Identifying Inflation Risks in the Building Business

Identifying Inflation Risks in the Building Business

27th February 2018

Some of the larger construction projects here in the UK have been in the news recently due to the increased costs that have been incurred – Crossrail, Battersea Power Station and Hinckley Point C, to name just a few.  However, it’s not just the big projects that can run over budget, smaller ones can too but they tend not to hit the headlines, probably because they’re not being financed with public funding.  However, any construction business owner will know that jobs can go over budget and, in the cases of these smaller companies, this can be a real headache for the person responsible, namely the construction company owner.

Inflation is a risk that construction business owners and managers have to take into account as it can affect the out-turn price in two ways:

  • There is likely to be inflation in the market prices until contracts are agreed with the constructor

  • There will be inflation in the constructor’s costs during the delivery period.  Long contracts may also contain market price risk for subcontractors as well.

Inflation in market prices is reflected in the underlying costs of resources, but is also affected by tendering conditions and market changes (such as increased prices associated with an increase in demand and the availability of specific resources.  Pressure on supply and demand may be local, national or global, occurring, for instance, when another country buys enormous quantities of raw materials.  Supply and demand is also affected by how the UK is viewed by a market – for instance, the recent plummeting value of sterling has affected the costs of imported materials and equipment.  Furthermore, the supply and cost of EU labour will be influenced by how attractive an option work in the UK is considered to be after Brexit.

It’s vital at the outset to identify who will be expected to carry the risks of inflation and how these will be accounted.  However, ultimately, it’s the client that pays for the increased cost of a contractor’s assessment of them.  The client will always bear the inflation risk up to the point where the contract is agreed.

Projects with a fixed price contract should allow for the movement in tender prices to the point where the contract is agreed and for any increases in costs that the constructor is likely to bear during the delivery of the project – this may also include some market risk.  Projects that have a single fluctuating-price contract involved the clients taking the risk of underlying inflation in resource costs during the delivery period.

On Projects with multiple contracts over an extended period the inflation risk should take into account the delivery programme and the risk of any alterations to the individual contracts and their timing.  An inflation adjustment clause can be added to contracts but these are usually more relevant to large, long-term contracts.  

Unfortunately, there is no way of completely avoiding risks as there are often unknown factors that may arise over the course of a contract.  One of the best methods of managing the risks is to be aware of the various types and how they can be managed.  If you can identify and categorise the risks right at the outset, you can optimise your risk management strategy in order to avoid losses.

Next week we’ll take a look at the six different categories of risks in more detail.