The surge in inflation we are currently experiencing occurred because of a number of disruptive events coming together to form a perfect storm of too much demand and not enough supply. The rate of inflation is the highest in over four decades. Contractors will need to take action to protect their bottom line and cash flow, and secure additional working capital to finance the higher cost of materials and supplies, payroll, and other operating expenses.

What Caused the Surge in Inflation?

The disruptive economic events began with the onset of COVID-19. Pandemic restrictions around the world resulted in record unemployment, the shutdown of non-essential manufacturing and production, and severe disruption of all forms of transportation. As a result, the U.S. and other major countries had economic contractions not seen since the Great Depression.

Several countries reacted with unprecedented fiscal stimulus programs and more accommodative monetary initiatives to provide liquidity and facilitate an economic recovery. The fiscal stimulus programs in the U.S. resulted in a record level of “excess savings” which helped fuel the imbalance in demand and supply when the economy began to open up.

After vaccines were rolled out, pandemic restrictions were eased, setting the stage for a tsunami of consumer spending in the U.S. and other advanced countries. The nascent recovery, however, was very uneven around the world. Major manufacturing and transportation centers could not ramp up to meet the surge in demand because of labor and materials shortages and transportation equipment that was not in position around the world. These events snarled supply chains globally.

Fuel costs, which had been already on the rise, were added to the fire with the war in Ukraine, further disrupting supplies of energy, commodities, and metals, causing prices to spike.

Is the Surge in Inflation Temporary or Will It Last for a While?

The wave of inflation we are experiencing has become pervasive, affecting consumers, manufacturers, transportation, distributors, service providers, and construction contractors. The prices of goods and services from gasoline, groceries, and airplane tickets to labor, No. 2 Diesel Fuel, copper tubing, and cement have increased significantly.

The disruptive events created shortages in key raw materials, commodities, metals, and labor, and bottlenecks in shipping and transportation, which drove up the costs for these goods and services. Producers, manufacturers, and transportation providers passed these additional costs along by raising prices to wholesalers, retailers, and contractors. Retailers in turn raised prices for the final consumer.

Inflation can be temporary when it doesn’t permeate the entire economy, and prices fall as demand drops and shortages ease. Take lumber for example. Prices rise and fall with demand from the construction industry. The price of lumber does not directly affect the entire economy and becomes embedded in the cost of many end products.

In other cases, inflation can last for a while when the supply of a number of key inputs is affected, and demand and shortages remain at elevated levels. Price increases permeate the entire economy and become embedded in the cost of many products and services.

Examples of this situation are No. 2 Diesel Fuel and labor. No. 2 Diesel Fuel is used extensively in transportation and construction equipment. It impacts the cost of many products and services. Its cost may remain elevated for some time due to geopolitical events and the transition to renewable energy. The cost of labor impacts the cost of all products and services. It may stay elevated for some time due to shortages caused by the pandemic and reduced labor force participation.

In addition, a paradigm shift in supply chains to avoid exposure to geopolitical risks, increase sources of supply, and shorten replenishment times may continue to increase costs for the foreseeable future.  

How Cost Increases Impact Contractors

Inflation will reduce your gross profit on contracts and increase the cost of overhead resulting in a smaller profit or even a loss. Additional working capital will then be needed to finance your business operations. 

Gross profit is eroded by higher costs for labor and material inputs. The following are examples of cost increases for construction material and labor reported by the Bureau of Labor Statistics.

Construction Material Inputs

Average Hourly Earnings All Construction Employees

Overhead costs are also increasing as inflations permeate the cost of goods and services throughout the economy. Salaries, benefit programs, insurance travel, utilities, and many other business goods and services are increasing. Unlike some construction material costs, which fluctuate with changes in demand and supply, overhead costs tend to become embedded in a company’s cost structure and are more challenging to reduce.

In addition, supply-chain issues may result in the need to carry more materials and supplies, further increasing the working capital needed to fund projects.

In an inflationary environment, you will need more working capital to fund purchases of materials and supplies and pay salaries wages, and operating expenses. In other words, you would need more money in the next 12 months to finance the projects you worked on in the last 12 months. 

Tips on Mitigating the Effects of Inflation on Gross Profit and Overhead Costs

Contractors can take a number of steps to mitigate cost increases with changes to contract language and operations, including:

• Contract Language Changes
  • Mobilization clause – Negotiating this clause into the contract will demonstrate good planning and transparent communication that prompts customers to agree to advance a mobilization fee or deposit. This helps minimize timing issues created by mobilization costs. 

