Inflation: The impact on the construction sector

How rising inflation is affecting construction companies in New Zealand and around the world. Learn more about supply chain pressures and materials and labour shortages and what these risks may mean for your insurance coverage.

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. Here in New Zealand for example, the annual inflation rate reached a 30-year high of 6.9% in the March 2022 quarter with predictions that it may peak at 7% sometime in the June quarter of 2022. According to Stats NZ, the main driver has been the housing and household utilities group, influenced by rising prices for construction.

Construction companies are unsurprisingly 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 such as the war in Ukraine — 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, labour shortages are a problem in many developed countries. In New Zealand, the construction sector is showing some positive indicators, but there are also considerable challenges. According to the New Zealand Government’s “Building and construction sector trends biannual snapshot” published in May 2022, the construction sector is the country’s fourth largest employer and there is a significant pipeline of apprentices currently training in the sector. However, many construction businesses experienced considerable recruiting difficulty in 2021. According to Stats NZ’s Business Operations Survey 2021, “around 90% of construction businesses reported that they experienced moderate to severe difficulty when recruiting tradespersons.”
Annually, wages in the construction sector also rose by 3.3%.

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 New Zealand.

The latest Stats NZ Consumer Price Index, shows prices for the construction of new dwellings increased 18% in the March 2022 quarter compared to the March 2021 quarter, the largest increase recorded since the series began in 1985. And their senior prices manager Aaron Beck, highlighted the “many supply-chain issues, higher labour costs, and also higher demand” facing the construction firms. 

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. And lack of clarity about future costs is complicating the bidding process and affecting contractors’ competitiveness. The UK and Australia for example are expecting to see bid prices increase several percentage points this year.

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.

LCPA 22/272 

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Donald Gardner

Construction, Practice Leader