Fast Fast Forward

Seven Ways Contractors Can Manage Cost Escalation Risk

Understanding and Managing Cost Escalation_NA Construction

Part Two in a Series on Controlling Construction Risk

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So, having considered the Seven Factors that can  Escalate Contractors’ Costs (in the previously published Part 1 of this 3-part series), the question presents itself—Do you want to play dodge ball? Or chess?

Any contractor that has experienced the sting of an unexpected cost impact, knows what this means. Ouch. Should a contractor strategically address these issues one by one, or just wait for an impact and take the hit? Managing these factors becomes very important if a surprise hit is to be avoided. Successful builders generally prefer a highly proactive stance. It is also crucial that everyone on the contractor’s team understands his or her respective roles and responsibilities when addressing these risks. Estimating and Project teams have the ability to influence exposure to escalation significantly. Are they aware of this?

The general feeling around cost escalation tends to be that these risks are passed down to subcontractors contractually.  However, if a subcontractor has an issue due to cost escalation, it is very likely that this will become a contractor’s problem.  It could be felt as a subcontractor default or result in schedule challenges due to manpower shortfalls, change order disputes, issues obtaining specified materials, etc.   Therefore, it’s in everyone’s best interest to take an active role in managing cost escalation.

There are many tactics in use to minimize or mitigate cost escalation, and, as all construction companies are unique, what works for one will not necessarily work for all. 

1.     Contract: While it is typical to include an escalation clause in subcontracts, it is also worth asking if consideration should be made to including concessions around escalation in the owner contract. Is it possible to build in some contingency for exceptional escalations, should they occur? Some builders do, and an “eyes open” approach to escalation from all parties tends to make for a more collaborative project environment. When all parties share the risk, all parties are incentivized to mitigate and manage it.

2.     Prequalification: Financial Prequalification is critical to insulating a contractor’s projects from the impact of cost escalation on subcontractors. If subcontractors bear this risk--and most do--financial analysis becomes an even more important component of a contractor’s overall prequalification effort, allowing  greater assurance that they can absorb the cost of an anomaly in escalation on a given project. Subcontractors’ financial ratios, especially days of cash, pipeline, and their WIP can speak volumes about their enterprise risk.

3.     Schedule: Construction schedules also present potential to reduce escalation exposure, or mitigate its impact. To reduce the time exposure on a project, and therefore potential exposure to many forces contributing to escalation, contractors may wish to examine their schedule for potential acceleration, or stacking of activities, which can reduce its overall duration and therefore exposure to potential escalation. Alternatively, any time saved by compressing the schedule may increase the float to allow for situations that would potentially lead to cost escalation. Again, time is money, and if contractors have some time, they may be able to save some money.

 

 

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Time is money, and if contractors have some time, they may be able to save some money.

 

4. Purchasing: To remove some exposure to escalation, it often makes sense to put some effort into identifying key scopes with potential for it, collaborate to get the related design documents early, and expedite buying these scopes to lock in pricing as early as possible. Focused, phased bidding may allow a contractor to do this in a more aggressive fashion, as the need to wait for complete documents for all scopes prior to bidding and procurement is eliminated for the most concerning scopes. There is some downside here, as later scopes are perhaps more exposed to escalation if the time frame for procurement overall stretches out, so a contractor’s approach should be very strategic in nature, if used. And while it is comforting and familiar to use subs that a contractor “knows so well,” it is more advantageous to cultivate a deep field of bidders, prequalify them responsibly, spread the work around, and build strong working relationships with the larger community of subcontractors.

5. Materials pre-purchase: As builders, contractors have options related to the procurement of materials when they know that a cost escalation is likely. They may wish to have a strategic delivery/product storage plan to enable them to have materials strategically purchased and staged in advance of need. Strategies could include purchasing materials in advance themselves, or paying subcontractors to do so via payment for stored materials. Both approaches have potential issues to work through, including cost, contract, insurance and a variety of logistical implications.

6. Value Engineering and Alternates: Subcontractors are on the front line, and they have the advantage of proximity to suppliers and labor to see emerging escalation potential, whether from manpower issues or supply dynamics. Working with subs to identify value engineering and alternates when a specified material or practice exposes a construction firm to potential escalation can be invaluable.

7. Awareness of Safety, Code, or Project Certification Requirements during estimating: It is necessary to consider both internal and external factors to ensure that this type of escalation is controlled. If a construction company’s protocols (internal) or OSHA requirements (external) for safety measures change, it’s important for estimating to consider those additional costs as well and/or ensure that subcontractors have them included in their bids. Compliance with these requirements can cause internal or external cost escalation, and must be accounted for in some way. Furthermore, any changes a contractor might be forced to make to the project after the subcontracts are signed will certainly cost money above and beyond what is budgeted and subcontracted.



This is part two in a series will continue on Fast Fast Forward with 2 more installments in the coming weeks:
Part 1: Seven Issues that Boost Contractors' Costs
Part 3: Five Insurance Considerations for Managing Cost Escalation

OR DOWNLOAD THE COMPLETE WHITEPAPER HERE




About the authors

Daniel Tolman is a Vice President at the Willis North America Construction Practice and one of the National Market Experts of their Default Insurance Group (DIG).

Cheri Hanes is a Construction Risk Engineer with XL Group’s North America Construction team. She holds both LEED AP and CRIS certifications.

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