Article

Inflation: The impact on the construction sector

Construction companies are feeling the effects — not only are essential materials and skilled labour significantly more expensive, but supply chain pressures and shortages are making it harder to secure needed construction materials.

Aerial view of a residential building construction site during a vibrant summer sunset. Taken in Burnaby, Vancouver, BC, Canada.

How rising prices are affecting construction companies

Rates of inflation are increasing rapidly in many developed economies. And construction companies are feeling the effects — not only are essential materials and skilled labour significantly more expensive, but supply chain pressures and shortages are making it harder to secure needed construction materials.

Timber, steel, and many other materials critical for construction projects have experienced skyrocketing increases in pricing. Whilst the root of the problem can be traced back to supply chain disruptions in materials and labour due to the COVID-19 pandemic, new challenges — including geopolitical risks — continue to crank up the pressure on pricing at a time when there is an increase in demand due to government-led infrastructure activity.

At the same time, the available construction workforce is shrinking as an ageing cohort of skilled workers either retire or face restrictions related to travel and workers move into other professions given competitive salaries elsewhere.

Skyrocketing costs impinge on slim margins

As in other regions around the world, dramatic price hikes are having a significant effect on contractors and developers in Australia. The latest Producer Price Index published by the Australian Bureau of Statistics indicated the cost of house construction rose 15.4% in the 12 months ending March 2022, mainly as a result of price increases for timber and metal products. Over that period, the cost of reinforcing steel increased 43.5%, structural timber 39.2% while plastic pipes and fittings increased 26.5%[1].

Contractors or developers, depending on need or contract, may have no option but to absorb the increased costs, eating into already slim margins and affecting their liquidity.

Lack of clarity about future costs and supply is complicating the bidding process and affecting contractors’ competitiveness. All this will lead to above inflationary increases in bid costs for Australia with global engineering consultancy Arcadis forecasting building tender increases of 4-5% in Sydney and Brisbane and up to 5-7% in Perth[2]. Similarly, infrastructure tender prices are forecast to increase by 6% in NSW and Victoria over 2022 and 5% in Queensland.

Rising fuel prices are putting even more pressure on contractors’ budgets. Not only has it become significantly more expensive to get materials to a construction site, but many pieces of essential heavy equipment — such as bulldozers, cranes, and backhoes — run on fuel.

Labour shortages and increasing wage costs have been affecting the construction industry for a number of years. Given the broader economic pressures that exist, this challenge is unlikely to be resolved in the near future. Since wages can account for over 50% of the overall construction costs, the impact of labour pricing has an acute influence on the profitability of a project.

What does this mean for the construction industry?

Since most contractors operate on slim margins, increased costs are impacting the bidding process. The steep recent price increases make it extremely difficult to estimate future costs, which may be several times the original estimates by the time work commences and more still by the time the job is completed. And delays in getting materials on site due to supply chain challenges often mean that the timeline for a project’s completion is often unclear.

In most countries, the risk of inflation and delay through non-force majeure events are borne by contractors. In these situations, incorrectly pricing costs into a bid or having enough allowance for bottlenecks in supply can have catastrophic effects on budgets, particularly for contractors that operate via fixed price contracts. This has led to an increasing number of construction companies getting into financial difficulties and even going out of business.

Some contractors and developers are facing increased challenges to secure funding for projects amidst questions about the bankability of projects. In a high inflationary environment, funders will generally be more cautious when offering funding to projects that are high in value, complex, or have long build times.

5 actions to address inflation

As inflation continues to affect economies and industries, contractors and developers should consider actions that can reduce the impact on their operations. Some actions include:

  • Review project budgets against current pricing. Consider how inflation — whether for materials or labour — could impact the final cost of a project. Be realistic about the increased costs and make the necessary adjustments in your bidding process. Contractors may also consider adjusting their approach to bidding by adding contingencies into the pricing models to cater for future price uncertainties and increased costs.
  • Discuss risk sharing with stakeholders. Have an open discussion with project owners about potential challenges and consider sharing the risk of inflation under contract conditions, whether through alliance-style agreements or alternate contract conditions for both new and existing contracts. This is already taking place in certain segments of the Australian construction industry.
  • Consider supply chain challenges. Construction materials are not only more expensive, but also becoming more difficult to secure. This new reality may require changing completion timelines both for ongoing projects and also in new bids.
  • Consider challenges in labour supply.  As we recover globally from the pandemic, borders and the movement of people should revert to the norm as delays in visas and availability to travel improves. In the meantime, demand for labour in Australia will continue to put pressure on wages, impacting projects in remote areas where it is harder to attract the necessary talent.  
  • Reassess your material procurement procedures. Revisit your supply chain and assess its resilience when faced with both price increases and delays. Consider the benefits of stockpiling essential materials and balance the benefits to budget and schedule against the additional costs of storage and security.
  • Revisit insurance policies. Higher prices for material and labour will be reflected in the final cost of a project. And since losses will also lead to more expensive rebuilds, the sum insured may need to be revised to minimise the risk of being underinsured. Your construction insurance broker or advisor can assist you with the valuation process and help you assess your policy limits.

[1] Rising costs hit home in the construction sector (afr.com) - accessed 14 June 2022

[2] Construction costs ease but significant challenges in the near term - Australian Property Journal - accessed 14 June 2022

"This publication is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. The information contained herein is based on sources we believe reliable, but we make no representation or warranty as to its accuracy. Marsh shall have no obligation to update this publication and shall have no liability to you or any other party arising out of this publication or any matter contained herein. Any statements concerning actuarial, tax, accounting, or legal matters are based solely on our experience as insurance brokers and risk consultants and are not to be relied upon as actuarial, accounting, tax, or legal advice, for which you should consult your own professional advisors. LCPA 22/272"

Marsh Pty Ltd (ABN 86 004 651 512, AFSL 238983) (“Marsh”) arrange this insurance and is not the insurer. The Discretionary Trust Arrangement is issued by the Trustee, JLT Group Services Pty Ltd (ABN 26 004 485 214, AFSL 417964) (“JGS”). JGS is part of the Marsh group of companies. Any advice in relation to the Discretionary Trust Arrangement is provided by JLT Risk Solutions Pty Ltd (ABN 69 009 098 864, AFSL 226827) which is a related entity of Marsh. The cover provided by the Discretionary Trust Arrangement is subject to the Trustee’s discretion and/or the relevant policy terms, conditions and exclusions. This website contains general information, does not take into account your individual objectives, financial situation or needs and may not suit your personal circumstances. For full details of the terms, conditions and limitations of the covers and before making any decision about whether to acquire a product, refer to the specific policy wordings and/or Product Disclosure Statements available from JLT Risk Solutions on request. Full information can be found in the JLT Risk Solutions Financial Services Guide.”