Construction inflation: Current outlook and how contractors can protect their bottom line

After a few tumultuous years, the construction industry is looking at a situation it hasn't quite seen before. Labor shortages, long lead times, cost escalations, and supply chain issues are all happening at the same time. It’s a perfect storm for historic inflation rates. 

The annual construction input inflation rate in 2021 came in at 19.6%. By year's end, 2022 is expected to see a 14.1% increase. To put those numbers in perspective, the nonresidential construction inflation rate in 2019 was just 1.8%. In June 2022, rates reached 9.1% — a rate so high that it hasn’t been seen in almost half a century.

Rates have slowed down as of September 2022 (falling to 8.2%); the market appears to be correcting, albeit slowly. In the meantime, contractors need to understand two things: how we got here and what they can do to shield their businesses from the effects of inflation. We’ll start by looking at the main factors causing construction inflation.

What is causing construction inflation? 

Global pandemic

COVID shutdowns in February 2020 brought factories in China and Italy to a halt. Shortly thereafter, many factories in the EU and the US shut down as well. The resulting lack of supply and unchanged demand from the market meant the cost of residential building materials had nowhere to go but up. In fact, costs increased by about 19% during the pandemic, according to the National Association of Home Builders (NAHB).

Compounding this issue is the United States' heavy dependence on imported building materials. A typical home in the US is built using an estimated 40% of imported materials. With a lack of supplies and high costs, many projects were delayed, resulting in an even larger backlog of work nationwide.

Continued labor shortage 

Extending a decade-old trend, the industry continues to see job openings far exceed the number of hires. There are roughly 25% more unfilled construction positions than new hires. Unfortunately, firms are not in a position to downsize. In fact, job openings increased by 29% from 2021 to 2022. A high volume of delayed and upcoming projects means firms are in need of skilled labor now more than ever.

Companies are struggling to fill positions, but this isn't for a lack of trying. Many companies are raising wages and upgrading their benefits packages to better appeal to new hires. Incentivizing more workers to join the industry will help ease the situation, but it will bring its own set of challenges. Increasing labor prices will cut into margins at an already uncertain time. 

Unexpected global events 

Adding fuel to the fire, a series of global "one-off" events served as a tipping point for the historic inflation rates that we see today. The blockage of the Suez Canal in March of 2021, for example, disrupted an astonishing 12% of the world's global trade. The intensifying conflict in Ukraine is another recent example. Trade restrictions imposed on Russia have limited the supply of many materials, including crude iron, semiconductors, and ceramic tile.

Meanwhile, the United States has seen severe weather events, such as wildfires in California, an energy crisis in Texas, and hurricanes along the coasts. The year 2022 was one of the costliest hurricane seasons in US history, culminating with Hurricane Ida.

Events like Ida saw massive recovery efforts, rerouting materials, trucks, and workers. Combined with an already extensive backlog of projects, materials became even more scarce. Flooring, roofing, plumbing, and electrical supplies all experienced significant price increases as a result.

Low supply, high demand

Through it all, demand for builders and specialty contractors has remained remarkably high. Delayed projects are starting up again. A historic housing shortage means houses can't be built fast enough, and a rebuild of the nation's infrastructure is underway. Year-to-date, total construction starts are 11% higher compared to 2021. As we have already seen, firms don't have access to the materials and labor they need to meet this demand. This situation has put the laws of economics into practice, resulting in historically high inflation.

Construction material inflation by the numbers

Source: ACG Construction Inflation Alert

How construction inflation impacts the industry 

Bidding 

In June 2022, material costs were 24% higher than bid prices. Across all trades, changes in input costs exceed changes in bid prices. It’s worth mentioning that similar situations have happened before — once from 2009-2012 and again from 2016-2018. Never has the difference been as high as 24%. For comparison, in 2009, the year-over-year change in material costs vs. bid prices was 10%.