• Price escalation clause – Add language to allow price increases under certain criteria such as increases in a construction cost index, or increases exceeding a cap or price range.
• Uncontrollable events – Add language to allow changes in price due to uncontrollable events including changes in tariffs, duties or trade policies, epidemics, wars, and market conditions.
• Force Majeure clause – Add language to protect against events or effects that cannot be reasonably anticipated or controlled.

• Operational changes

• Pre-order material and stock up on inventory.
• Hedge forward purchases of commodity items.
• Postpone or delay projects.
• Fix costs as soon as possible.  Ensure the risk of price increases from subcontractors is mitigated by promptly binding subcontractors. 
• Adopt new construction techniques that reduce labor and/or material content.
• Automate business processes to reduce overhead costs.
• Use technology tools to facilitate project management.
• Adopt best practices such as Target Value Delivery to manage projects to bid targets.

How Invoice Factoring Can Help Contractors Manage in an Inflationary Environment

In an inflationary environment, the faster you convert accounts receivable to cash to purchase tangible assets such as materials and supplies, the easier it is to stay ahead of inflationary price increases.

Invoice factoring can help to accelerate the conversion of accounts receivable to cash. With invoice factoring, you can convert your outstanding accounts receivable to immediate cash instead of waiting 60 days or more for your customers to pay. The cash can then be used to accelerate your purchases of materials and supplies and help avoid price increases. 

Inflation will likely impact our economy for some time due to the perfect storm of disruptive events coming together to create shortages and increase demand. You can prepare your company by acting now to secure the additional working capital you will need with an invoice factoring program.

Purchase order (PO) Financing and invoice factoring are two financial strategies that businesses can use to purchase inventory or materials and accelerate the conversion of accounts receivable into cash.  With so many financial products out there, it is easy for people to be confused about these financing tools, how they work, and their advantages. 

The two strategies are closely related but they are distinct.  Helping business owners understand the difference will allow them to be paired with the right financial strategy and will also make them more comfortable using these financial tools.

What PO Financing and Invoice Factoring Are Used For

PO financing (aka purchase order funding) and invoice factoring are both used to address cash flow issues and provide working capital, but they are utilized at different stages in a transaction cycle.

PO financing is used to purchase inventory, materials, or other resources related to specific purchase orders or contracts.  It provides funding to a business’s vendors or suppliers so they may fulfill an order or get started/ complete a project.

Frequently, small and medium-sized businesses are unable to obtain credit from suppliers or a loan from a bank to purchase inventory or materials due to varying circumstances.  It is important to note that in certain instances where the supplier is located outside the U.S., a letter of credit is usually required.  PO financing provides businesses with the ability to fulfill orders as well as perform work BEFORE they’ve invoiced and received payment for the invoices.  In essence, it’s an advance against the funds a business expects to receive once their customer’s invoice is paid and is meant to cover the cost of goods sold.

Invoice factoring, on the other hand, is a financial tool that businesses use to accelerate cash flow by selling their unpaid invoices for a completed order or project to a factor company at a discount. Businesses receive cash immediately for their unpaid invoices instead of waiting for their customers to pay.  This funding can then be used for things such as payroll, operating expenses, growing the business, moving on to the next contract or project, etc.

How PO Financing Works

Invoice factoring can be used by itself to accelerate cash flow without also using PO financing. However, when PO financing is used, invoice factoring is also used to complete the financing transaction.

The steps in a PO financing transaction include: 

• Client receives an order or enters into a contract with their customer.
• Client forwards the purchase order to their supplier and the supplier provides an estimate of the cost to fill the purchase order.  In cases when the client enters into a contract for a service or project, the client obtains estimates for materials or other resources from the respective vendors.
• Based upon the need for funding, the client enters into an agreement with a factor company to fund the purchase of inventory, materials, or other resources for the specific purchase order or contract.
• The factor pays the supplier/ vendor through cash proceeds (or with a letter of credit if the supplier/ vendor is located outside of the U.S.), and the client takes delivery of the inventory or materials.  The proceeds may cover up to 100% of the cost however the client may have to pay out of pocket to make up any difference.
• Client completes and ships the customer order, or performs the work contracted for and invoices the customer.
• Client assigns the invoice for the completed order or services to the factor. The factor purchases the invoice once the validity of the receivable is verified and makes a partial advance on it first deducting the supplier/vendor payment and fees.
• Once the related balance under the PO financing facility is retired, the client is then eligible to receive the remainder of the factor advance amount depending on the terms of the factoring agreement.
• Client’s customer will remit payment for the invoice directly to the factor.
• The factor receives payment on the invoice from the client’s customer and deducts the factoring advance as well as factoring fees, and remits the balance to the client.

