WHEN PULTE HOMES PLOWED AN ESTIMATED $42 million into a joint-venture partnership with Phoenix-based framing and foundation contractor Pratte Construction in January, the agreement revived a long-standing debate on the pitfalls and potential benefits of vertical integration. Builders weren't the only executives considering the implications of Pulte's strategy. BMC Construction, which provides turnkey framing and foundation services to 19 of the industry's 25 largest home builders, recently opted to survey its clients to find out whether any were thinking about bringing some elements of manufacturing, distribution, or labor management in house. The results—only four companies said they were contemplating such a move—reassured BMC, a division of San Francisco-based Building Materials Holding Corp. Still, the survey reflected an industry in which builders may be edging closer to that next bold leap that would impose greater management control over supply chain.

Currently, only 10 major home building companies are known to incorporate one or more vertical integration functions into their operations. Family history as much as local economics often explains why some builders maintain these extended business units. There's little evidence, in fact, to suggest that droves of builders are about to jump on this bandwagon anytime soon. Nevertheless, vertical integration is never too far from some builders' minds in looking for ways to accelerate production and hold down costs. A handful of builders—KB Home is often mentioned by other builders—is reportedly taking a more serious look at expanding processes vertically. (KB Home did not return requests for comment.) And those builders who are already committed to vertical integration say they want to expand what they insist has become a vital competitive advantage.

In markets where its volume reaches “critical mass,” Centex Homes, for one, is actively seeking opportunities to extend its CTX Builder Supply division, whose four manufacturing and distribution facilities provide components and lumber to approximately one-third of the homes Centex builds, which this year will total about 37,000. “I can see that [capacity] easily going north of 50 percent,” says Paul Dodge, Centex Homes' vice president of purchasing and distribution. McLean, Va.-based NVR—whose building products division is composed of six structural component manufacturing plants that supply about 30 percent of the builder's product needs—could soon be adding to its capacity to support new-home construction in the Mid-Atlantic region, according to a source knowledgeable about NVR's operations.

These examples—and a few other builders—remain exceptions in an industry that is skeptical about vertical integration. The true economic benefits, vis-à-vis outsourcing, are hard to gauge, say many builders—especially when executives whose companies have been at it for decades still talk mostly in generalities about cost containment and cycle-time reductions. And why, most builders argue, should they travel the vertical integration route when myriad supply sources with installation capabilities vie aggressively for their business? One builder, based in the Southeast and who requested anonymity, says that distributor Stock Building Supply provides and installs trusses for all of the homes his company builds and has one of its reps sit in on that builder's production meetings every Monday morning.

“You have to focus on activities you do best unless control of those activities is critical to the value of your product,” says Mike Mahre, CEO of BMC Construction, which this year will frame or pour concrete for more than 25,000 homes. “It's not just enough to capture more profit; you've got to create value.” Michael Ulinski, vice president of sales and marketing for Daytona Beach, Fla.-based Masco Contractor Services, whose 16,000 on-staff installers provide turnkey services for many large builders nationwide, says he sees vertical integration as counterintuitive to the strength of builders' “variable cost models,” which allow them to adjust their fixed costs up or down depending on seasonal demand.

Of course BMC, Masco, a growing number of manufacturers, and virtually every pro dealer and distributor have vested interests in downplaying the value of vertical integration for builders. Their prosperity depends, in part, on builders' continued enthusiasm for outsourcing materials and labor. But at least one home building executive thinks the industry could be headed toward change, with home builders controlling—either organically or through acquisition—more of their own manufacturing and manpower needs.

“We are a management company, a process company, and we're hoping one day that we can eventually frame [and install] better than outside sources,” says Mark Hodges, senior vice president of corporate operations for Red Bank, N.J.-based Hovnanian Enterprises. In Ohio, Hovnanian's Summit Homes division operates a 215,000-square-foot distribution center with employees who handle some of the division's installation needs, such as foundation waterproofing, HVAC, and carpeting—and has just expanded into plumbing and electrical. Summit's on-your-lot business model may not be transferable to its parent company's other divisions, Hodges concedes. But he says Hovnanian is committed to figuring out how vertical integration can work more broadly for its operations in other markets. “This could represent a huge shift if builders get deeper into the supply chain,” he says.

Special Circumstances Before builders start storming the ramparts, though, they will need to be convinced that vertical integration can be all it's cracked up to be. On that score, the jury is decidedly out.

Vertical integration in the housing sector dates back to at least the 1960s, when Ryland Homes and Ryan Homes opened panel and truss plants. Centex got into product distribution in 1972, when it acquired Fox & Jacobs, and Toll Brothers has operated panel plants since 1986. Atlanta-based John Wieland Homes may be the industry's integration with manufacturing plants for cabinets, windows, and doors; a lumberyard (Forest Materials & Supply); a grading company; and a light fixture supplier. Another success story is Pulte's DiVosta Homes division in Florida, which employs its own crews that pump out houses within a 55-day production cycle. (Pulte declined to comment about either DiVosta or its joint venture, Pratte Building Systems. However, Pratte is expected to supply materials and labor for the 8,500 homes Pulte projects it will build in Arizona and Nevada this year.)

