Construction companies are facing unprecedented challenges. From the COVID-19 pandemic to geopolitical risks, the industry is dealing with rising rates of inflation and supply chain disruptions.
In addition, weather-related events can create unsafe working conditions, delay material deliveries and prolong project timelines. As a result, these events can increase project costs and lead to cost overruns.
1. Inflation
Inflation – an increase in prices and a decline in the purchasing power of currency – affects multiple sectors of the economy, including construction. Contractors must consider increased material costs, longer lead times for delivery of materials and inflated labour rates.
In a high inflationary environment, contractors need to be careful about bidding their projects. They should use price indices that reflect the full cost of construction. General Construction and Input Price indices don’t track whole building final cost or include overhead and profit margins, while PPI Final Demand indices do.
In addition, if a contractor is using fixed price contracts with clients, they must be careful to include enough contingencies to cover higher prices and long lead times. They must also review their supply chain for its resistance to price increases and delays. Options include stockpiling materials, but this can create logistical problems and add storage and security costs. It is also important to consider the impact of inflation on the profitability of their existing projects when estimating future bids. This will help to prevent a situation where the profitability of a project drops significantly due to rising inflation.
2. Geopolitical Risks
Global construction companies must be prepared to deal with a high level of uncertainty. In addition to the impact of rising costs, political instability and trade conflicts can lead to disruptions in business, labor and financial markets. These factors can also affect project timelines, budgets and completions.
For example, Russia’s invasion of Ukraine has rattled the world economy by triggering economic turmoil and causing international military disputes. This has impacted human capital, physical infrastructure, global financial markets and international peace. It has also resulted in material shortages and higher energy prices.
As such, it’s important to integrate geopolitical risk into the planning phase of global projects. This can be done through scenario development, stress testing and modeling. For instance, a sports industry client who wanted to host a large televised event in a Middle Eastern city received a geopolitical risk report that informed them of the regulatory and business environment, the availability of labor, corruption levels and cultural and societal issues. This helped them make a more informed decision and develop strategies to minimize the risks of a potential negative outcome.
3. Supply Chain Disruptions
In a highly-inflationary environment, contractors need to be more careful when pricing costs into their bids. Incorrectly priced materials can quickly eat into the profitability of a project, especially for contractors that operate via fixed price contracts. Moreover, inflating costs make it harder to secure financing for construction projects, as banks are more likely to be wary of high-risk investments.
Over the past year, global supply chain disruptions have led to material shortages and increased prices across multiple industries. From face masks to computer chips, car parts to construction materials, a wide variety of products have been affected by shortages and inflated prices.
For contractors, this lack of supply has directly impacted construction costs by increasing the amount of money required to complete a project on time and budget. From the need to pay for expedited shipping to paying overtime to mitigate delays, construction companies have been forced to absorb higher project costs as a result of supply chain disruptions. To minimize these costs, construction companies should implement effective supply chain management strategies that promote improved collaboration and visibility between suppliers, subcontractors, and project teams.
4. Natural Disasters
Natural disasters are costly to construction companies because they can lead to delays and disruptions in projects. They can also increase labor costs, as workers may need to leave their jobs in order to help with rebuilding efforts. The increased need for materials and supplies can also drive up prices. For example, a massive hailstorm in Sydney caused a 30% price hike for strand board and a 2000% increase in the cost of tarpaulin sheets.
The impact of natural disasters on construction costs depends on the extent to which they damage building materials and infrastructure. Direct impacts are measurable in terms of property losses and can be estimated using catastrophe models or empirical data on losses. Indirect impacts, on the other hand, are more difficult to measure.
Few studies estimate long-term economic costs of natural disasters, and those that do face significant methodological challenges. Felbermayr and Groschl (2014) use the GeoMet database of physical measures of disaster intensity (as opposed to the monetary loss estimates used by EM-DAT and NatCatSERVICE), and find a nonlinear and stable relationship between disaster intensity and GDP growth.
5. Interest Rates
Interest rates affect the profitability of construction projects. When rates are low, project costs are lower and the return on investment is higher. In contrast, when rates are high, the cost of borrowing is higher, making the project less profitable.
The impact of interest rates varies depending on the type of work being undertaken. Privately financed categories, such as infrastructure and commercial construction, are likely to be harder hit than publicly funded projects. This is because the construction of these projects is typically based on a large number of pre-orders that are dependent on an economic upturn.
Contractors can mitigate the effect of changing interest rates on their business by working closely with financial advisors to develop a strategic financing plan and developing relationships with multiple lenders. Maintaining strong creditworthiness and a healthy cash flow also helps to reduce the risk of interest rate fluctuations.