By Jason Dudas
Contractors are often dependent on the price of materials and labor when planning and completing a project. As the August Bureau of Labor Statistics (BLS) data showed signs of a general decrease in inflation rate, pricing for final demand construction has been deviating from that of the overall economy. The accelerating rate of construction inflation is evidenced not only in the overall trend of specific products and materials, but also in the producer price index (PPI) for completed building types.
The Associated General Contractors (AGC) of America compiles a summary table of several construction price and cost indexes, as reported by the U.S. Bureau of Labor Statistics. This table serves as an excellent resource for overall construction price.
From July 2016 to July 2017, there was a 3% rise in the PPI for goods used in construction. Meanwhile, the price index for new nonresidential construction increased at a slower pace of 2.4%. As the sales price of completed buildings keeps trailing behind the costs of materials, profits on construction contracts continue to be squeezed. Once a contract is awarded and construction begins, it becomes increasingly difficult for contractors to adjust for the rising cost of materials. How can contractors best mitigate rising prices?
Contractors must monitor pricing daily and reflect current pricing in their bids. Contractors should establish budget line items in their project estimates to track major material costs on projects. Breaking down each major cost component by line item will help project managers identify changes in pricing compared to amounts used during the bidding process. Tracking costs as a whole by contract does not allow for proper analytics to be applied. Utilizing construction accounting software will help contractors track costs on jobs and better predict when estimates may need to be adjusted. Accurate job costing today leads to better estimating in the future. Comparing actual costs to budgets will help a contractor identify when there is a problem on the job. For jobs that are not starting in the next 12 to 24 months, it is a best practice for contractors to reduce the risk of price inflation by locking in prices for subcontractors and supplies.
Contractors should also take time to review local bid results when made available to the public. Consistently bidding the lowest on projects within your niche may be a sign that your pricing may need to be adjusted. Bidding projects just to win work can lead to lower profit margins and an increase in labor costs to complete projects timely.
Contractors also need to understand their contract clauses. This is especially true for clauses relating to contract allowances and escalation clauses. In an increasing cost environment, it pays to have a well-worded contract to allow for cost increases and surcharges. For example, some state departments have fuel price adjustment clauses that cover the method of payment adjustment for fuel price increases or decreases. Other price increase clauses state that Unit Pricing may be adjusted on an annual basis. Such clauses are effective on each anniversary date upon written notice. Do not lock yourself into today’s pricing on long-term contracts where pricing of materials could increase by over 20% over a two to three-year period.
As indicated from the AGC summary table, all major categories of materials used in construction experienced significant increases compared to 2016. Among the major contributors to the rise in construction materials costs were increases in the cost of diesel fuel (20.4%), iron and steel crap (20.3%), copper and brass mill shapes (15%), and steel mill products (10.2%). While the short-term trend for some inputs are reversing, it is clear the shortage of skilled labor is beginning to impact the construction industry.
Rising labor costs due to a shortage of skilled workers continues to be one of the biggest challenges for construction contractors. According to 1608 participants in AGC’s 2017 Workforce Survey, 70% of contractors had a hard time filling some hourly craft positions. An additional 38% stated that they had a hard time filling some salaried field positions. The tight labor market prompts contractors to change the way they operate, recruit and compensate their employees.
To mitigate the growing labor cost, contractors should build a pipeline of potential candidates during the recruiting process. Staying in touch with candidates that may not be currently searching for a position could pay off over a two to three-year period. Contractors also need to make an effort to retain good employees. The cost of retaining current employees versus the cost of acquiring new employees can be staggering. The cost of employee turnover is made up of four factors: cost of hiring, cost of onboarding and training, cost of development, and the cost of underutilized employees. It is of economic benefit to develop younger staff into senior leaders within the firm instead of hiring experienced employees at a premium.
According to a September 8th news release from the Bureau of Labor Statistics (BLS), employer costs for employee compensation in the 2nd quarter of 2017 averaged $35.28 per hour, comprising of $24.10 (68.3%) and $11.18 (31.7%) per hour worked for salaries and wages, and benefits respectively. See table A for the breakdown of various compensation components making up the employer cost in different sectors.
Contractors can also mitigate labor hours and costs by utilizing technology. Purchasing or developing a routing software to assign employees to jobs and create a daily schedule for trucks will help reduce non-productive down time of employees and equipment. Time tracking apps are also an effective way to track employee time on job sites and allocate costs between jobs and overhead. Some applications even use location services within devices to clock employees in and out of job sites. Equipment usage technology is also a good way to track when routine maintenance should be performed to avoid breakdowns and unforeseen repairs.
A contractor must also have a growth strategy in place. Growing a backlog from $20 million to $40 million sounds very enticing, but can be catastrophic to a business if the right pieces are not in place prior to bidding the additional work. If the business is not properly staffed to complete projects by required deadlines, the contractor will likely have to pay a premium to bring on additional employees to complete such projects. Hiring too many employees at once when employees are underutilized but still carry high costs, can cause profits to plummet or even create losses.
Subcontracting effectively is also becoming more important to contactors now more than ever. Subcontractors are vital to your company’s productivity and profitability. Having a structured, customized and consistent onboarding process in place for your subcontractors can help create a good first impression. A well-planned process will allow subcontractors to hit the ground running and stay with your company long-term. Contractors should also create a subcontractor prequalification checklist to ensure that the subcontractor is a good fit and mitigate risk of poor performance.
Contractors must monitor costs effectively to run a successful business. Understanding how price increases can affect your bottom line and how to best respond to those increases are imperative to a successful business. Being proactive instead of reactive to pricing helps separate the best contractors.
Ryan & Wetmore, P.C. publishes construction updates and articles regularly on our company blog page. Visit www.ryanandwetmore.com to take advantage of the free knowledge and learn more about our firm!
Peter Ryan, CPA, MBA (firstname.lastname@example.org) and Jason Dudas, CPA (email@example.com) both specialize in the construction industry. For assistance with industry comparisons, establishing a job cost system, or software, please visit us online and contact Peter and Jason directly.
Ryan & Wetmore, P.C. is a Washington D.C. metro area firm with offices in Bethesda, Maryland, Frederick, Maryland, and Tysons’ Corner, Virginia specializing in construction contracting. We are members of the BDO Alliance’s Construction Accounting Network, Construction Financial Management Association, and Rainmaker Companies Real Estate & Construction CPAs.
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