Builders must balance the need for value and velocity
By Charles C. Shinn Jr., Ph.D.
Founder, Builder Partnerships
Too many builders determine the sales price of their homes based on direct construction cost and land. They come up with a plan, establish the standard specifications, go out to bid, add up the costs, and put a markup on the costs to determine the sales price.
The problem is costs do not necessarily create consumer-perceived value. Most of the time, the resulting sales price is too high, so the velocity of sales does not meet expectations. To stimulate sales, the builder begins to give sales incentives (discounts).
The amount of the sales incentive is 100 percent lost profit. Suppose the builder gives a $10,000 sales incentive (discount) to generate sales and the builder is making a typical 5 percent net profit. Since the $10,000 represents lost net profit and 5 percent is 1/20 of sales revenue, the builder needs an additional $200,000 in sales to make up for the lost profit caused by the incentive.
Sales incentives or discounts typically do not create the same sales velocity that would have occurred if the price was set correctly to market in the first place, thus losing the potential return on investment for the community.
The crucial role of sales velocity
The total revenue for a home builder is made up of the sales price of the homes and the net velocity of sales. Normally in setting sales prices, I like to start with the velocity of sales desired out of the community. When you buy a piece of land you look at the financial risk and the return desired from the investment.
Let’s say you are buying a 90-lot community. Based on your risk calculation and the desired return on the investment, you don’t want to be active in the community more than 18 months. So, your sales velocity needs to be a net 5 sales per month. Based on experience, you expect one cancellation per month, so you need to have a gross sales velocity of six contracts per month.
The fixed expenses invested in the community also should be considered when determining velocity. These include as a sales center, model homes, advertising, signage and collateral sales material, sales staff, the superintendent, a construction trailer, and temporary facilities. The cost for these needs to be kept within a certain percentage of sales revenue.
I also like to look at what activity levels are needed to motivate the sales staff and fully load superintendents and trade contractors. Generally, these considerations focus on a fairly tight sales velocity for the community. Too often, I see communities the builder would be better off closing, since the velocity of sales cannot justify them and they are consuming revenues from more viable communities.
The affordability triangle
Based on the general location of the land, the school district, access, builder competition, Realtor community, appraisers, and the home buyers’ perception of adjacent neighborhoods, the market establishes the basic sales price band you can charge for your homes. The band is typically fairly narrow.
I refer to this as the affordability triangle for the community. The higher the base sales price is in the affordability triangle, the lower the sales velocity to be achieved. The lower the base sales price, the higher the sales velocity.
The selection center allows the customer to upgrade the base house, catering to a larger segment of the affordability triangle. Within the range of the affordability triangle pricing, the base market home sales price is determined based on the price that will generate a gross home sales rate of six homes per month with a net yield of five firm contracts.
Once the base market sales price is determined, work backward to the direct construction costs. The first thing to deduct from the market sales price is your profit. Remember, this is why you are in business.
Next, deduct the land cost at what I call “builder retail,” or the price at which you could sell that land to another builder. An operating expense allocation also should be deducted; this needs to cover indirect construction costs, financing, sales and marketing and general administrative expenses.
You also need to cover your historical slippage, or direct construction cost variance rate. Don’t forget you are going to have warranty costs, so a warranty allocation also needs to be deducted.
What is left is how much you can spend on direct construction costs. The home should be designed, specified, and estimated to this direct construction cost budget to protect your profits. If you need to make cuts, make them from direct construction costs, not your profit. Profit should not be treated as the residual or what is left over. It is your company’s life blood.
Managing cost increases
To cover anticipated construction cost increases, you should be proactive. Analyze the cost increases experienced during the last year. Consult with key trade contractors and suppliers about the anticipated cost increases and their timing. Determine the amount of anticipated cost increase you will have to absorb and develop a strategy to increase your selling price.
Don’t play catch-up with a large sales price increase, which will cut off your sales velocity. Small repetitive price increases should be communicated to sales in writing in advance so they can be used as a closing tool to create urgency.
Options and upgrades
Regarding the offering and pricing of options and upgrades, you need to achieve a balance between choice for the customer and control of the building process. The higher the price of the homes, the more choices typically need to be offered. However, be conscious of offering too many choices, which creates confusion and indecision.
A target gross margin should be established for the options and upgrades. Not all options will or should have the same gross margin. Structural options typically can have very high margins.
If the customer can compare your pricing with retail stores, you need to be ready to justify the differential between the prices. Remember, we are not in the retail business. We are in the lifestyle business. You should try to package the options; it reduces the number of decisions the home buyers need to make and the ability to competitive shop the prices.
All structural options you offer should be pre-planned and pre-priced in the estimating and purchasing database. Create a catalog to allow your sales team to easily sell them at the point of sale instead of redlining plans with similar, but unique custom changes, which continually create work and confusion in your back office and field operations.
If you follow these guidelines, you'll be in a better position to achieve your desired sales velocity and profits. Good luck!