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Squeeze Play

Squeeze Play

Fluctuating material prices and increased competition drive down margins

Using producer price indexes (PPIs) from the U.S. Bureau of Labor Statistics (BLS) for specific construction inputs, finished building types, and subcontractor categories, the Associated General Contractors (AGC) of America tracks construction costs relative to the price index for new construction to 2010. According to AGC, from 2004 through 2008, the construction industry was hit with a succession of steep price increases affecting a variety of materials. Although fluctuations in material costs have been tamer in the past three years, in 2009, as the effects of the recession took hold and many major projects were put on hold or canceled, increased competition brought down bid prices. In the past year, input costs have continued to outpace bid prices, lowering contractors’ margins (click here to see Table).

More specifically, in September 2011, the amount contractors paid for a range of key construction materials held relatively steady from the previous month but experienced an average year-over-year increase of 8.1%. Several materials had an annual price increase in the double digits. For example, diesel fuel was up only 3.3% for the month but 39.4% since September 2010; copper and brass mill shapes were down 0.7% in September but up 14.8% over the last 12 months; steel mill products prices, which fell 0.6% for the month, were up 13.5% year-over-year; and aluminum mill shapes, down 1.8% for the month, were up 10.4% percent from a year earlier.

"These prices can spike anytime there is a global supply disruption or a consensus that demand is strengthening worldwide, not just from U.S. construction,” said Ken Simonson, AGC’s chief economist, in a press release accompanying the recently released BLS data. "In contrast, materials produced here and used only by U.S. construction have shown little price movement.”

Simonson cited, as examples, the PPIs for concrete products, up 0.2% in September and 0.3% over 12 months; lumber and plywood, down 1.3% for the month and 0.4% for the year; and gypsum products such as wallboard, down 1.7% for the month and 4.6% year-over-year.

Meanwhile, contractors eked out only a meager 2% to 3% price increase — depending on building type — for new non-residential building construction over the last 12 months. "Feeble demand for construction is forcing contractors to absorb the bulk of materials price hikes, instead of passing them along to owners,” said Simonson. "This pattern has persisted for more than two years, and many contractors are increasingly at risk of going under.”

The annual price index for new construction rose 2.2% for industrial buildings, 2.6% for offices, 2.8% for warehouses, and 3% for schools. "In light of the much steeper materials cost increases, these gains are not enough to keep contractors solvent,” Simonson warned.

Battle Royale

It’s a dog-eat-dog world out there, according to David Parden, owner, DBP Electrical Consulting, a Loveland, Colo.-based provider of electrical estimating and electrical estimator/electrical contractor training services. "The summer right before the last presidential election, things got really crazy — stupid crazy,” says Parden. "A lot of contractors were taking work at cost, and everything just spiraled downward. Their margins went away.”

The biggest culprits, according to Parden, were the newer, inexperienced contractors. They entered the industry during the boom time, and then drove down bid prices when projects became more scarce. "There’s so much competition because the economy roared along for so long with record building, so fewer jobs have sparked greater competition,” he says. "A lot of amateurs, who were just kind of faking it before, were now biting off work. They needed to be here when the economy was strong, but now that the work has gone away — and there’s only a third of the jobs coming out — there are still a lot of guys trying to get the work.”

In Parden’s opinion, these contractors didn’t even know their true operating costs. "They were just putting out numbers and worked too cheaply,” he says. "I worked for a man one time, and he had a great quote. He said, ‘He’s broke, and he doesn’t even know it.’ He was talking about bidding practices, and I think that’s true of a lot of guys.”

Although construction in some areas of the country was less affected by the recession than in others, areas that really did well when the economy was doing well seem to be hurting the worst, says Parden, who explains that in the three years since the downturn, bid prices haven’t even come close to pre-recession levels. "Things haven’t rebounded,” he says. "Today more than ever, electrical estimators are being asked to bid more and more projects. They are being asked to bid jobs outside of their comfort zones. They’re mired down in pitiful numbers.”

As a result, electrical contractors are currently in a "battle of attrition.” This is a painful time for the electrical construction industry, says Parden. "You simply cannot compete against the electrical contractor buying a job to keep billing going. If you hold to your principles and make smart business decisions, there is a very good chance you will still be standing when the economy recovers. Much of your competition today will not be around when this happens. Perhaps the electrical industry will be a better place without these contractors.”

Not surprisingly then, fewer players may mean eventual increases in project prices. "The decrease in capacity will sow seeds of price increases,” said Julian Anderson, president, Rider Levett Bucknall (RLB), a global property and construction practice offering cost management, project management, and advisory services, in the presentation "Building Materials & Labor Cost Trends,” given at the McGraw-Hill Construction Outlook 2012 Executive Conference in Washington, D.C., in October. "Those left at the end of 2011 will be in great shape for end of 2012 into 2013.”

