Construction Update

Protect Yourself Against Skyrocketing Materials Costs

In meteorological terms, a perfect storm occurs when several events occur simultaneously — events that in themselves might not be disastrous, but that when combined create a storm of exceptional strength.

Today a confluence of economic events is causing sharp increases in the costs of many basic building materials. These sudden and dramatic hikes can wreak havoc with bids and put contractors and subcontractors at significant risk.

Living in a Material World

Consider these examples:

• Basic steel prices increased 44 percent in the year ending August 2004.
• Lumber cost 24 percent more in July 2004 than it did a year earlier.
• A cubic yard of concrete cost $48 in 2002. Today it costs $64, and may reach $77 in 2005.
• Costs for other raw and finished materials are expected to increase significantly.

These increases all stem from a persistent imbalance between supply and demand, itself the result of several simultaneous developments.

Why Demand Is Outpacing Supply

A sustained construction boom is underway in China, driven by the 2008 Summer Olympics, the Three Gorges Dam and expanding middle-class markets for housing and infrastructure. China buys more than 60 percent of the world’s concrete, and to make concrete rebar it purchases huge volumes of scrap metal.

A shortage of tanker ships, meanwhile, is making it more costly to import cement — and in some places, China included, is causing actual cement shortages. In the U.S., western cities are facing the greatest increases in transport prices.

As crude oil prices top $50 a barrel, transportation costs naturally increase. But fuel prices have an even more direct impact on the cost of materials. Some 25 percent of the price of cement, for example, can be attributed to fuel costs.

Finally, in August, U.S. construction spending reached its highest level ever. That’s good news for the economy and the industry, but it means demand for construction materials will continue to rise.

Guard Against Unpleasant Surprises

These price increases present significant risks for contractors and subcontractors. They can turn a profitable project into a loser, and cause delays that not only disrupt schedules but can trigger completion-date penalties.

Risk-conscious contractors face a dilemma: They may win the bid but lose money to price hikes and delays, or they may lose the work entirely to lower bidders less sensitive to risk. It’s impossible to eliminate risk altogether, of course, but steps can be taken to limit your firm’s exposure to the risk of volatile material costs.

1. Build protection into the initial bid. “Cost-plus” contracts, which shift price increases entirely to the project owner, are increasingly rare. But it may be possible to spread the risk among contractors, subcontractors and owners through an escalation clause that defines a trigger price for a given commodity. If the price exceeds the trigger, the GC and/or the owner absorbs some portion of the increase.
2. Stay informed about developments that could impact future prices. The thinking of suppliers and manufacturers’ reps, though speculative, can alert you to possible trouble ahead. Construction associations, industry publications and academic resources can provide insights into the likely direction of prices.
3. Document price escalations. If you’ve negotiated an escalation clause, you’ll have to show that you have in fact encountered escalating costs — and that they were outside your control, not the result of poor purchasing practices.
4. Reduce other risks. A bid on a single-story retail center, for example, entails considerably less risk than a bid on a high-rise condominium, because the smaller project’s shorter schedule gives prices less time to increase.
5. Consider buying materials in advance. This can bring its own problems, like weakened cash flow, storage costs and the risk of loss or theft. But if you have a firm contract for a project, or if you are certain of your continued need for raw materials, it may make sense to purchase some price-sensitive commodities in advance. Some suppliers might even agree to delayed delivery, relieving you of the storage costs and risks.
6. Get to know your suppliers. Regardless of what type of delivery contract you arrange, it is important to deal with reliable, reputable and informed suppliers. Purchasing from the same supplier over a long period can earn you a certain amount of loyalty; by the same token, a reliable supplier deserves your loyalty. When shortages crop up, it pays to be working with someone who is both willing and able to get you the materials you need.
7. Investigate all aspects of the contract. A subcontractor who fails to notice an “incorporation by reference” clause, for example, may be in for a bad surprise. That clause means that the terms of another contract — the agreement between the GC and the owner — take precedence over the subcontractor’s agreement with the GC. Early-payment and cost-sharing deals can be made moot by such clauses.
   
   Even if you can’t avoid an “incorporation by reference” clause, you must understand it and factor it into your overall negotiations. And subcontractors have a right to know how the general contractor will be paid, because in most instances that will have a direct bearing on how subcontractors will be paid. Professional analysis can help you make an informed decision on these contract provisions.

The element of risk can’t be removed entirely from the construction process. Most contractors and subcontractors are entrepreneurial by nature, and are willing to undertake a reasonable risk in exchange for an adequate potential reward.

But in the case of rapidly escalating materials costs, the potential risks are very high, and the offsetting reward is virtually nonexistent. Thus it’s critically important to take adequate steps to mitigate these risks.

These suggestions, when coupled with prudent bidding, patient negotiating and careful attention to detail, can help you limit your exposure and protect your company from costly surprises. Our firm can help you with all of these things.

For more information about our services to the construction industry, Contact:
Mark Lund, Parter-in-Charge of Construction Services at 713.297.6907.

The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.