Managing the Costs of Construction
It should be no surprise to anyone reading this paper that containing project costs is an essential means of maintaining contractor profitability. What may come as a surprise, however, are the elements that can directly (and indirectly) influence cost escalation: industry factors, risk management and insurance coverage. We will examine each in detail to help contractors develop a clearer picture of cost escalation, its impact on their projects and how to keep it under control.
Seven Issues that Boost Contractors’ Costs
Many contractors, desperate for work during the economic downturn, have bid on projects with (or agreed to work for) thin or no margin to maintain ongoing operations. This compounds the already significant concern of cost escalation by reducing the “cushion” available to deal with any issues that arise during a project. To manage cost escalation, it is important to identify and stay attune to the issues that result in added, unwanted expenses. Here are seven of the most prevalent:
1. General Inflation refers to the overall increase or decrease of all goods and services in the economy over a given time. For the most part, builders are aware of general inflation as an escalation risk, building it in to pricing using historical data and forward looking trends. Unfortunately, simply accounting for general inflation may not address the immediate concern. The construction industry has its own specific inputs, the prices for which may not be consistent with overall prices across all industries. Additionally, a radical change, outside anticipated variation, of the cost of a single input can have a significant impact.
2. Global Market Forces: The world is getting smaller every day, and nowhere is this truer than in construction. Buildings are constructed of the same materials all over the globe, and those materials are manufactured and fabricated from the same supply chains for all uses. Increased demand on the other side of the world, whether due to a localized boom in construction, a natural disaster, or supply chain disruptions, can affect contractors wherever they operate. The global nature of the industry affects pricing, sourcing, availability and material costs. Furthermore, the complexities of regulations and trade laws (both in the US and other countries) can cause additional impacts. Projects of a global nature (like ports), can and do cause ripple effects. And as the world becomes more and more interconnected through technology and logistics, these rippling effects from far away projects will only become more and more pronounced.
3. Skilled Labor Shortages / Labor Supply: In some markets, this issue is not on the radar yet. In others, it’s a major concern. Work in the oil and gas industry has drawn many potential workers away from other sectors and markets where the oil-shale industry is hot, and must be contended with, the current dip in petroleum prices notwithstanding. The resurgence of residential construction – particularly multi-family construction – has drawn off many craftsmen who previously worked in the commercial field. The expansion of the Panama Canal is having far reaching effects due to preparatory construction going on in various ports across the country; the demand for workers on these projects is significant. Additionally, many experienced tradesmen left the construction field during the downturn and do not appear to be returning. Employment numbers indicate the war for talent will continue to escalate. Though recent reports show a sharp dip in construction unemployment, the increases in construction employment numbers are not as high as would be expected if all things were equal. This indicates that many workers have left the construction field entirely – whether through retirement, or a career change. As construction spending continues to escalate, this will become an even more important factor, as productivity gains – though positive - have reached a seeming maximum.
The increased demand created by the existence of many or very large projects in a region can cause shortages of manpower, capacity, and materials.
4. Increased Demand / Many or Large projects in a region: The increased demand created by the existence of many or very large projects in a region can cause shortages of manpower, capacity, and materials. It can also mean that subcontractors have more choices with regard to the builders with whom they choose to work. This increased demand on subcontractors’ capacity puts them in a position to make a better profit on newer work, and if a job was bid with a lower margin, it may suffer from being a lower priority. Hence, many contractors may end up with the “B” or “C” team. Also, more time spent supervising any team on project means less time for something else, which further impacts the productivity concerns expressed above.
5. Material/Fabrication Supply: Builders and subcontractors were not the only ones who had particular challenges caused by the recession. Suppliers felt the pain as well. Many had to lay off workers. Some struggled – and failed – to survive. Like many contractors, suppliers and fabricators reduced their own output capacity in order to cut costs. Now, with the current resurgence in construction volume, combined with the reduced number suppliers in the market as a result of failures, the demand is in excess of capacity in some cases. This, as a result of demand exceeding supply, leads to inevitable price increases; that’s just Econ 101. It also means that if the supplier fails or cannot meet requirements, the contractor will have fewer choices for replacement, and may see premium prices charged by any replacement supplier.
6. Natural Disasters: Weather events of the magnitude of Superstorm Sandy or winter 2013-14 polar vortex-related weather can be a strong driver of cost escalation. This happens as labor floods in to take advantage of the “hot market” – leaving a lack of manpower in their home markets, and as particular supplies (e.g. plywood) are exhausted in preparation for and response to the events.. As mentioned above, the effects of a storm or other disaster in one location have a greater than ever potential to impact projects many miles away. Natural disasters may also delay completion – or start – of a project, which increases the potential for cost escalation by drawing out the overall schedule.
7. Safety, Code, or Project Certification Requirements during estimation: Changes in building codes, internal or external changes in safety requirements and a project’s certification requirements can lead to cost escalation. Any lack of awareness in these areas can cause unanticipated costs, which will likely land squarely on the contractor’s balance sheet.
This series will continue on Fast Fast Forward with 2 more installments in the coming weeks:
Part 2: Seven Ways Contractors can Manage Cost Escalation Risk
Part 3: Five Insurance Considerations for Managing Cost Escalation
OR DOWNLOAD THE COMPLETE WHITEPAPER HERE
About the authors
Daniel Tolman is a Vice President at the Willis North America Construction Practice and one of the National Market Experts of their Default Insurance Group (DIG).
Cheri Hanes is a Construction Risk Engineer with XL Group’s North America Construction team. She holds both LEED AP and CRIS certifications.