A Move Ahead of Construction Costs
Global demand and decreased production capacity have facility executives searching for strategies to beat material cost increases.
Facility executives could suffer sticker shock in the coming months if they’re planning new construction projects or renovations. That shock can be particularly stinging if they haven’t kept close tabs on material and labor costs.
Changes in the global economy that began in 2003, coupled with a violent hurricane season in 2005, have material cost inflation approaching double-digit percentage increases for the first time in recent memory.
Cost increases are nothing new, says Karl Almstead, vice president of New York-based Turner Construction Co. Since recordkeeping began in the early 1900s, costs fell only three times. What is significant is the size of the increases.
Material costs increased 9.13 percent in 2004, followed by a 9.47 percent jump last year, Almstead says. Turner has been forecasting building cost projections for more than 50 years. These numbers are almost double the more modest increase average of 4.6 from the late 1990s to early 2000s.
“Construction costs are going up,” he says. “The issue is the rate of the increase. It’s more than people would like. During the past couple of years, it has escalated significantly, and that’s part of what gets everyone concerned.”
Carl Haines, senior project manager at San Diego-based Johnson & Jennings General Contracting, says what makes the increases difficult for facility executives is that budgets are based on historical costs. Some facility executives might have budgeted for 2006 not realizing material costs would escalate beyond typical inflation.
Why these increases are occurring requires a quick lesson in global economics.
“At the end of 2003, China was buying up scrap steel,” Almstead says. ”If you follow what happened in 2004, the price of steel escalated significantly. When China bought up all that steel, it affected shipping.”
With the supply chain tied up, other materials such as cement became harder to get. “They couldn’t get the ships back to deliver more product,” he says.
With a sustainable growth of more than 9 percent, China began to demand other raw materials as well. Then India, with an 8 percent growth rate, became equally demanding.
“For a long time the United States was the giant in the consumption of materials,” Almstead says. “It’s now faced with a global market for the raw materials of the world, including oil. There was a series of things that started happening around the world, but the events of 2003 with steel seem to trigger a waterfall of events. The demand for raw materials, not just steel, has increased at a greater rate around the world.”
Then came last year’s harrowing hurricane season. Hurricanes damaged oil refineries and seaports from Houston to Florida. The Port of New Orleans, the major deep-water seaport for imported steel, rubber, forest products and copper, was the hardest hit. Refineries were knocked off line, creating shortages in the resins used to make plastics. And of course, fuel supplies for transportation were cut.
As hurricanes Katrina and Rita stormed inland, they shut down drywall and lumber facilities as well as hydrogen production plants. Hydrogen is a critical component in the production of galvanized steel products. In an unfortunate coincidence, another major hydrogen facility was down for maintenance. The combined result was a 70 percent decrease in hydrogen used in galvanized steel products.
Almstead says the increased market pressure made it more difficult to get galvanized steel products. These combined forces resulted in steep price jumps in a short time period.
“You go to buy materials, and it costs a whole lot more,” he says. “There was a two-week period where the cost of a particular kind of copper wire went up 10 percent. Some of the increases have been fairly significant.”
By the end of January, many of the kinks in the supply chain were unwinding. The American Association of Port Authorities reported that port activity has returned to about 65 percent of pre-Katrina levels, with strong volumes of so-called “breakbulk cargo,” which includes steel, aluminum and rubber. Meanwhile, many manufacturers and raw materials suppliers are reopening plants.
Still, demand is expected to exceed supply in the coming months. The rebuilding of New Orleans and other Gulf communities has not yet begun in earnest. The real impact of that effort is still unknown, but builders already are feeling the pinch.
“What they’re doing there is remodeling and all of the materials have to be available now,” Haines says. “The government is putting holds on a percentage of materials in the United States so it can supply construction in the coming year. With the natural disasters and the labor costs, I suspect we’ll be impacted even more.”
Mike Jones, chief estimator in the HOK Construction Services Group headquartered in St. Louis, cautioned that some of these estimates include materials used primarily in residential rather than commercial construction.
“Commercial markets aren’t going to be involved in the shortages of the residential market,” he says.
He also pointed out that not all building materials are in short supply, but some producers will seize the opportunity to raise prices because of perceived shortages.
Then there is the domestic building boom. Homes, hospitals and professional sports complexes rank at the top of the construction project list. This means that labor already is in short supply — even before the massive rebuilding of New Orleans and other Gulf Coast cities picks up.
Consulting with an architect or general contractor early in the planning stages is the first step in avoiding surprises.
“Get the general contractor on board early and get them working for you,” Haines says. “It will save time and money in estimating budgets when the contractor buys in to the project.”
