Well, just because you know the relationship between supply and demand doesn’t help get what you needed. For instance, if you only have $200 to spend on a new lawnmower, and they used to be $175 when your neighbor got one last year, you expected when you went shopping that you would purchase a new mower. However, the price of the lawnmower is now $225, you are realizing that you will have to come up with a different solution for cutting the lawn within your budget, find more money elsewhere, or table the purchase for a later time and just let the lawn grow. The same is true when tackling the expectation of a construction project. Part of the success of a properly budgeted program is estimating the future value of goods and services in the market; price escalation.
There are several indexes that try to provide a metric for what the escalation rate will be, that is the rate to attribute to current goods and services to predict the future price of those same goods and services. Depending on what it is you are looking for, and your point of reference, picking the correct index is the key. Today we will consider the Construction Cost Index (CCI) index, as published in Engineering News-Record (ENR) for escalation, as compared to our index.
If you are a subcontractor, the CCI is an excellent index to use to track overall fluctuations with labor rates and material costs. However, the CCI does not account for labor productivity and markups; it is an input index. In busy markets, for example, labor productivity is low due to diminishing skilled labor, as that skilled labor is already allocated on current construction projects. Therefore, new labor must be hired or acquired to satisfy the market, decreasing the efficiency of that labor. Using the Structural Steel Pricing graph below as an example, look at the labor price change from a recovery market to a high growth market. The cost for steel erectors increased because the demand for new workers in this trade was greater than the supply and new workers were needed to be hired and trained and those new workers productivity would be less and need to be accounted for.
In slow markets, the labor efficiency generally grows (or at least doesn’t decline) as the best labor force is kept busy and productive, helping to minimize potential losses and maximize time spent, thereby being the most efficient.
Another component of the total price that the CCI does not track is the subcontractor’s markup, which is the portion of the cost for all trades that has the most fluctuation. In a high growth market, the subcontractors are all busy and do not need to be carrying a low markup in order to get work. They may be spending that additional money to purchase equipment, invest in technology or to train their labor force. In a market that is down or contracting, the subcontractors need to be as competitive as possible to get work and stay in business. In this scenario, they are running at cost which means the markup is as low as they can go, they aren’t purchasing equipment and their profits are as low as they can afford to stay in business.
Our projections for escalation take into account both labor productivity and the subcontractor markup; in essence, an output index. We track construction labor growth across the country, individual states and all major metropolitans. The construction labor growth rate is calculated by the current 12 month rolling average in construction employment relative to the previous 12 month average in construction employment.
We then classify the growth rate range from a high growth market down to a contracting market. Depending on where your city or state falls, and how it compares to the national average, we will then assign a forecast to that region. Another factor is the all‐time high with respect to construction labor that has been achieved within the state; even if the market were a contracting market for a relative period of time, our recommendation would be to still carry some escalation factor.
In the lawn mower example, you knew the price from last year from your neighbor. The CCI is 10%, so even though you knew the price would be higher, you thought $200 would still be enough. But if your location is a growing market, more and more people would be relocating to there, buying homes and needing to take care of their lawns. As more lawn mowers sold, existing companies had to make more units per month than previously, and likely have to hire more labor. This attracts new competitors to enter the lawn mower market and they too have to hire labor. As the demand for skilled labor depletes the supply, new labor must be trained to keep up with the skilled labor, which is where the inefficiency lies. With having to overcome that labor inefficiency, a premium is added and with the demand in the market so high that everyone that needs a lawn mower will buy one somewhere, the markups are higher as well.
In looking at other indexes, in this case the CCI, it is important to know what is being evaluated to know how good a predictor the index will be. If you are a subcontractor looking to evaluate the material cost change or the labor rate change, an input index such as the CCI index is great. If you are an owner, developer, etc. and are looking for the overhead/markup to be accounted for, an output index like ours is the better reference. To have the best chance of getting the right value of escalation attributable to the goods and services in your particular market, it is best to apply the metric that addresses all the nuances of that market. That way, you know you will be able get a lawn mower that you can afford.
Previous Vermeulen Insight Blogs