Key inflationary and deflationary pressures
Based on our observations of the market, survey feedback and our extensive discussions with the supply chain, we have established that a number of inflationary and deflationary pressures are likely to impact tender pricing. The rapid recovery has brought with it significant inflationary side effects. Meanwhile, the number and severity of deflationary pressures continues to fall and lessen.
Soaring prices, patchy availability and lengthy delays are preventing contractors from taking on new work or completing some of the pipeline of work.
The effect of the supply chain crisis has been to curtail expansion of the UK construction sector. Restricted supply of materials has weighed on output growth and construction activity, and comes at a time when the economy has just started to bounce back. Furthermore, the crisis has dented confidence and increased cost burdens which have started to spill over into increasing tender prices.
Disruption to global supply chains has arguably been caused by the pandemic but exacerbated by Brexit migration rules and border controls. A handful of secondary, but directly related, factors have also acted to create a scarcity of construction products and materials, triggering steep inflationary rises. According to BEIS data, in the five years leading up to the pandemic (2015-2019) the annual average rate of material price inflation was 1.75%. Now, as we emerge from the pandemic, the ‘All Work’ material price index has risen by more than 23.5% in the year to August 2021, catching many contractors and clients off guard. Assuming that the materials element accounts for around 30% of the total cost of a construction project, the overall inflationary impact of the recent material price rises on the cost of a project would be around 6%.
Of course tender prices, on average at least, haven’t risen by this much over the last year. Other factors such as the sector and the specific choice of materials have a bearing. Due to the staggered and somewhat uneven recovery in the economy, tendering in certain sectors has been more competitive than others. Accordingly, a portion of the material price inflation element on certain projects may have been absorbed in order to secure work and guarantee turnover for contractors in these less active sectors.
Due to the volatility in prices, materials pricing has been difficult to fix in tenders. Contractors are often requiring payments in advance in order to purchase the materials early, otherwise they are unwilling to commit to fixed prices. We are also seeing requests from the supply chain to make amendments to payment terms in order to improve their cashflow.
Another inflationary trigger set to continue to impact on the pace of recovery is logistical challenges. A lack of shipping containers and HGV drivers is causing delays and increasing transport costs. The Road Haulage Association estimates that there is a shortage of more than 100,000 qualified HGV drivers in the UK alone, so this is clearly a pressure that is set to be with us for the longer-term.
What was originally an issue primarily affecting steel and timber, inflation has spread to other materials and product categories. Although fabricated structural steel inflation (up 74.8% in the year to August 2021) and imported wood (up 74% to 78.4%) still lead the charge, according to the BEIS almost all other materials have experienced above-average levels of inflation over the past 12 months.
Paint prices are up nearly 10%, pre-cast concrete products are up 10.5% and sanitaryware is up by more than 11% - all well above the 1.75% annual average rate of material price inflation between 2015 and 2019. Our survey revealed pressures on the following:
- Cost of some M&E items (eg sprinkler pipework, cables) has increased by 10% or more due to shortages
- Lead times on semiconductors are now six months
- Cost of steel is fluctuating dramatically and can cost anything from £2,500/tonne to £3,500/tonne and lead times are long
- Significant shortages in drylining and MDF are affecting fit-out projects, especially due to the strong demand for remedial works
- Brick shortages (despite brickmakers getting back to full production capacity)
- 2030 sustainability targets, limited supply and a heavy reliance on the EU is pushing up prices of facades and making some models financially unviable
- Fierce competition for concrete deliveries and further issues are envisioned as demand for low-carbon concrete grows
- Most materials are on long lead times and clients are often having to procure directly and novate orders to maintain the programme
The IHS Markit/CIPS UK Construction PMI in September didn’t reveal any signs of material price inflation abating just yet as shortages of building materials led to another rapid increase in purchase prices during the month. Over 60% of supply chain managers said their deliveries were taking longer and 78% said they were paying more for their goods as inflation remained stubbornly high. However, a positive lead indicator for material price inflation is falling commodity prices. Iron ore, copper and timber prices have all fallen from their recent peaks in late spring/ early summer. While these price corrections haven’t filtered down the supply chain yet, falling commodity prices bodes well for construction material prices in the medium-term.
In the meantime, we can expect project delays on-site and lengthened lead times. This unpredictable pricing environment has slowed clients’ decision-making on new orders and led to delays with contract awards. The volatility has hindered new business intakes and some contractors, unable to hold prices, will have renegotiate, re-bid or revise their cost projections in the coming months.
Labour pressures are mounting as skills shortages and a high number of construction vacancies push wages higher. On a seasonally adjusted basis, average weekly earnings in construction rose 11.8% in the three-months to July 2021 compared to the same period one year earlier. However, the low base effect (which is of a statistical nature) has made this rise seem more pronounced. While the month-on-month series for average weekly earnings shows a dip in July to £662 per week – down from their peak of £676 in June – this is unlikely to mark the start of a persistent downward trend in labour costs.
