By its very definition inflation means rising costs. The rising cost of inputs to a construction project (material, labor, equipment, etc.) can affect a company’s bottom line and the price it passes on to its customers (as we’ll see later).
With so many goods and services needed to complete a project, and with the interrelationships among those goods and services, construction inflation can have an exponential impact on costs.
Contractors must be nimble if they want to mitigate the effects of inflation on their business. There are several things you can do to keep inflation from bankrupting your company.
How Does Inflation Affect Construction Costs?
Inflation affects the cost of everything on a project, from materials and labor to insurance.
Materials
The rising cost of construction materials, especially lumber and steel, have been making mainstream media headlines for the past three years. Lumber prices shot up over 300% and product was hard to come by. Steel prices also escalated. Jeremy Baker, a design-build residential contractor and co-owner of Letter Four in Los Angeles, estimated that his costs have gone up 25% overall.
Labor
The construction industry has been dealing with a labor shortage for the past couple of decades. Contractors have been scrambling to provide enough labor to keep projects on schedule. The stiff competition for workers has led many contractors to raise their wages and benefits packages to lure young people to their companies. Add to that the necessary cost of living increases, and wages have climbed an average of 4%, compared to 3 or 3.5% for the past decade.
Fuel
Fuel is a necessary expense for almost all contractors. They have to get their workers, materials, and equipment to and from the job site. According to the Bureau of Transportation Statistics, from January to June 2022 regular gasoline went up by 49% and diesel rose by 55%.
Insurance
A cost you may not consider is business insurance. According to the Wall Street Journal, business insurance costs rose 12% in the first quarter of 2022. A rise in overall prices means that insurance limits must go up to cover damages, this leads to a direct increase in the premiums businesses pay.
How Does Inflation Affect Construction Companies?
We spoke with a couple of contractors to ask them how construction inflation has affected their businesses. Overall, they’ve noticed reduced profits, increased costs for and more difficulty securing financing, and a reduction in consumer confidence which has led to reduced sales.
Matt Hagens with Obsessed Woodworking said, “If the rate of inflation is higher than the rate at which the construction company can increase its prices, then the construction company is likely to face diminishing returns. This means that while inflation may increase the cost of construction, it also decreases the ability of the construction company to make a profit.” With the popularity of fixed price contracts, contractors often don’t have an avenue to address higher costs and have to absorb these additional expenses.
Hagens also noted that “lenders may be less willing to lend to construction businesses when the inflation rate is high, since the uncertainty of the future economy makes the risk of repaying the loan more uncertain. This can make it difficult for smaller construction businesses, which may not be able to secure another source of funds.”
Additionally, “if the cost of borrowing money increases due to inflation, then the cost of construction increases as well. This can be especially true when construction projects require long-term financing, as inflation can have a more pronounced effect over longer periods of time.”
Lauren Adams, a design professional and co-owner of Letter Four in Los Angeles said,
“High inflation rates can also reduce consumer confidence, making it difficult for businesses to secure new contracts or retain existing customers as they become increasingly wary about spending money on large-scale renovation or building projects during times of economic uncertainty.”
How to Mitigate the Impact of Inflation to Your Contracting Business
Here are some tips to help you mitigate the effects of construction inflation on your business:
1. Raise Prices
The first thing you can do is attempt to pass the higher costs on to your customers. Although this may not work for existing contracts, it can be a way to recoup costs on future projects. Raising your prices does come at a risk, as you may chase off customers who are price conscious.
Adams said they “try to be as transparent as possible with our clients at each phase of the pricing process. We tell them what the state of the industry is and where we're seeing those increases at each step of the way.”
2. Negotiate With and Find New Suppliers
This is a good time to reach out to your suppliers and subcontractors and see if you can negotiate better pricing with them. They may be able to lower their prices with the promise of future orders or extend payment terms to help with cash flow.
If your current vendors aren’t willing to haggle, you can shop around to find suppliers and subcontractors who offer better pricing or are willing to work with you. It’s always a good idea to get multiple bids on everything to ensure that your pricing is competitive.
3. Buy Off-Season
If you’re in an area where construction slows down due to seasonal changes, take advantage of the slow period to order materials ahead of time. For example, the cost of decking materials may be down during the winter due to the reduced demand. This is a great time to stock up for next summer’s projects. Make sure that you have adequate space to store materials and protect them from damage and theft.
4. Use Technology
Contractors can invest in technology and software to help them better manage their costs, gain insights, and lower their overhead expenses. Tech can speed up administrative tasks, estimating, and cost reporting, allowing your team to spend more time on production.
5. Value Engineering
Evaluate the materials and equipment specified for each project and determine if alternative materials can be used without compromising the quality or function of the project. You may be able to save time and costs by looking at alternatives that aren’t as expensive yet provide the same quality and durability.
6. Improve Cash Flow
Contractors need cash to pay their bills and pay their workers, and a lack of cash can stall a project or even cause a company to close its doors. To get a quick infusion of cash, offer your customers incentives for early payment, such as a discount. Make sure the discount isn’t so much that you lose your profit. You can also look at alternatives like invoice factoring to help bring cash in.
7. Change Services
Between rising costs and material and labor shortages, new construction contractors have been struggling to control costs and complete jobs on time. If you find yourself in a similar situation, you may want to look at offering alternative services, like remodeling and house flipping, as a way to hedge the losses from new construction. These projects aren’t as material-intensive and generally operate on shorter schedules, so you’ll see quick results.
Bill Samuel of Blue Ladder Development in Chicago, a residential developer that specializes in rehabilitation and flipping houses, said that they’ve been focusing their business on rehabs because of inflation. “We've tried to focus more on rehabs for that reason because you're hedged better against inflation because you don't have 100% of your material costs rising. While with new construction, everything's brand new and has to be purchased at an increased price.”
8. Order Early
Contractors are finding it beneficial, and sometimes necessary, to order their materials as soon as possible. The earlier you order long lead items, the better the chance you’ll stay on schedule. Baker uses this strategy effectively with his projects, especially when it comes to windows.
“We aim to purchase windows as early as possible in anticipation of additional price increases,” said Adams.
This requires early coordination to get materials and equipment specifications approved but will pay off with lower costs and fewer delays.
9. Set a Time Limit for Your Bids
After seeing how much a project costs, some customers may want to delay the work, either hoping for a price reduction or to give them time to save money or get financing. Make sure your proposals have a time limit (“good for 30 days” or “effective until February 28”). This will give you a chance to reprice the project if the customer decides to go ahead at a later date.
10. Include a Price Escalation Clause
A good way to ensure that you will get reimbursed for increased costs after a project goes to contract is to include a price escalation clause. This clause sets a limit on the scale of price increases a contractor has to endure before asking for additional funds from the customer.
For example, the clause may say that the contractor will be reimbursed for all costs that escalate over 10% during the project. These clauses can help contractors stay profitable and protect customers from unnecessary cost increases.
While the effects of recent inflation have been drastic, contractors can do several things to mitigate the damage to their businesses. Strategies like buying materials early, negotiating, and adopting technology can help contractors keep costs as low as possible in this volatile time.
