University of Mindanao – Main College of Engineering Education Case Study: Effects of the Inflation Rate on the Finance Management of Engineering Firms In Partial Fulfillment of the Requirements In CE 108 – Engineering Management Submitted by: Jarligo, Ghaylee Mae O. Labastida, Rhey Anthony G. Monterde, Ian Kenneth T. Pesado, Elmar Cris S. Vale, Ronna Faith Amor L. Submitted to: Engr. John A. Bacus July 2022 EXECUTIVE SUMMARY There are numerous factors affecting the economic growth of the country, and this includes inflation. This study proposed to determine the effect of the inflation rate on finance management, especially in the Philippine construction industry. The Department of Labor and Employment considers the construction agencies the largest job-generating sector. In addition, the construction industry is a significant contributor to Philippine economic development. With the increasing inflation rate, the construction industry encounters challenges in maintaining sustainable operation. Construction industry inflation varies among markets and industry sectors. This is because of technological advances, extensive engineering projects, the complexity of customers' needs, and numerous other factors. This merely demonstrates how susceptible engineering firms are to rising costs. Project additional costs will result if the inflation rate is ignored because machinery expenditures, production costs, and operational expenses vary yearly. Additionally, as the insurance industry adjusts to inflation, insureds will have to pay more for security. However, researchers proposed solutions that will be essential in mitigating the effects brought by inflation, such as a cost-plus contract, retainage clause, securing a signed agreement, performance bonds with banks, and subscriptions to various insurance policies. ii TABLE OF CONTENTS Page Title Page i Executive Summary ii Table of Contents iii Introduction 1 Background of the Study 2 Proposed Solutions 4 Recommendation 6 Resources 7 iii INTRODUCTION According to the recent report of the Philippine Statistics Authority (2022), the country’s headline inflation rate for all items rose sharply to 6.1% in June 2022, the highest record since October 2018. This skyrocketing percentage has significantly affected the cost of living for everyone since purchasing power decreases, which pushes workers to demand salary increases, which afterward drives businesses to raise their prices. Moreover, with this increase, every aspect of the economy is struck because the cost of doing business, mortgage rates, borrowing costs, and returns on corporate and government bonds are all affected. The high inflation rate spares no one. One of the most strained sectors by the increasing inflation rate is the construction industry. This industry offers engineering services that generate work opportunities and training for many people. According to PSA, the Department of Labor and Employment considered it the country’s most significant job-generating sector in the Philippines, with net employment of 100,000 (Medenilla, 2021). Additionally, it gives a chance for investment and financial gain, generating money for small businesses that offer similar products or services, supporting companies that focus on health and safety, increasing revenue due to foreign trade of materials and services, etc. The construction industry is indeed an immense contributor to economic progress and growth. However, with the influence of high inflation, the construction industry faces the challenge of maintaining sustainable operations. The budget, the main determining factor in construction projects, faces difficulties with an increasing inflation rate, which causes initial and total costs to vary. Furthermore, as prices of inputs such as raw materials, wages, and machinery increase, project completion becomes delayed to prevent cost overruns or unforeseen project budgetary modifications that subsequently increase total costs (Musarat, Alaloul, & Liew, 2020). This just shows how engineering firms are vulnerable to rising costs. 1 There is a need to dwell on this topic because there is a significant relationship between the inflation rate and the construction industry's performance, which in turn affects the economy. Since inflation is ever-changing and is not a one-day event, engineering firms must develop strategies to uphold a steady industry, especially in today’s inflationary trends. BACKGROUND OF THE STUDY The impacts of inflation are perceived throughout the whole engineering sector. Owners are now paying premiums on building prices in addition to the rising costs of facilities and capital. Given the significant investments required, the construction industry is crucial for any country looking to develop its economy. However, the inflation issue is worsening and hurting the building sector. The cost of materials, equipment, and other building project inputs is rising due to inflation when project participants have little choice but to postpone the project to avoid cost overruns, primarily caused by inflation. According to Jaya, Alaloul, & Musarat (1970), the engineering industry significantly influences the economy's growth. Inflation is one of the factors that influence a nation's economy. It is impossible to overlook inflation's impact on economic growth because it might have either a positive or negative response. It has been found that most construction projects' economics and budgeting fail to account for inflation, which causes project cost overruns because the costs of building materials, labor, and machinery are susceptible to annual change. According to Musarat, Alaloul, and Liew (2020), the global economic recovery is greatly aided by the engineering industries, which create millions of jobs. In July 2019, the construction industry employed 7,505,000 people, and by 2026, it was expected to add 864,700 new positions, with an average growth rate of 12 percent. Many nations 2 are gradually enacting anti-inflation policies to maintain price stability. Asian economies have implemented a low and steady inflation policy. According to Statista, the ASEAN countries have seen stable inflation over the past six years, with Thailand's rate in 2015 being 0.9% and Myanmar's at 10.04%. Maintaining a low and consistent inflation rate in macroeconomic management is challenging for many countries where Malaysia's inflation is eccentric. The engineering sector is dynamic and significantly contributes to any nation's economic development, but it suffers the most from essential elements that upset stakeholders. Inflation impacts economic growth, the jobs market, and the consumer price index, as stated by Khaled Batayneh (n.d.). Although low material prices can affect inflation, contractor and supplier rates have a significant impact. Inflation in the construction business varies throughout markets and across various sectors. Contractors must deal with great uncertainty when submitting bids and funding work on projects. Contractors' inability to predict long-term returns on their investments and the need to redirect resources to cover resource expenditures impact productivity. Owners and contractors must make plans to prepare for these effects and lessen the dangers involved. As stated by Stukhart (2021), long-term costs must be reduced by adequately allocating economic risks in contracting, albeit this would necessitate significant changes in how the engineering sector operates. 