According to G&T’s Main Contractor survey, the current availability of project labour resource is low with some commenting that the rates currently being demanded are unrealistic and unsustainable. The availability of staff has, according to some, been impacted by demands from big projects like HS2 and Hinkley Point but also by Brexit, and is quickly becoming a major business and industry issue. Expectations for labour availability over the next six months are split between remaining the same and decreasing but fortunately there is slightly more optimism that this will improve over the next year. Despite this, over the next year nearly all main contractors surveyed said they expected both staff and sub-contract labour costs to increase and most said that this would have a medium to major impact on their businesses.
Labour capacity constraints are currently plaguing certain specialist trades such as groundworks, bricklayers and dryliners. Cladding and MEP sub-contractors also have resource capacity constraints ranging from pre-construction, design and installation. The sub-contractor squeeze has featured prominently in the most recent PMI surveys, with September’s survey noting that shortages have led to additional cost pressures in terms of rates charged for sub-contracted work. Because sub-contractors are struggling to fill the widening gap of need, prices charged accelerated to survey-record levels according to the IHS Markit/CIPS sub-contractor rates index.
Until headcount improves, sub-contractors will continue to enjoy strong pricing power and capacity will remain stagnant. Unfortunately, there appears to be no quick fix to improve labour availability but encouragingly the latest ONS statistics suggest the employment levels of EU nationals are beginning to recover after having dropped by more than 13% between Jan-Mar 2020 and Jul-Sep 2020. With London and the UK regions heavily reliant on this source of labour for construction work this is a positive recovery trend but nearly 80,000 more are needed to fulfil the Government’s building ambitions. For this, a demand-led system of long-term visas may be required to plug gaps in labour supply while the UK works to attract and train a domestic workforce.
PROFITABILITY AND PROCUREMENT
OH&P and Preliminaries
There have been no seismic shifts in on-costs or preliminaries over the last three months. Most TPI survey respondents reported that both main contractor overheads and profit (OH&P) and preliminaries costs were unchanged. However, over the next 12 months a growing majority believe both will increase.
Some contractors appear to be de-risking themselves by increasing overheads on new work. Meanwhile BIM and additional health and safety measures are expected to drive overheads higher and as more work comes forward and contractors are able to be more selective on which projects they tender. There was some reticence among survey respondents who suggested that if new work begins to drop, contractors would aim to keep their on-costs at the same level in order to remain competitive and counter expected rises in labour and material costs. Some also noted that they expected headline OH&P to remain static over the next year but that contractors would aim to increase margins through package procurement.
Another recent phenomenon is larger contractors adapting their business model and entering into new sectors (eg repurposing commercial into residential) and persuing projects in different contract size bands to help meet their overheads. In some cases this has pushed smaller contractors out of the market or caused some to reduce their margins to remain competitive.
Preliminaries costs are being pushed higher by rising fuel prices and reduced plant availability. Increased management staff wages is also applying upward pressure to preliminaries costs. Until recently the market has been competitive and so ramping up preliminaries costs would have been a bold choice. However, now that tendering competition has eased and general inflation has been seen in the wider economy, contractors are likely to exercise a little less restraint and look to recover losses incurred during the pandemic.
While contractors still appear to be keen to get on tender lists, they are certainly being more selective on the projects they bid for.
The main reason for turning down requests to tender stems from an unwillingness to accept projects with higher risk profiles due to the current supply chain issues. The supply chain is generally unwilling to fix prices and take the risk of inflation on packages in two-three years’ time. Against this backdrop, contractors are seeking to de-risk work and limit their exposure by using two-stage tendering or negotiated contract tenders. Furthermore, it was noted that design and build (D&B) contracts are currently preferred due to the current issue of materials shortages. These shortages are forcing design changes that can be better managed by the contractor in order to maintain the programme.
Clients inevitably favour the single-stage procurement route to get the most competitive price but this requires a good team and a quality set of employer’s requirements setting out a detailed specification, scope of service and risk allocation in order to be successful.
In our last Q3 TPI report, a little over 44% said that D&B two-stage tendering was the most favoured procurement route in the preceding three months. In our Q4 TPI survey this dropped slightly to just over 36%. The reverse was true for D&B single-stage, which saw the proportion of respondents indicating this was the most favoured route jumping from 27% to 37%. Although choice of procurement route is driven by sector, size and project strategy rather than the market, this Q-on-Q shift is perhaps telling - an indication of the increasingly risk-averse nature of contractors in a market where workloads are rising and space capacity is low.