BMC's Mahre points out that Di-Vosta's business model, with “cookie-cutter” homes and “assembly line” construction, would probably be too limiting for most builders to accept. Other builders offer explanations about why vertical integration wouldn't be suitable for their companies: For one, the fixed asset and labor costs present financial risks for cyclical businesses—and turn off investors. Cost efficiencies can also be achieved by working closely with trade partners. And perhaps most compellingly, vertical integration falls outside most builders' core competencies.

“None of us knows how to run an HVAC company or manage mostly Spanish-speaking labor in a disparate market,” says Hodges. “You have to make a conscious strategic choice to get into vertical integration and determine whether the return will pay for the management distraction and business risk.”

The source familiar with NVR points out that vertical integration is “a tough process to perfect” because it requires “total buy-in from corporate management,” who must resist the temptation to shop around for lower prices. NVR's plants, he says, currently supply all of the company's structural components and have an annual capacity of 20,000 homes. NVR is on track to build 14,000 units this year.

Benefits Of Control That more builders seem unwilling to even experiment with vertical integration is a mystery to its proponents, who say their companies have realized substantive improvements in product quality and a reduced number of construction defects. “Our support companies do a much better job than what we could get on the open market,” insists Terry Russell, John Wieland's CEO. He adds that vertical integration also gives his company “tremendous design flexibility,” which it markets as “The John Wieland Difference,” because, explains Russell, “we can offer customization at a much lower price.”

Easier To Customize The same holds true for the Bethesda, Md.-based Winchester Homes division of Weyerhaeuser Real Estate, which operates a panel plant, a lumberyard, and a 30,000-square-foot millwork warehouse in Baltimore. “A big part of vertical integration is that it lets our customers customize,” says Winchester's president Larry Burrows. “If someone wants a different stair configuration or a first-floor master bedroom, vertical integration allows us to pull off the value proposition easier.” Winchester markets its ability to customize under the banner: “Your Home. Your Way.”

Winchester will build about 750 houses this year, and one-fourth of those homes' construction costs are attributable to products running through its Baltimore complex. Burrows estimates that his company saves 20 percent on those materials, compared to what it would pay other suppliers, and gains greater control over production quality and damage. (Its warehouse ships panels and other commodities to jobsites in sea containers.)

What builders won't reveal, though, is how much—or even if—vertical integration actually contributes to their bottom lines. Russell claims, without offering corroborative data, that all of John Wieland's integrated businesses except its lumberyard are profit centers.

“Everyone in our company has a different answer” when asked if vertical integration induces more profit, quips Joel Rassman, CFO for Huntingdon Valley, Pa.-based Toll Brothers, which receives its own lumber, assembles its windows and doors, and constructs roof and floor trusses. Rassman says vertical integration “easily” cuts Toll's construction costs by $2,000 a home.

Centex reported that its construction costs fell to 50.8 percent of its housing revenue in 2003, 10 percentage points lower than in 1998. The timing of those reductions correlates with the addition over the past four years of manufacturing to CTX's distribution centers. Component manufacturing generates more than half of CTX's revenue, and “CTX's value is much more on the manufacturing side than the distribution side,” says Centex's Dodge.

CTX's 65,000-square-foot facility on 17 acres in Buda, Texas, for example, started distributing lumber in April 1995 and added roof truss and wall-panel manufacturing in June 2002. It services Centex's construction in four Texas markets and produces components for about 13 homes a day (its capacity is 18). “We are a captive supplier, but we still have to run as a profit center,” adds Scott Bauer, Buda's divisional manager who joined Centex in January from Menard's, the home improvement dealer, where he managed its truss division.

Changing Times Most of the builders who already have internal manufacturing and distribution support say they expect to expand those operations as their companies get larger. “We're always looking for pieces to add that make sense logically,” says Russell, noting that John Wieland has considered adding framing and HVAC installation to its operations.

Diversifying into labor management, though, raises issues builders haven't completely resolved yet.

Hodges at Hovnanian says he thinks the era of captive subs and staff installers could fast be approaching for large builders because, “while there are a lot of good trade partners out there, they are already getting stretched.” Rassman at Toll Brothers—which got into vertical integration in response to a shortage in carpenters—is less certain. Subs, he explains, “are very independent, so vertical integration may be less effective.”

Still, Toll once considered buying another builder that owned a carpentry company. And as his company expands—its closings this year are projected to increase 22 percent to 6,000 units—Rassman predicts Toll may decide that ensuring its access to sufficient manpower outweighs any caveats it might harbor about integrating labor management into its operations. “One day, we will have some geographic regions that will have their own crews,” he says.

And as skilled labor becomes scarcer, one might reasonably ask how far away that day will be for all those builders talking about doubling their volume over the next five years.

INTEGRATED APPROACH John Weiland Homes is among the most vertically integrated builders in this year's BUILDER 100. “Our support companies do a much better job than what we could get on the open market,” says Terry Russell, John Wieland's CEO. Among the manufacturing and service operations that support John Wieland Homes:

  • Wieland Financial Services (mortgage)
  • Cabinetcraft
  • Qualitycraft (windows and doors)
  • Forest Material Supply (lumberyard)
  • JW Specialties (lighting and plumbing fixtures and miniblinds)
  • Wieland Remodeling
  • Wieland Realty Associates
  • Foundationcraft
  • Greencraft (landscaping and tree spade)
  • JW Grading
  • WES (Wieland Environmental Services)
  • Wieland Management Associates (community association management)