How inflation affects commercial construction costs
17 August 2022
Inflation is one of the major challenges construction companies will have to face in the coming decade. From a lack of clientele to delaying the completion of projects, many current issues found in construction markets stem from inflation.
What is inflation?
Inflation refers to a rise in prices, often represented using a percentage number. When inflation occurs, the value of a unit of currency is able to purchase less than it could in the past.
Goods and services in an economy do not exist in a vacuum. Humans require several commodities for sustenance and personal satisfaction, and the prices of these are intertwined. Due to inflation, for instance, a cup of coffee priced at $ 0.25 during the 1970s may be valued at $ 1.85 today.
While the fluctuations in the price of a single commodity may be easy to measure over time, inflation shows the overall impact of price changes for a diversified set of goods and services. If one sector of the economy is considerably affected by some kind of event, it can produce a ripple effect where the overall price of goods rises.
If left unchecked, inflation can rapidly increase the cost of living of the general public, which in turn leaves people with less money to spend on other goods and services. Eventually, this can reach the point where economic growth as a whole decelerates and the economy suffers.
What causes inflation?
Inflation is caused by a decline in purchasing power. The consensus among economists is that inflation occurs when the money supply outpaces economic growth (source).
The root cause of inflation is an unmeasured increase in the supply of money. However, this situation can be reached by different economic mechanisms working individually or in tandem with each other.
The monetary authorities of a country can increase the money supply, and therefore cause inflation, through the following actions:
- Indiscriminately printing and giving away money;
- The legal devaluation of the legal tender currency;
- Purchasing government bonds from banks to loan new money into existence. The price increases that lead to inflation are typically caused by this event.
The mechanisms of how the loss of purchasing power causes inflation can be categorized into three types:
- The demand-pull effect
- The cost-push effect
- Built-in inflation
The demand-pull effect
Demand-pull inflation is a price increase that corresponds to a rise in demand. It occurs when the supply of capital, be it money or credit, increases. This causes an over-stimulation in the overall demand for commodities. People spend more, which causes the price of goods to rise further. When demand rises so fast that the economy’s production capacity can’t keep up with it, inflation happens.
The cost-push effect
Cost-push inflation is caused because prices along the supply chain are increased. In any kind of industry, higher material prices translate into a spike in the price of finalized goods. This becomes particularly evident when commodities that are critical to the functioning of entire industries, such as the fuel required to transport goods and people, are in short supply.
Built-in inflation is based on people’s expectations of current and future inflation rates and their efforts to adapt to them. As the general population is impacted by the rising costs of inflation, they will demand improvements to their own purchasing power to maintain a decent standard of living. If prices keep rising alongside wages, it will cause a wage-price spiral, where both prices and wages keep rising in a race to balance each other.
Effects of inflation on companies
The most immediate way companies feel the impact of inflation is through an overall rise in prices. Not only will supplies, labor, transportation, and management operations become more expensive, but fewer people spending means that there will be a diminished flow of capital.
The commercial construction cost index has risen dramatically over the last few years. For example, construction costs for non-residential buildings in Canada increased in the first quarter of 2022. This increase in costs was most noticeable in Toronto (+3.6%) and Montreal (+3.0%), and it was the construction costs of factories and warehouses that recorded the most pronounced increases (source).
Are all businesses affected by inflation the same way?
Some businesses are impacted harder by inflation than others. Goods that are considered essential by consumers will not see their demand drastically reduced by price hikes. Businesses such as healthcare provision, childcare, grocery stores, and tax professionals suffer considerably less from inflation.
The more optional a commodity is considered to be, the more it will be affected by inflation. When prices are high, people are bound to shop around for the best deals or put off their purchases until they feel comfortable with spending large amounts of money.
How is the construction industry affected by increasing inflation?
Rising prices bring more challenges to construction companies than only higher spending. The effects of inflation can cause a severe emotional strain on some people, leading them to make unpredictable choices that can damage business. Not only will business opportunities be scarcer, but they will also be less reliable.
Increased raw material prices
Raw materials are indispensable for the completion of construction projects. A rise in the price of raw materials inevitably leads to an increase in construction costs. The cost-push effect created by commercial construction costs rising across a nation can cause severe harm to its economy.
Disruptions in the supply chain
Supply-chain issues and inflation go hand-in-hand. It is very important to always plan ahead, either by having enough inventory to survive a lack of supply or by having a reliable network of suppliers.
Increased overhead and inventory costs
The price of fuel, rent, and utilities may rise during inflation. If you rent storage space for supplies or a similar purpose, this can become a huge liability. Likewise, employee wages may also have to rise to stay competitive.
High interest rates
When rates are raised to combat inflation, borrowing money becomes more expensive. Businesses must be smart about how they loan, borrow, invest, and spend during inflation.
How should commercial construction companies prepare and manage rising inflation?
While the high inflation caused by the onset of the Covid-19 pandemic may be transitory, construction companies shouldn’t expect it to end any time soon. Companies can prepare for the rising inflation rates by starting the restructuring of their operations now.
Leveraging competitive prices
Working capital becomes more valuable during inflation. As the price of raw materials, fuel, and other supplies rise, construction price indexes do as well. Unfortunately, this means that commercial construction will cost more than it previously did. If you don’t readjust your own prices in a timely manner, the price increases of others will severely impact your bottom line.
Take a look at other companies in the construction sector. Evaluate what strategies they have used and their results, and then contrast that to how your company is doing. For instance, they may have found a way to lower the costs of construction by taking certain decisions regarding material use. By taking inspiration from other companies’ strategies, you can stay competitive as the construction industry transforms.
Reevaluating construction markets
If inflation makes working on commercial construction projects too expensive for your company to handle, that doesn’t mean your operations have to stop. You can stay competitive by diversifying the scope of your operations. A way of doing this is accepting projects that may not be as lucrative but have the benefit of being simpler to accomplish.
There are alternatives to commercial construction, such as residential building construction. Residential construction costs are exceptionally low when compared to commercial construction. This difference in price stems from a variety of factors, including labor, equipment, and overhead costs, as well as different materials and standards of compliance.
Take advantage of current fixed interest rates
It is also advisable that adjustable-rate debts are converted to fixed loans whenever possible. The devaluation of money will make fixed-rate loans cheaper over time, while adjustable-rate loans will rise alongside inflation. If you want to borrow money for a construction project and are going to do it at a fixed interest rate, now may be the right time.
Diversifying the supply chain
If you have only one supplier of a business-critical material and they go out of business, then you’re probably next in line. By having multiple sources, you have access to more options and can circumvent rising prices and delays more effectively. You will have more bargaining power during inflation if you have multiple suppliers you can trust.
Handling construction projects in the current economy can become extremely overwhelming. If you wish to get the best value for your money, the experts at Spacia have what you’re looking for. Spacia is ready to fulfill all your needs when it comes to new constructions, refurbishment, expansions, renovations, and much more.
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