Jones recommends that facility executives select service providers who are familiar with the area.
“Work with an architect and contractor who know the conditions in your area,” he says. “Most good contractors can sit down with an owner and tell them what materials are in short supply now and in the future.”
They also should know what materials are produced locally, Haines says. This is a particularly useful strategy for projects outside the Gulf region. In the past, it was common for locally produced materials to be more expensive than imported materials. But this is changing. Purchasing locally produced products can reduce transportation costs and improve availability.
If the project is still a few months out, the facility executive must keep an eye on the marketplace and update the budget accordingly, Jones says.
Next, facility executives can shield themselves from rising costs by employing an old-school tactic: stockpiling materials.
During the last decade or so, conventional wisdom in supply chain management evolved from the buy-now-use-later philosophy to a just-in-time philosophy. Designed to improve cash flow, the new paradigm essentially eliminated the concept of warehousing.
“The idea was, ‘Don’t buy a piece of drywall until it’s needed,’” Almstead says. “What that meant is that the supply chain is strong enough to meet the demand. If I know a day ahead of time that I need something, FedEx can have it here tomorrow, and I don’t have to pay for any stockpiled material.”
In light of the current market, that idea should be re-evaluated.
“That was the thought process 10 years ago, but the formula has changed. It may be more cost-effective now to store materials,” Almstead says. “For every facility executive, the decision has to be looked at in light of the core business and in terms of costs. What is it that they’re trying to buy? Is its use so repetitive that they know they’ll need it? If you can buy more than you need, will you have a place to store it? What is the cost of storage? What is the chance to reuse it? Will demands change in the future?”
Sometimes, thinking long-term is the best way to protect budgets from escalating costs. That’s where value engineering comes in.
For example, a construction project may call for the same flooring material throughout the entire facility. This might mean that an expensive grade of carpet designed for heavy traffic areas is installed in a rarely used conference room. The room doesn’t sustain enough traffic to warrant such a highly durable floor covering. Conversely, a moderate grade of carpet could be installed in a high-traffic corridor where it quickly wears out and must be replaced within a few months.
Value engineering looks at the function of each space, and flooring products are selected based on their applicability to that space.
“Value engineering is a positive thing,” Almstead says. “It’s attempting to get the best value by looking at first costs and life-cycle costs.”
While value engineering is a positive process, it shouldn’t be a separate process. Both the architect and the contractor should offer value engineering recommendations as part of their services, Haines and Jones say.
Both should know what’s going on in the market and be positioned to make suggestions regarding materials, manufacturers, scheduling and techniques. For example, contractors keep tabs on pricing trends and might be able to suggest materials that previously weren’t considered
“Because of price increases, what used to be too expensive is now more cost effective,” Haines says.
Then there is the labor issue. Labor is the biggest cost component in a construction project, Jones says. And in busy markets, it’s going to command a premium.
“When the industry is busy, labor is hard to get,” Jones observed. “When it’s not, it’s easier. It’s a matter of supply and demand.”
In unionized markets, skilled workers can get $25 an hour, compared to $12 in non-union markets. Even when the work slows a bit, there’s not much incentive for union workers to migrate outside their markets, he says.
While imported labor might be an option, it’s not an option anyone likes to discuss.
Haines offers an alternative. When a general contractor is locked into a project early, he can get subcontractors locked in as well.
“This benefits the facility executive,” he says. “If the contactor is locked in on fee, the owner still gets the benefit of competitive bidding among subcontractors. The general contractor still gets two or three bids, and the information is all shared with the building owner. It keeps costs down and eliminates surprises and change orders.”
Subcontractors are more willing to give better pricing to general contractors with multiple projects on the books in hopes of repeat business.
To grease the wheels, it might be tempting to establish compensation plans that encourage contractors to stay within prescribed construction time tables and budgets. If the contractor fails to meet deadlines, the owner can recover damages. If the contractor comes in early, it receives a bonus. That idea, however, is not without its drawbacks.
While the project might finish on schedule or even sooner, quality can suffer. “They move so quickly, that things are left undone,” Haines says.
For a contractor to consider agreeing to bonus compensation plans, the project must be “really important and big enough, and it has to be doable,” he says.
Outlining expectations is a better alternative, Jones says. “When the contractor has to have the project done by a particular date, that has to be addressed upfront so that everybody understands what’s going in. It has to do with the quality of the contractor. Most good quality contractors will do their best to complete the project on time and in budget.”
Lynn Proctor Windle, a contributing editor for Building Operating Management, is a freelance writer who has written extensively about facility management issues.