Valuation matters: inflation

In writing this article, I have used the very helpful ‘fluctuations’ RICS practice note. This is an authoritative and very helpful guidance document that is used and referred to by industry professionals when dealing with inflation-related issues.

In this article, I will provide an overview of the basics, explore how you might manage inflationary risk, look at programme shifts and how this might lead to cost increases, and cover some other considerations.

The basics

Inflation is also referred to as escalation. The term used will depend on how the contract describes it and, possibly, the country you are working in. In my experience, these terms are used interchangeably.

It’s an obvious statement, but one worth making, that inflation has a bearing on the cost of construction because the rate paid will be driven by factors that impact cost. These might include the Consumer Price Index (CPI), leading to the cost of goods increasing and therefore leading to increased wages; they might include government changes that impact the cost of employment; or they might include macroeconomic factors that create a supply and demand shift in the market and lead to prices going up.

There are numerous data sources that are used in the construction industry to measure price inflation, which include the BCIS Tender Price Index and the Consumer Price Index, which tend to be the most common, but there are many others.

These data sources can sometimes be used between the parties as the reference point in the contract for adjusting prices.

Managing the risk

It is very common that the price of a construction contract is fixed for the duration of the contract. There are some exceptions to this where it is a long contract duration or there is a high component of a particular commodity that is experiencing severe price fluctuation. The approach will depend upon what the parties agree.

In the latter case, the contract will contain a mechanism to adjust the rates for inflation. You will follow that mechanism to apply an adjustment in the monthly application for payment. This may be sufficient to cover your costs, or it may not; that is the risk you take, so make sure you check the mechanism and model the scenarios before agreeing to the provision.

In the former case, you will make an allowance for inflation at tender and take the risk. Again, you could make money on this or lose money. This allowance is a commercial consideration because you will often be in a tender process where others are thinking about this, and the allowance you make could result in you being more or less competitive.

The important issue when calculating the allowance is to ensure that it is scientific and it realistically reflects the cost increases that are likely to occur. You will probably have some reliable information to inform any allowance to cover wages, and, using historical data, you should be able to predict the probable price increases. However, some increases, such as the post-COVID hyperinflation, are very difficult to predict.

That said, it is not impossible that deflation could occur and you profit significantly. I recall working on a project that was secured prior to the 2009 Global Financial Crisis, and because the macroeconomic picture shifted, it was very profitable because the procurement of subcontractors occurred later. There was more supply than demand, which meant prices reduced.

Programme Shifts

The risks outlined are, in some ways, normal construction trading risks that most businesses wrestle with on a daily basis. You have some understanding of the risk; you place your bet and hope that you win more than you lose. That is contracting.

However, it becomes more difficult for a contractor or subcontractor where delays occur, the programme shifts to the right, and this causes you to incur costs in an inflationary period that is beyond the allowance you made in your contract sum.

A simple example would be steel reinforcement. You may have planned to place the order immediately, but the design is delayed by your client. You place the order later than planned, and the rate is much higher.

This is recoverable through loss and/or expense or compensation event provisions. However, it can be difficult to prove.

This is because the sell rate in the contract will often be a composite rate including labour, plant, and materials. How do you demonstrate the material element of that rate and show that late procurement was caused by delay?

One way to proactively manage this risk is to state the allowance per unit for key commodities. This will create a baseline where, in the steel reinforcement example, there is a price per tonne on which the contract is based and can be used to measure changes.

You should also show your planned procurement dates on the contract programme. This will allow you to establish, as a fact, that an order you have been placed on a date was actually ordered on a later date, and you can show that the price per tonne has increased; one less the other is, in simple terms, your loss.

Other considerations

That said, these claims can still be difficult to prove. Did you buy from the only available rate, and, if you had tested the market, you would have achieved a better price? Will your client agree to the baseline rate, and what do you have to do to demonstrate this, which might include opening up your tender? Are there other factors that caused this increase that are not the client’s risk?

Regardless of your recovery position, it is best practice to track your cost rates against the rates you are recovering. Comb the tender, pull out the cost rates per unit, and track the market rates/your actual purchase rates against the tender.

If you are seeing increases, then investigate why; is it something that is your risk under the contract, or was the rate increase caused by a risk that is your client’s? If it is the latter, then raise your notice quickly, substantiate the valuation, and include it in the application for payment to stay on top of your cash position.

Final Reflections

Price inflation is often a concern on construction contracts, but, more often than not, the risk is manageable within reasonable limits.

However, the management of the risk is intricate, and when extraordinary events occur (e.g. COVID) or when client delays occur, it becomes very relevant. And when it does, because it is not in the daily QS routine, it can become quite challenging to handle.

You can see the order values significantly exceeding your allowances; you know it is caused by cost inflation, but connecting it to a risk event that is the client’s is not always straightforward and can be challenging.

If you are seeing this, take action to protect your financial position. Don’t wait and hope the losses will be balanced by some wins, as you may regret it!

Next week, we will continue the focus of this valuation matters mini-series with a focus on defending contra charges.

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