| Winter 2005 |
Construction Advisor
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Protect Yourself Against Skyrocketing Material 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 laid 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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 you have a right
to know how the general contractor will be paid, because in most instances that
will have a direct bearing on how you 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 material 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.
The Construction Advisor is produced
quarterly by Bober, Markey, Fedorovich
& Company's Construction
Services Team. If you would like additional information about the services that
we can provide to construction companies and contractors, please call or
email our team leader, Dale A. Ruther, CPA, CIT at (330) 762-9785 or dale@bobermarkey.com.
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