Building resilience into the Australian construction industry18.10.22
Trips to the supermarket these days are a constant reminder that a regular basket of goods is much more expensive than a year ago due to inflation. Similarly, the construction basket of goods – the steel, concrete and wire that goes into our infrastructure - has also gone up.
A recent market sentiment survey by the Australian Constructors Association (ACA) and Arcadis found construction material input price rises of up to 70 percent in the 12 months leading up to publication of the report. This hyper-price escalation is a big problem for an industry operating mostly on fixed price contracts, some negotiated and locked-in years prior. A follow up survey will be conducted in 2023, which will provide good insight into how the situation is unfolding.
Less resilient businesses, operating on slim margins, are becoming insolvent and leaving clients with half-finished jobs and unpaid subcontractors. Construction is Australia’s third largest industry and company failures exact an enormous social cost and have the potential to fracture our economy.
Reasons for the price increases are largely beyond the control of business. These include supply chain challenges caused by the COVID 19 pandemic, with closed borders reducing migration and the flow of skilled workers. The economy-boosting infrastructure investments by State and Federal governments, along with pent-up consumer demand, has created a heated market for people, goods, and services. Geopolitical instability has impacted on oil prices, and there has been a string of adverse weather events in parts of the country.
Price escalation does not just affect the client and constructor – it also impacts the ability of the supply chain to accommodate the pipeline of work in Australia. It is therefore in the interests of government, clients, and construction businesses to work together on solutions to these unprecedented price escalation issues.
Solutions for a sustainable industry
Improving cash flow and security of payment throughout the industry is critical for a sustainable, resilient sector.
Construction projects have high working capital requirements to fund and manage the upfront cash outlays arising from high mobilisation costs, weekly paid labour, monthly paid staff, plant and equipment, and early supply chain engagement.
Few other industries are expected to finance such large amounts of work undertaken on behalf of a third party.
Improving the liquidity of the sector through advance payment arrangements assists with site mobilisation costs and enables early ordering and storage of price sensitive materials.
Liquidity can also be influenced by frequent and timely payments throughout the whole supply chain, simplified requirements for payment, clear and rapid variation claims process, avoiding excessive security from contractors, and increasing bid cost reimbursement to tenderers.
The commercial delivery model is paramount in tackling these issues. Where project scope and design are well developed and risks quantifiable, seeking lump sum prices from the market may be appropriate. In other situations, a more transparent approach to the management of cost and broader project risks should be adopted.
Commercial delivery models which tie up cash or create negative cash flow positions for contractors and suppliers not only increases risk; it also hinders investment in technologies which can improve productivity.
It’s surprising to learn that construction productivity today is lower than it was in 1990. The case for change is significant and there is an enormous opportunity to transform the industry to one that represents global best practice.
Addressing price escalation
In July, the ACA released a document called Construction Cost Inflation: Ways to Address an Escalating Issue. Laing O’Rourke, a member of ACA, contributed to this report, which outlines some of the challenges and practical solutions to address the current risks fairly for all parties. A key issue with hyper-escalation is that subcontractors and suppliers are often unable or unwilling to give or hold a fixed price. Without a cost adjustment mechanism, asset owners are effectively asking head contractors to price significant and unforeseen escalation.
Pricing for hyper escalation is a lose-lose proposition. If you put a realistic risk allocation on items, you may price yourself out of the market in a competitive industry. However, the client may also end up paying a premium if input prices decline.
Risk sharing contract models, such as those involving incentivised cost risk sharing, are improvements from lump sum contracts. However, they still put contractors at risk of losing overhead recovery and profit for events largely outside their control – such as price escalation. This is inequitable and means the asset owner is potentially receiving a finished product cheaper than it cost to build it. Regardless of the form, commercial models should contain price adjustment clauses (rise and fall) to ensure future fluctuations are dealt with fairly.
Both fair allocation of risk for new contracts, and mechanisms to address issues with current contracts, are needed.
Early Contractor Involvement and Collaborative Contracting
The use of an Early Contractor Involvement process, as the name suggests, gets contractors involved at the earliest stages of procurement. ECIs encourage innovation and provide contractors with the ability to influence design, materials, and delivery process to achieve maximum value and safer workplaces.
Similarly, collaborative contracting arrangements provide an opportunity to align the interests of all parties to what is best for the project. Problems can be resolved as they occur to achieve mutually beneficial outcomes and it facilitates earlier involvement of the supply chain to identify potential issues and drive innovation.
While some economic commentators are predicting inflationary pressures will ease in coming years, given most major projects have delivery schedules lasting longer than that forecast, it makes sense for clients as well as contractors to engage with more flexible models.
Contractors want sustainable businesses, the ability to make a fair profit and to continue to deliver value and certainty to clients and asset owners. By adopting solutions, we can successfully navigate and emerge with a stronger and more resilient industry.