How Invoice Factoring Works

The steps in an invoice factoring transaction include:

• Client enters into an agreement with a factor company.
• Client completes and ships the customer order, or performs the work contracted for and invoices the customer.
• Client assigns the invoice for the completed order or service to the factor. The factor purchases the invoice once the validity of the receivable is verified and makes an advance to the client depending on the terms of the factoring agreement.
• Client’s customer will remit payment for the invoice directly to the factor.
• The factor receives payment on the invoice from the client’s customer, deducts the factoring advance amount and factoring fees, and remits the balance to the client.

Advantages of PO Financing

PO financing allows business owners to increase the necessary working capital required to boost sales, increase product or service offerings, and allows the business to gain the edge over the competition.  

PO financing is more accessible to obtain than a bank loan and may be easier to qualify. The credit underwriting decision is based on the financial strength of the client’s customer, unlike a bank that uses the business’s credit profile regardless of the income and cash flow that will result from fulfilling a firm purchase order or contract.

This is particularly important in light of the Federal Reserve’s change to a tight monetary policy, and the possibility that it might induce a recession. In this environment, bank credit requirements are tightened. Banks favor large customers and have a tendency to reduce credit exposure to small and medium-size customers.

PO financing may sometimes cover up to 100% of the supplies, inventory, or resources needed to get started/ complete a project or an order.  All the while without using credit available under existing lines of credit. It also enables clients to pursue business opportunities, which they might not otherwise be able to do because of insufficient working capital financing, and it can also be a stepping stone to developing a relationship with a supplier that leads to open-account terms.

Advantages of Invoice Factoring

Invoice factoring helps to accelerate cash flow by converting accounts receivable to immediate cash. Clients will not have to wait 60+ days for their customers to pay an invoice. Having access to those funds increases cash flow and reduces the need to draw down on availability under existing lines of credit.

An invoice factoring facility is also easier to obtain than a bank loan, and the credit decision is based on the financial strength of the client’s customer, not the client.  Invoice factoring facilities are more flexible to use than bank loans. In addition, they can be custom-tailored to fit within a business model.

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While PO financing and invoice factoring are both designed to provide solutions to a business’s working capital needs, the key points to consider are the timing of when the funds are needed in the transaction cycle and the use of funds.  Understanding the differences will help pair the right financial strategy with the right type of business. 

The surge in inflation driven by record fiscal stimulus, pandemic lockdowns and restrictions, supply-chain disruptions, and the war in Ukraine has created a major challenge for business owners in the construction industry in bidding on new projects and maintaining sufficient cash flow.

Many of the commodities used in construction are subject to changes based on third-party events outside of your span of control such as changes in world market prices and geopolitical events. Despite the Fed’s tighter monetary policy, inflation appears to have become embedded in the economy and may continue to persist at elevated levels for some time.

Construction Cost Increases

The following table lists some examples of changes in the Producer Price Index (PPI) reported by the Bureau of Labor Statistics for key materials and other inputs used in construction.

Along with these costs, labor and wage costs have increased in response to inflation and worker shortages. Average hourly earnings in construction rose 5.8% from February 2021 to January 2022 for hourly tradesmen. The average for similar workers in the overall private sector jumped 6.9%. Unfortunately, these wage increases have not kept pace with inflation and further wage increases may be required to keep your skilled staff employed with your company. 

Overhead costs have also experienced inflationary increases. Personnel costs, rents, and other administrative costs have surged. Unlike construction materials costs, which rise and fall with demand and supply, overhead cost increases tend to become ingrained in a company’s cost structure.

Impact of Inflation on Profit Margins and Cash Flow

Inflation in construction costs has squeezed contractor profit margins significantly. The PPI for input costs rose 1.8% for the 12 months to September 2020, matching the 1.8% increase in PPI for bid prices. But the 19.6% increase in PPI for input costs for the 12 months ended December 2021 far outpaced the 12.5% increase in the PPI for bid prices. 

