Construction spending and the
cost of projects 

Posted: March 2010

The US construction marketplace experienced dramatic changes from 2002 through the beginning of 2010.

From 2002 to a peak in March 2006, overall construction spending increased by 50% or an average of almost 11% per year. After 2006, spending decreased by almost 35% through the end of 2009.

The chart below illustrates that 2002 - 2009 recorded by far the most significant upward and then downward change in the last 40 years.

What has happened to cost of projects?

From the late 1990s through the mid 2000s, demand for construction was balanced by supply. Therefore, prices were reasonably consistent and predictable. Owners could plan and program their projects with adequate funds to meet eventual bids and/or negotiated prices.

However, from 2005 through 2008, continued increases in non-residential spending caused bid prices to rise more rapidly than basic inflation. Overseas demand for raw materials also created "spot" shortages, e.g. steel. Prices exceeded budgets by 10, 20 or even 40% - despite considerable contingencies.

Since 2008, non-residential demand has dropped dramatically and bid prices have also dropped, allowing owners to comfortably fund their projects including most of their "wish" lists. The downward swing, as much as 40%, compared to 2006, 2007 and 2008, is a dramatic change.

Labor costs increase with time and material costs will tend to swing up and down to a certain degree. But why do construction costs (measured by bid prices) vary so much more than what labor and material costs would indicate?

Competition

The chart below illustrates how the number of bidders affects pricing. The chart aligns seven bidders as the bid factor of unity (1.0) and for two bidders a "premium" of 15% would be anticipated. Ten bidders would provide a "discount" of 5%. While individual projects can certainly vary, over a large number of projects these relationships have been predictable and consistent.

The competition issue affects both prime contractors and sub-contractors. Even if there is no direct bidding to a prime contractor, sub-contractor pricing is affected.

Noting that the marketplace of 2004 - 2008 resulted in constrained competition - commonly fewer than 3 bidders - premiums were 10% to occasionally over 40%. By comparison, in today's marketplace, competition for projects has become extreme with often 6 - 8 prime bidders and even larger numbers of subcontractors.

Why does competition affect prices so much?

Much of a bidder's cost is defined and settled. Either they have direct control over their own costs or indirect control through a subcontractor's quote. However, much of their cost is variable. Major factors that affect variable cost:

Risk premium

• How much to add to compensate for risks that cannot otherwise be controlled? The premium can be mitigated by extensive analysis, addition of qualifiers and provisions, more in-depth estimating, transfer of risk to lower tier sub-contractors and more in-depth general conditions staffing.

Purchasing aggressiveness

• Aggressive purchasing of sub-contractors and suppliers will allow a prime or general contractor to reduce their bid. Certain contractors command more competitive pricing regardless of market. The method of allocating overheads can affect bids. For example earthwork contractors are heavily equipment intensive and can adjust their bids significantly depending on how equipment overheads are calculated.

Indirect overhead costs

• Indirect costs affect a contractor's cost of doing business, e.g. staff, marketing, insurances and bonding capacity.

Technological/informational advantage

• Advantage over competitors can be gained by superior construction methodology and management strategies. High competition creates incentives for creative solutions. Literal interpretation of documents and scope of work can limit a bid, potentially provide an advantage and may create expensive change order opportunities.

Opportunity cost

• Most contractors view backlog and the prospects of future backlog as critical for long-term success. The investment required to prepare a bid compared to other opportunities is also significant.

Profit margin

• Profit margin remains a significant decision for the prime contractor and for all subs and suppliers. Regardless of how accurately a contractor prepares a bid, they may adjust it upward or downward at the last minute in line with how much the work is worth.

Each of the above can affect a bid by 5-10% and the combined total can exceed 30%. Competition is a major factor in how these issues are assessed, how the bid is prepared and why bids can vary so dramatically.

Will these market conditions continue?

The current US economy with reduced spending on construction can be expected to continue for at least a year or longer. So, extreme competition in construction will likely keep bid prices low for that time period. A number of major issues will have a longer-term impact:

Gross Domestic Product (GDP)

• Even if there is a substantial increase in GDP, construction spending is a lagging indicator that tends to follow GDP increases by at least a year. This will tend to keep prices low well after a GDP increase.

Government spending

• "Stimulus" spending will continue for at least a year. While the overall impact on the industry is not yet clear, "grants" can affect localized activity and pricing.

Inflation and debt

• The increasing federal debt may lead to general economy inflation of over 5% and perhaps higher. General inflation would affect labor and material costs, raise prices and also increase the cost of capital to fund construction. This will tend to increase cost.

Supply constriction

• Many contractors, sub-contractors and suppliers are barely managing cash flow and with recent bids offering modest if any profit, many may fail in the coming years. This reduces competition and will eventually increase costs.

Overseas competition

• China and India particularly continue to compete for natural resources, contracting capacity and capital investment. The net effect tends to raise prices.

Alternate delivery methods

• The move to negotiated contracts, design-build and integrated project delivery (IPD) all present significant advantages to owners but can reduce competition. Care must be taken to assure a fair price is paid.

Projects under design with anticipated bidding within a year will almost certainly benefit from a competitive marketplace. Projects in planning or early design, where the prospective bid date is more than one year in the future, may still benefit, but the risk of increasing cost are definitely worth considering.

Projects durations of over three years will present risks to the bidders that are hard to quantify and may be worthy of special consideration.