretation, builders should always seek the advice of a legal counsel.

    by: admin