In October we looked at inflation and how companies could mitigate its impact. The latest Office for National Statistics (“ONS”) data continues to show the material affect inflation is having on the Construction industry.

In 2020 and 2021 government support was effective in keeping the UK Construction industry afloat, with insolvencies falling to historic lows in 2020. The withdrawal of this support, combined with the current labour shortages, material supply disruption, high energy prices and increased borrowing costs have created a perfect storm.

During the year to October 2022 the construction industry made the largest contribution to total insolvencies in England and Wales, registering almost 20% (2,083) of insolvencies in H1 2022. With contractors trapped between rising input costs and fixed price contracts, this theme is expected to continue into 2023.

The cost of construction materials is between 35% to 60% of an overall construction cost and the  ONS suggested that these costs were 15.5% higher in October 2022 than the same month in 2021, compared to a CPI increase of 9.6% for the same period. This has materially reduced or wiped-out profits on contracts; in the extreme a contract quoted to deliver a 5% margin would now be forecasting an 8% loss. Contractors have been utilising their cash reserves weakening balance sheets. 

Contractors are increasingly including fluctuation clauses in contracts that enable them to receive additional payments in respect of price fluctuation risks. These alone are not perfect as they don't address material shortages or short-term price fluctuations, they do however provide an opportunity to mitigate risk of price increases over the life of the contract.

Even where fluctuation clauses are included this can lead to disputes with customers who have not budgeted for the increased price at the start of the contract.

Increased prices for certain construction products were less noticeable in November 2022, however there has been an increase in the number of customers deferring or even cancelling projects.

Construction firms have also responded by with increasing prices for future projects. Aecom’s UK tender price index which captures the tender price of building products has risen 10.7% in the quarter to December 2022.

Looking forward to 2023, construction firms will continue to grapple with rising and uncertain material, energy and labour costs including the National Minimum Wage increase of 9.7% on 1st April. There is additional uncertainty surrounding the next 12 to 18 months for the UK as a recession looms. Further insolvencies and consolidation in the industry are highly likely, which can only weaken the sector when the next growth cycle begins. 

Construction firms have few options to mitigate inflation when fixed price contracts have been agreed. However, when tendering for new contracts in a market with high inflation they should consider these key factors:

1. Have they included sufficient contingency costs into their tenders to protect against overruns?
2. Can "fluctuation" or "provisional sums" clauses be included within the contract?
3. Could insurance be used to mitigate the risk of inflation?
4. Can they forward purchase materials at known costs?

Finally, they should consider whether a fixed price contract is ultimately too risky or whether a target cost or a cost-plus contract might be more appropriate.