Contract Cost Analysis – How Much More Expensive Labor and Materials Impact Your Bottom Line
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
|May 2022 YTD||2021 AVG|
|No. 2 Diesel Fuel||70.2||79.8|
Average Hourly Earnings All Construction Employees
|Average Hourly Earnings||% Change from Prior Year|
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.