In a comparison of its construction costs index to the construction price index, RLB bears out the widening disparity between construction costs and new building prices (click here to see Figure). "You can have construction costs going up at the same time you have bid prices going down,” said Anderson. "In January 2009, it fell off the cliff.”

Furthermore, as construction unemployment has risen, the cost of skilled labor has also increased. "The price of labor has continued to ease upward,” said Anderson, predicting that if bid prices remain competitive, they will have to rise again. "There will be a bid price tipping point.”

Still Standing

According to the National Electrical Contractors Association’s (NECA) "Electrical Contractors’ Financial Performance Report 2010,” responding electrical contracting firms reported that material costs make up an average of 38% of their direct costs (an additional 36% is attributed to labor costs). Although most jobs are bid based on a fixed price, there are ways to manage these costs, even under the assumption that material prices may fluctuate from the time of bid to completion.

Much of the burden of managing costs lies with the estimator, says Parden. "The electrical estimate is the foundation of all electrical jobs,” he advises. "The job’s success can be won or lost during this process.”

Estimators should work to make their estimates as tight as possible, he says. In order to effectively bid work, they need to have a consistent process or methodology. "The process should always be scalable and consideration should be given to how the project will be built and managed once contracts have been signed,” he says.

Preconstruction service is essential for setting costs, scheduling, determining alternative methods and solutions, and providing early identification of issues and risk management. First, estimators must also give an expiration date to each proposal. "You have to qualify for how long the proposal is good for,” says Parden, who recommends a 30-day proposal. "That’s the very first thing you need to do. Don’t just send out an open-ended proposal. A lot can happen after 30 days.”

Additionally, the estimator can write a contingency to bill for stored materials in the proposal. "Write into the scope letter that the proposal is contingent upon being able to bill for stored materials.” he says. "That way, once the contractors have a letter of intent, they can purchase the materials, put them in a warehouse, and they can mitigate some of that risk as far as materials going up over the long run.”

Contractors can also try to get the owner to pay for the storage of materials in a bonded warehouse. A materials escalation clause, which shifts the risk to the owner, can also be added to the proposal or contract. However, Parden has doubts about how well they may hold up in court. "I have written those into scope letters,” says Parden. "But I don’t know how they hold up under legal scrutiny.”

Still, an escalation clause may work better in this economy than proposing the addition of contingency money. "Before the economy got so bad, it wasn’t uncommon to see 10% contingency on material,” Parden says. "In today’s economy. if you do that, you’re almost assured that you’re not going to get the job. It would be better to draw up the materials escalation clause, put it in, and hope for the best.”

Outside of the proposal, electrical contractors may also try to forge relationships with general contractors and electrical suppliers/distributors. "When I worked for a company, I’d always pick up the phone and call the general contractors,” says Parden. "I found a reason to call them, even if I had to stretch for that reason. Generally, I would tell them my interpretation of the scope, and ask them if they agreed with that interpretation of the scope. What ultimately happens is you can kind of weed out real quick which general contractors are interested in talking to you and which ones aren’t.”

However, you must exercise caution when giving away information about the jobs you’re bidding, particularly when dealing with electrical wholesalers. "Some of the suppliers are a step up from the proverbial used-car salesman,” says Parden. "They’re ultimately trying to get the commission, and they’re going to do whatever they can to get it.” However, a relationship with your electrical distributors can get your firm access to products, inventory management, logistical support, short-term financing through trade credit, technical expertise and information, and training. "You really need to be talking to everyone,” says Parden. "You have to know who your allies are.”

This is particularly important when value engineering a project. "In today’s competitive market, your ability to value engineer projects may well be the difference between landing the job or not,” says Parden. "Often, owners are taking the lowest bidders and allowing them to come up with innovative ways to lower the electrical cost.”

According to Parden, light fixtures are a natural for value engineering. The next area of the project most people look at value engineering is changing the feeder conductors from copper to aluminum. "Now you are reducing the cost of the feeder conductor along with reducing the labor and material cost of the raceway in which the feeder is installed,” Parden says. "Better placement of the distribution panels can also help to eliminate conductor cost.”

In addition, you can try to find savings in the switchgear. "There are lots of things to consider here, such as AIC ratings, aluminum versus copper bussing, surface versus flush mounting, door-in-door covers, and bolt-in breakers versus snap-in breakers. If it’s a multi-story building, can you use feed-through lugs? This is an area where having a competent sales rep for gear in your area is invaluable.

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