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How contractors can manage costs amid deepening uncertainty

In a deeply uncertain operating environment, data from Arcadis shows contractors will need to adopt adaptable strategies and focus even harder on managing their costs.

The Arcadis Input Cost Index for Q2 2016 hit 205.3, up 4.1 per cent compared with Q2 2015 and 2 per cent from the previous quarter.

The past two years have seen many key commodities endure flat or falling prices. However, some of these have begun to see a rebound over the past nine months, including coking coal, steel, zinc, sand and gravel.

Materials costs show a mixed performance, with bricks and blocks among the biggest risers while timber has been relatively flat.

A substantial increase in the costs of importing dollar and euro-denominated produce as a result of the devaluation of sterling over the past year has compounded any increases.

Continued labour and skills shortages in construction remain another primary source of input cost inflation, with little sign of abatement. Even plant costs, which have declined for more than two years, are now showing indications of levelling off as a result of the fall of sterling this year.

The post-referendum outlook

The Treasury’s September consensus forecast for GDP predicts growth of 1.8 per cent for 2016 and 0.9 per cent for 2017 – a revision on the previous forecasts but still representing positive performance prospects.

Economic growth for the first half of 2016 outperformed expectations and strong consumer spending has been reported – both promising signals of robust performance in the face of Brexit-related uncertainty.

However, while these more direct and shorter-term indicators are encouraging, there are some longer-term indicators that call for caution. Property and construction-related shares are yet to recover to pre-referendum levels, further decline in the value of sterling is a risk and economic stability is potentially very fragile, with much riding on how Brexit negotiations progress.

The Markit / CIPS Construction PMI for August showed an index level of 49.2– an improvement on July certainly, but still indicating contraction.

The PMI data also indicates a further acceleration in input cost inflation. It was reported that purchasing prices rose at the fastest pace for just over five years, driven by increased charges among suppliers of construction materials. The survey of sentiment showed input cost inflation picked up for the third month running and reached its highest level since July 2011, with respondents overwhelmingly linking the latest rise in input costs to exchange rate depreciation.

But it isn’t just surveys that are giving strong indications of steeper cost inflation: price data from the Office for National Statistics confirms the trend of accelerating increases.

The overall input price of materials and fuels bought by UK manufacturers rose 7.6 per cent in the year to August 2016, while core factory gate output prices were up 1.3 per cent. This means that costs of outputs are rising faster than the prices that can be charged for those outputs, which will inevitably put pressure on overheads and profits.

“In some sectors, the downward pressure on demand will outweigh the upward pressure of rising input costs”

As a result of Brexit-related uncertainty and economic headwinds, Arcadis’ most recent quarterly tender price forecast anticipates flat or falling tender prices in 2017. This is due to the expectation that uncertainty and the tightening of fiscal conditions will lead to delayed and cancelled investment decisions, which will have an adverse impact on construction demand.

In some key sectors, the downward pressure on demand will outweigh the upward pressure of rising input costs, when it comes to the prices contractors are able to tender. Rising costs and falling or flat prices will hit contractors’ margins, leading to the need for proactive management of their cost bases.

Materials price increase

According to the International Monetary Fund, commodity prices rose 16 per cent in the first half of 2016, with energy prices up 21 per cent surge.

The devaluation of sterling has compounded these price rises for UK-based buyers of dollar-denominated commodities. Some major UK steel producers announced price rises of up to £150 per tonne in the first half of 2016.

Materials costs – Q2 2016
Region Concrete £/cu m Reinforcement £/tonne Structural steel £/tonne Bricks £/1,000 Blocks £/sq m Timber £/m
East of England
86 555 1658 303 9.0 3.3
London 90 503 1625 408 10.5 3.0
Midlands 79 635 1510 303 7.5 3.2
North-west 84 430 1470 313 6.4 3.1
Northern 90 390 1500 290 9.4 3.4
Northern Ireland 56 484 1543 301 5.3 2.7
Scotland 80 504 1475 162 6.9 2.6
South-east 95 444 1542 364 9.8 2.9
South-west 99 518 1550 350 9.3 2.9
Wales 76 415 1525 203 6.4 3.1
Yorkshire & Humber 76 460 1600 265 7.5 2.5
National mean 83 485 1545 296 8.0 3.0

Manufacturers’ price rises were largely driven by a combination of the need for margin inflation, raw material price rises, labour costs and a changing procurement environment.