3 PROPOSED SOLUTIONS Recent worldwide events, like the pandemic and the war between Ukraine and Russia, have driven inflation to surge across the globe. Based on Tobias (2022), the inflation rate in the US climbed to 8.5% in March 2022. It is reported to be the highest since the year 1981. Meanwhile, the annual inflation rate in the Philippines reached 6.1% in June 2022 (Trading Economics, 2022). Many businesses and industries suffer from this, including the engineering industry. The engineering field, specifically the construction industry, has experienced issues in the supply chain, building materials prices, labor shortages, and stymied projects. The study by Musarat, Alaloul, and Liew (2020) proved a strong relationship between the construction industry and the inflation rate. If the inflation rate is neglected, it will cause project overruns as machinery rates, materials prices, and labor wages change yearly. Insureds also face higher coverage costs as the insurance market adapts to inflation. To mitigate these effects brought by inflation on engineering firms, the following proposed solutions will be essential legal safeguards against inflation, as suggested by Baskerville (2021): • A cost-plus contract, also known as an open book contract, will help the contractors reimburse the actual project cost. He will also receive a percentage of the cost of the project or an agreed-upon fixed amount based on the contract. These will cover the services and overhead involved in the project management. • A retainage clause is included in the contracts. Engineering managers should have a retainage clause to hold back a certain percentage of a subcontractor’s payment until the project is complete. It will also help diminish the risk of losing a subcontractor before the project. 4 • Securing a signed agreement with key suppliers ahead of time is an intelligent approach for more significant projects, even if it necessitates a down payment. It can help the engineer manager or the contractor to have legal recourse if a supplier tries to back out of a deal or execute a price change. • Performance bonds with insurance companies or banks can aid the financial management of any engineering firm. It guarantees that the contractor will finish the project satisfactorily and meet the obligations specified in the bonds. • Subscriptions to various insurance policies can protect the engineer manager from significant material cost fluctuations. When a manager pays a monthly premium, he can receive an insurance payout if the raw material prices exceed certain fixed thresholds. 5 RECOMMENDATION Based on the analysis of the study, the following recommendations are suggested: 1. Engineer managers and contractors should use an open book contract, ensure a retention clause is included in the agreement, secure a signed contract, create performance bonds with banks, and establish insurance subscriptions. These precautions can minimize the effect of the increasing inflation rate that is currently affecting the whole engineering industry. 2. The news, newspapers, and other information sources should be often read and watched by engineer managers and contractors. These practices can give them access to the most recent trends and data on inflation and the engineering sector, aiding in firm decision-making. 3. Explore other firms aside from engineering and study the effect of the inflation rate on their finance management. This can make other managers and organization leaders more aware of the inflation rate's significant effects. 6 Resources Baskerville, H. (2021). Top Five Ways to Mitigate Risk in Large Construction Projects. Fortis Law Partners. Retrieved from https://www.fortislawpartners.com/blog/top-five-ways-tomitigate-risk-in-large-construction-projects Batayneh, K., & Additional information Funding The authors received no direct funding for this research. Notes on contributors Khaled Batayneh Dr. Khaled I Batayneh. (n.d.). The impact of inflation on the Financial Sector Development: Empirical evidence from Jordan. Taylor & Francis. Retrieved July 18, 2022, from https://www.tandfonline.com/doi/full/10.1080/23322039.2021.1970869 Construction Law (2019). Managing the risk of currency fluctuations in the international and domestic construction sector from https://www.hfw.com/Managing-the-risk-of-currencyfluctuations-in-the-international-and-domestic-construction-sector-Apr-19 Jaya, I., Alaloul, W. S., & Musarat, M. A. (1970, January 1). Role of inflation in construction: A systematic review. SpringerLink. Retrieved July 18, 2022, from https://link.springer.com/chapter/10.1007/978-981-33-6311-3_80 Levelset (2019). The Ultimate Guide to Retainage in the Construction Industry from https://www.levelset.com/blog/retainage/ Musarat, M., Alaloul, W, & Liew, M. (2021). Impact of inflation rate on construction projects: A review. Ain Shams Engineering Journal, 12(1), p. 407-414. ISSN 2090-4479. https://doi.org/10.1016/j.asej.2020.04.009 7 Medenilla, S. (2021). Construction still top jobs generator says DOLE. Retrieved from https://businessmirror.com.ph/2021/09/16/construction-still-top-jobs-generator-says-dole/ Philippine Statistics Authority (2022). Summary Inflation Report Consumer Price Index (2018=100): June 2022. Retrieved from https://psa.gov.ph/statistics/survey/price/summary-inflation-report-consumer-price-index2018100-june-2022 Stukhart, G. (2021, February 11). Inflation and the construction industry: Journal of the Construction Division: Vol 108, no 4. Journal of the Construction Division. Retrieved July 18, 2022, from https://ascelibrary.org/doi/abs/10.1061/JCCEAZ.0001063 Tobias, M. (2022). How to Mitigate Inflation Effects in Construction Projects. Nearby Engineers. Retrieved from https://www.ny-engineers.com/blog/how-to-mitigate-inflation-effects-inconstruction-projects Trading Economics (2022). Philippine Inflation https://tradingeconomics.com/philippines/inflation-cpi 8 Rate. Retrieved from