Contractors must take steps to factor inflation into bid prices, improve the accuracy of their bids, and ensure the project retains profitability.  Inflation erodes a project’s profit margin and if left unchecked can create serious cash flow issues. 

The risk of inflation increases with the size, length, and complexity of a project. Size increases the potential magnitude of impacts from inflation. The length provides the opportunity for inflation to occur and reduces the reliability of estimates. Complexity increases the number of variables subject to potential change. 

Whether you’re a general contractor, subcontractor, or in another segment of the construction industry, the following tips will help you develop your project bids in an inflationary environment. 

Tips to Improve Bid Development Process

Review the way your company develops bids to improve accuracy. 

• Checklists – Use checklists to ensure all important items are included in the bid.
• Carefully review plans – Check takeoffs and measurements to improve accuracy.
• Attend pre-bid meetings and site visits – Review project requirements and get clarification when needed.
• Technology – Use software to improve estimates and accuracy of bids.
• Subcontractors – Review past performance, bid details, and pricing. The lowest bid isn’t always the best if the job is late or performed unsatisfactorily.
• Labor costs and practices – Review local labor costs and practices. If union labor is used, review work rules and how they will impact productivity and costs.
• Financing costs – Work the cost of financing, or factoring services, into the price to your client.
• Bid the right projects – Bid on the projects that fit your company’s strengths.
• Expiration date – The bid should have an expiration date so you have the opportunity to rebid if the bid validity date passes to account for the higher cost of goods.

Implement Project Management Tactics

If your bid is accepted there are many project management tactics that can be used to mitigate the effects of inflation.

• Time material purchases – Careful timing of purchases can help to contain material costs, especially when seasonality is a factor.
• Monitor costs – Perform regular variance analysis to determine which costs are trending upward.
• Hedge commodity prices – Use futures contracts to lock in prices of key commodities.
• Inventory – Stock up on inventory to protect your business from future price increases if you have the cash to do so.
• Discounts for early payment – Manage your cash flow to regularly take advantage of early-pay discounts offered by your suppliers and vendors.  These discounts can really add up.  
• Critical suppliers and vendors – Identify critical suppliers and vendors then negotiate.  Some may be willing to offer better pricing to maintain a valuable customer. 
• Best practices – Use best practices such as Target Value Delivery to empower your team to manage the project to bid targets.
• Technology – Incorporate technology to facilitate project management.
• Performance and quality control – Complete the project on time and maintain a high level of quality control. Your customer may be more open to accepting future bids with more robust profit margins if they know they can count on you and will receive quality results.  

Include Inflation Terms in Contract Language

Construction cost inflation has not exceeded 5% for over three decades so many contractors do not have experience in an inflationary environment. Adding a few percentage points to bids for inflation won’t protect you sufficiently in this type of environment either.

There are many different approaches to mitigate inflation risk in bids.

• Time and material – Charging for actual time and materials cost shifts the risk of inflation to the customer. Customers may not accept this approach because it doesn’t place limits on costs.
• Price adjustment mechanism – Language that permits an increase in price under specific circumstances, such as – if the cost of concrete exceeds X then the price of the contract may be increased by Y.
• Collar – A price adjustment mechanism that works for both price increases and decreases. This can be a good alternative for commodity materials which can be subject to large swings in price.

Take Control of Inflation’s Impact on Your Working Capital with Factoring

Inflation increases the amount of working capital needed to fund a project and also negatively impacts your cash flow if left unchecked. Invoice factoring through funding sources such as Capstone is an excellent cash flow management strategy for construction contractors looking to combat inflation’s negative effects.  Business owners obtain the additional working capital needed to finance projects as well as the cash flow for operations. Factoring can be provided for a single invoice/ payment application, or as a program for all of your accounts receivable.  Credit approval is based on the financial strength of your customer, not the creditworthiness of your business.   

Keep in mind that in an inflationary environment, the value of your accounts receivable lessens the longer they remain outstanding.  Instead of waiting 60+ days for customers to pay, business owners can convert their outstanding invoices to immediate cash.  Having access to those funds provides you with staying power until cash flow catches up with expenses. 

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How Capstone Can Help

Capstone Capital Group, LLC is a leading commercial finance company that is focused on providing businesses with sufficient access to working capital. Capstone has the experience and resources to provide customized invoice factoring and PO financing programs that fit your needs in an inflationary environment.