In total, costs outstripped bid prices by more than double since the start of the pandemic. With profit margins becoming narrower and narrower, bids need to be handled with more care. Creating bids with accurate pricing is essential for mitigating the effects of inflation.

Availability of materials 

Outside of cost, the availability of materials to complete projects is a challenge all its own. Long lead times mean it’s taking longer and longer for materials to make their way to job sites. Even if companies manage to dial in costs, if crews don’t order material and equipment early, the project will likely get pushed out, causing costs to rise even further. Roofers have been hit especially hard in this regard. It's been reported that acquiring roofing assemblies and getting them to the job site can take as long as eight weeks or more.

To prevent disputes and underbidding, many firms are left with few options, such as delaying project bids until closer to the project start date.

How to mitigate the impact of inflation

Invest in technology to improve budgeting, estimating, and bidding

Despite the current situation, there are many steps that contractors can take to keep their businesses thriving. Dialing in bids has never been more important. Ensure you are analyzing job costs and material prices, keeping in mind that costs are likely to increase after a bid is submitted. Stay realistic about increased costs and evaluate that data regularly to identify cost-saving measures. 

Utilizing the right digital tools can help contractors stay organized. Track everything from work schedules, to daily field logs, to materials ordered and received. Automate accounting tasks through tools like QuickBooks Online to save time and money. Integrated applications like Knowify and other solutions are designed to support the unique needs of the construction industry. Technology is a worthwhile investment at a time when contractors need to closely watch costs and delivery schedules.

Consumer demand remains high. A backlog of residential and non-residential projects should provide a steady stream of business through 2023. Investing in technology now will ensure increased efficiency and organization. Use technology to hedge against the impacts of inflation and uncertainty.

Communicate, communicate, communicate

Take every step you can to obtain accurate information, especially when it comes to materials needed for a project. Project owners should provide bidders with complete design information. When negotiating contracts, consider working in price-adjustment clauses to protect from unanticipated swings in prices. For help, consult a legal professional and consider using industry-standard language. Find examples provided by The ConsensusDocs website.

Above all else, keep clients informed. If you become aware of schedule or material delays, relay this information to clients as soon as possible. Proper communication will help the change order process and build trust with all stakeholders.

Everyone from owners to general contractors to subcontractors needs to ensure they are creating an environment with complete transparency. General contractors and business owners need to show the cost of subcontracts, materials to be purchased, and optional materials. Everyone needs this information to make informed decisions. If you aren’t getting the information that you need, stay diligent and active in your requests.

Consider new partners, vendors, and strategies

It’s tempting to buy materials in advance to hedge against increasing prices. While it's true that buying items early can lock in fixed prices and protect against price hikes, proceed with caution. Early purchases come with storage, security, and insurance costs, and possible design changes. Work with stakeholders to discuss the best timing for ordering materials and components, so everyone knows what to expect.

When ordering materials, don’t shy away from searching for new suppliers and manufacturers. Join organizations specific to your trade and contact your local chamber of commerce for help finding potential suppliers. Conduct a vetting process and look for companies that provide what you need, whether it's new products, better prices, or faster delivery. From there, try to negotiate and lock in fixed prices.

Don't be afraid to make changes to current operations. Look for new ways to improve efficiency and save on costs. An increasing number of project owners are beginning to adopt a design-build strategy. The basic premise behind a design-build model is that it provides a more cohesive and collaborative effort by building in more flexibility and better communication. Many contractors believe this type of lean model is better suited for the complex issues they’re facing today. While that remains debatable, it's clear that many business owners are not shying away from seeking out new strategies to stay ahead.

Conclusion 

No single solution will resolve the hardships caused by labor shortages, high material prices, and supply chain issues. But there are steps you can take to give yourself a leg up on the challenges facing the industry. Start by closely monitoring your costs and delivery schedules for materials. Work to establish transparency and improve communication at every stage of a project. Look for new ways to improve profitability by expanding your network of vendors and suppliers. Finally, improve efficiency and organization by investing in digital solutions.