The latest Arcadis survey shows steel sections prices have continued to grow – up 1.9 per cent in Q2 2016 compared with Q2 2015 – though some buyers would have seen rises in excess of this.

“The pound is reported as being the worst-performing currency in the world in 2016 so far”

Bricks are still recording significant price increases – up 5.8 per cent in a quarter and 2.4 per cent in the past year. This coincides with data from the Department for Business, Enterprise and Industrial Strategy that recorded a year-on-year 1.2 per cent increase in brick deliveries in June 2016.

Concrete blocks saw a rise of 1 per cent over the year. This incremental increase was relatively measured when considered against increases in block deliveries of 17.2 per cent in June 2016 compared with June 2015 and a 5.6 per cent month-on-month rise. Timber prices, meanwhile, have remained stable.

Labour costs takes the lead

Labour costs continue to be a main driver of input cost inflation. Average labour rates for a bricklayer rose 5.2 per cent to £179 a day over the past 12 months, while those for carpenters were up 4.4 per cent to £175.

Labour costs – Q2 2016
Region Bricklayers £/per day Carpenters £/per day Labour average £/per day
East of England
187 187 187
London 201 191 196
Midlands 170 169 170
North-west 178 185 182
Northern 175 175 175
Northern Ireland 186 155 170
Scotland 170 170 170
South-east 192 189 190
South-west 185 185 185
Wales 163 163 163
Yorkshire & Humber 158 163 160
National mean 179 175 177

London and the South-east have remained the most expensive places for labour costs, with Scotland and Yorkshire & the Humber the least costly.

ONS data shows unemployment in construction has fallen to a low of 3 per cent, compared with the overall UK figure of more than 5 per cent in Q2 2016. This amounts to 69,000 people deemed unemployed in the construction industry, of which 27,000 are long-term unemployed, highlighting a low level of excess capacity in the industry compared with other sectors of the economy.

Practical steps for managing rising costs

  • Manage transactional exchange rate risk: This risk occurs as a result of timing differences between a contractual commitment and actual cashflows. Contractors should consider hedging purchases involving suppliers abroad, though the level of uncertainty will increase the costs of doing so.
    Deliberately fast-paced negotiation is another option, as is the pre-purchase or pre-allocation of currency. Another might be to adopt a floating currency approach to payment.
  • Optimise use of resources: Can more be done to undertake back-to-basics reviews of waste in relation to labour, staff time and materials usage?
    Reducing duplication of effort and ensuring everyone is fully utilised and enabled to perform tasks efficiently is crucial to making the most of what we have – as is reduction of materials waste.
    Adaptation of performance objectives and key performance indicators to incentivise a focus on waste have been used successfully by some contractors. Implementation is not easy, but the returns can potentially be significant and relatively quick to achieve.
  • Review material sourcing strategy: Undertake a review of material sourcing. Identify where materials originate from with a view to switching to suppliers that can provide materials in a favourable currency denomination – buy local.
    Work with clients to review specifications and assess sourcing alternative materials.
  • Review procurement: Shifts in materials costs may call for a rethink on procurement models. Greater collaboration with suppliers may drive more commercially advantageous arrangements.
    Could now be an appropriate time to revisit terms associated with any volume purchase arrangements that are in place?

Sterling’s downward movement actually began 12 months ago and accelerated after the referendum – plummeting 13 per cent the day of the result. It is now worth 16 per cent less against the dollar and is even weaker against the euro, having fallen 18 per cent in the past year.

Bloomberg reports that the pound is 2016’s worst-performing currency in the world to date.

Weighted assessment indicates that the depreciation of sterling since last summer could add around 6-8 per cent to the cost of imported dollar-traded materials, with some work packages particularly vulnerable, such as cladding or switch-gear. This could lead to some difficult conversations between clients and the supply chain and potentially create challenges where target cost arrangements are in place.

There are reputable currency forecasters estimating both appreciation and depreciation of sterling in the next year. Agility will therefore emerge as the operative principle in managing and mitigating the associated effects on input costs.

With clear evidence that input costs are rising and tender price growth under threat from Brexit-related uncertainty, operating conditions for the supply chain look set to present both challenges and opportunities.

Rising input costs and static or falling prices will put pressure on the supply chain’s margins and this will require proactive mitigation.

Kevin Nimoh is a research analyst at Arcadis

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