Pricing Spec Homes Using a Capacity Based Markup Model

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

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