Expert Commentary

Managing Construction Cost Escalation

The price of critical building materials is up. Even a casual glance at the price of wood or PVC pipe at your local hardware store tells the story. There's something of a perfect storm behind the phenomenon in a combination that could never have been anticipated.


Subcontractor Performance Risk
May 2021

Supply chain issues related to COVID-19 and an almost unprecedented deep freeze in the southern United States are two of the major factors driving the spike. With the seeming "V-shaped" recovery from the shutdowns of the pandemic, you have a recipe for cost impacts.

Identifying Escalating Construction Costs

It is important to identify and stay ahead of the issues that result in added expenses to manage cost escalation. Here are some of the most prevalent.

Inflation

Builders are typically aware of general inflation as an escalation risk and build it into pricing using historical data and forward-looking trends. Unfortunately, accounting for general inflation may not address the immediate concern. When cost increases are due to factors like those related to the COVID-19 pandemic or the extreme winter weather in the south-central United States in February, sharp changes in the cost of a single input can have a significant impact. Currently, pain is being felt around wood materials, steel, and resins that go into a variety of construction materials, to name a few.

Supply Chain

The saying that the world is getting smaller every day is especially true 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 their many uses. Production impacts from supply chain interruptions or increased demand on the other side of the world may affect builders wherever they operate. And, as the world becomes more interconnected through technology and logistics, these rippling effects will become even more pronounced.

Materials/Fabrication

Due to the pandemic, many suppliers shuttered facilities for periods of time due to government mandates or community spread of the virus. Some failed to survive. Now, with construction volume rebounding, demand is in excess of capacity in some cases. This leads to price increases—that's just Econ 101. It also means that if a supplier fails, builders will have fewer choices for replacement and may see premium prices charged by replacement suppliers.

Natural Disasters

Weather events of the magnitude of the recent Winter Storm Uri can be a strong driver of cost escalation. Many production facilities were damaged, and others lost power and production time, resulting in supply challenges for projects far and wide. Natural disasters may also delay either the completion or start of a project, which increases the potential for cost escalation by drawing out the overall schedule.

Safety, Code, or Certification Requirements

Any lack of awareness in these areas can cause unanticipated costs. It is necessary to consider both internal and external factors to ensure that this type of escalation is controlled. Complying with new codes or sustainability requirements has costs associated that must be accounted for. The COVID-19 pandemic brought to everyone's attention the fact that required safety measures can add costs and hurt productivity. Initially, this may have been considered force majeure, but, going forward, estimating must consider those additional factors in project budgets.

Skilled Labor Shortages

Many markets are experiencing expansion in the size and type of work, and subcontractor markets may be overstretched as a result. The increased demand created by the existence of many or very large projects in a region can cause shortages of manpower, capacity, and materials—all of which may lead to cost impacts. Builders would do well to contemplate that when considering work in any given location. The resurgence of infrastructure construction expected due to federal investment may also affect this risk if it draws tradespeople who previously worked in the commercial construction field.

Planning for and Dealing with Construction Challenges

So, having considered these factors that can impact costs, the question presents itself: do you want to play dodgeball, or would you prefer to play chess?

Should a builder strategically address these issues or hope for the best and try to roll with the occasional hit? If strategy is the preference, everyone on the team must understand their role in addressing these risks. The general feeling around cost escalation may be that these risks are passed down to subcontractors. However, if a subcontractor experiences escalation, it is likely to become the builder's problem, perhaps as a default, a schedule delay, change order disputes, or issues obtaining specified materials.

It is in everyone's interest to take an active role in managing escalation and that the entity most able to manage the specific risk takes that responsibility. And, while the factors driving escalation change, the basic approaches to managing it are relatively timeless. Below are some prime examples.

Estimating Assumptions

Historical data related to cost or durations that worked just a year ago are hopelessly outdated now due to supply chain issues, labor costs and availability, and COVID-19 protocols. Builders should pay special attention to improving the accuracy of this information continuously. Escalation is more likely if your underlying assumptions result in an insufficient budget or schedule.

Phased Bidding

To remove some exposure to escalation, consider identifying high-risk scopes, educating owners on the risk, collaborating to get the related design early, and expediting buying these scopes to lock in pricing as early as possible. Focused, phased bidding may eliminate the need to wait for complete documents for all scopes prior to procurement. The downside is that later scopes are more exposed to escalation if the overall procurement time frame stretches out, so approach this with the big picture in mind.

Scheduling Considerations

The construction schedules you commit to are a key to escalation risks that will be encountered. Builders should examine their schedules for areas where escalation risks can be mitigated. This could entail accelerating some or all of the project to reduce the duration and limit exposure to forces contributing to escalation. It could also entail building additional time into the schedule or increasing float to allow for a more reliable or cost-effective supply chain or subcontractor to be used. Time truly may be money in this situation.

Materials Prepurchase and Storage

Builders have options related to the procurement of materials, and a strategic delivery/storage plan may reduce escalation risk. Builders may facilitate this via payment for stored materials. Related challenges must be considered: cost, contract, insurance, and a variety of logistical implications.

Contract Updates

While it is typical to include an escalation clause in subcontracts, consult with your advisers about including force majeure, material escalation clauses, and equitable adjustments in owner contracts to address escalation. In addition to some protection, this may lead to a more collaborative project environment. When all parties share the risk, all parties have an incentive to work together to manage it.

Subcontractor Prequalification Criteria

Financial prequalification of subcontractors is critical to insulating a project from the impacts of cost escalation. If subcontractors bear this risk, financial analysis is a critical component of subcontractor prequalification, allowing assurance that subcontractors can absorb the cost of any escalation. Subcontractors' financial ratios, especially days of cash, can speak volumes about their enterprise risk and their ability to be profitable and build a strong balance sheet over the long-term validates that they manage their business well. Do not forget about the operational side of their business—managing their supply chain and human resources well is key to mitigating escalation risks.

Communication

Establish robust communication with subcontractors and suppliers. They are on the front line and may be able to see emerging escalation well before a builder can. Working with them to identify these risks and alternatives can be invaluable. Subcontractors are also often the only direct link available to the manufacturers and shippers of materials. Work with them toward achieving the highest degree of transparency possible so that you have time to react at the earliest stage if an issue arises.

Final Thoughts

At the root of all these strategies is a preference for open communication, a recalibration of baseline assumptions, and an intense collaboration among all involved parties. In formulating a plan to address cost escalation, look for ways to embrace all three.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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