Understanding
and Managing
Cost Escalation
XL Group
Insurance
North America
Construction
1Introduction
Introduction1
Seven Issues that
Boost Contractors’ Costs 2
Seven Ways Contractors
Can Manage Cost Escalation
Risk
3
Five Insurance Considerations
for Managing Cost Escalation
5
Conclusion6
1
Understanding
and Managing
Cost Escalation
Cheri Hanes, CRIS, LEED AP BD+C
Construction Risk Engineer
XL Group
Daniel Tolman
Vice President
North America Construction Practice
Willis Group
It should be no surprise to anyone reading
this paper that containing project costs
is an essential means of maintaining
contractor profitability. What may come
as a surprise, however, are the elements
that can directly (and indirectly) influence
cost escalation: industry factors, risk
management and insurance coverage.
We will examine each in detail to help
contractors develop a clearer picture of
cost escalation, its impact on their projects
and how to keep it under control.
2
Seven Issues that
Boost Contractors’ Costs
Many contractors, desperate for work during the economic
downturn, have bid on projects with (or agreed to work for)
thin or no margin to maintain ongoing operations. This
compounds the already significant concern of cost escalation
by reducing the “cushion” available to deal with any issues
that arise during a project. To manage cost escalation, it is
important to identify and stay attuned to the issues that
result in added, unwanted expenses. Here are seven of the
most prevalent:
1. General inflation
This refers to the overall increase or decrease of all goods
and services in the economy over a given time. For the most
part, builders are aware of general inflation as an escalation
risk, building it in to pricing using historical data and forward
looking trends. Unfortunately, simply accounting for
general inflation may not address the immediate concern.
The construction industry has its own specific inputs, the
prices for which may not be consistent with overall prices
across all industries. Additionally, a radical change – outside
anticipated variation – of the cost of a single input can have a
significant impact.
2. Global market forces
The world is getting smaller every day, and nowhere is this
truer than in construction. Buildings are constructed of the
same materials all over the globe, and those materials are
manufactured and fabricated from the same supply chains
for all their many uses. Increased demand on the other side of
the world, whether due to a localized boom in construction,
a natural disaster, or supply chain disruptions, can affect
contractors wherever they operate. The global nature of the
industry affects pricing, sourcing, availability and material
costs. Furthermore, the complexities of regulations and trade
laws (both in the US and other countries) can cause additional
impacts. Projects of a global nature (like ports), can and do
cause ripple effects. And as the world becomes more and
more interconnected through technology and logistics, these
rippling effects from far away projects will only become more
and more pronounced.
3. Skilled labor shortages / labor supply
In some markets, this issue is not on the radar yet. In others,
it’s a major concern. Work in the oil and gas industry has
drawn many potential workers away from other sectors and
markets where the oil-shale industry is hot – and must be
contended with – the current 2015 dip in petroleum prices
notwithstanding. The resurgence of residential construction
(particularly multi-family construction) has drawn off many
craftsmen who previously worked in the commercial field.
The expansion of the Panama Canal is having far reaching
effects due to preparatory construction in various ports
across the country; the demand for workers on these
projects is significant. Additionally, many experienced
tradesmen left the construction field during the downturn
and do not appear to be returning. Employment numbers
indicate the war for talent will continue to escalate.
Though recent reports show a sharp dip in construction
unemployment, the increases in construction employment
numbers are not as high as would be expected. This
indicates that many workers have left the construction field
entirely – whether through retirement, or a career change.
As construction spending continues to escalate, this will
become an even more important factor, as productivity
gains – though positive - have reached what appear to be
maximum levels.
4. Increased demand / many or large
projects in a region
The increased demand created by the existence of many
or very large projects in a region can cause shortages of
manpower, capacity and materials. It can also mean that
subcontractors have more choices with regard to the builders
with whom they choose to work. This increased demand on
subcontractors’ capacity puts them in a position to make a
better profit on newer work. And if a job was bid with a lower
margin, it may suffer from being a lower priority. Hence,
many contractors may end up with a subcontractor’s “B”
or “C” team. Also, the more time contractors must spend
supervising any team on a project means less time for
something else, which further impacts the productivity
concerns expressed above.
3
Seven Ways
Contractors
Can Manage
Cost Escalation Risk
5. Material/fabrication supply
Builders and subcontractors were not the only ones who had
particular challenges caused by the recession. Suppliers felt
the pain as well. Many had to lay off workers. Some struggled
– and failed – to survive. Like many contractors, suppliers and
fabricators reduced their own output capacity to cut costs.
Now, with the current resurgence in construction volume,
combined with the reduced number suppliers in the market
as a result of failures, the demand is in excess of capacity
in some cases. This, as a result of demand exceeding
supply, leads to inevitable price increases; that’s just Econ
101. It also means that if the supplier fails or cannot meet
requirements, the contractor will have fewer choices for
replacement, and may see premium prices charged by any
replacement supplier.
6. Natural disasters
Weather events of the magnitude of Superstorm Sandy
or winter 2013-14 polar vortex-related weather can be a
strong driver of cost escalation. This happens as labor floods
in to take advantage of the “hot market” – leaving a lack of
manpower in their home markets, and as particular supplies
(e.g. plywood) are exhausted in preparation for and in
response to the events. As mentioned above, the effects of
a storm or other disaster in one location have a greater than
ever potential to impact projects many miles away. Natural
disasters may also delay either the completion or start of a
project, which increases the potential for cost escalation by
drawing out the overall schedule.
7. Safety, code, or project certification
requirements during estimation
Changes in building codes, internal or external changes
in safety requirements and a project’s certification
requirements can lead to cost escalation. Any lack of
awareness in these areas can cause unanticipated costs,
which will likely land squarely on the contractor’s balance
sheet.
So, having considered 7 factors that can
boost contractors’ costs, the question
presents itself: Do you want to play dodge
ball? Or chess?
Any contractor that has experienced the sting of an
unexpected cost impact, knows what this means. Ouch.
Should a contractor strategically address these issues one
by one, or just wait for an impact and take the hit? Managing
these factors becomes very important if a surprise hit is
to be avoided. Successful builders generally prefer a highly
proactive stance. It is also crucial that everyone on the
contractor’s team understands his or her respective roles
and responsibilities when addressing these risks. Estimating
and project teams have the ability to influence exposure to
escalation significantly. Are they aware of this?
The general feeling around cost escalation tends to be that
these risks are passed down to subcontractors contractually.
However, if a subcontractor has an issue due to cost
escalation, it is very likely that this will become a contractor’s
problem. It could be felt as a subcontractor default or result
in schedule challenges due to manpower shortfalls, change
order disputes, issues obtaining specified materials, etc.
Therefore, it’s in everyone’s best interest to take an active
role in managing cost escalation.
There are many tactics in use to minimize or mitigate cost
escalation, and, as all construction companies are unique,
what works for one will not necessarily work for all. We’ll look
at seven of those tactics.
1. Contract
While it is typical to include an escalation clause in
subcontracts, it is also worth asking if consideration should
be made to including concessions around escalation in the
owner contract. Is it possible to build in some contingency for
exceptional escalations, should they occur? Some builders
do, and an “eyes open” approach to escalation from all parties
tends to make for a more collaborative project environment.
When all parties share the risk, all parties have an incentive to
mitigate and manage it.
4
Seven Ways Contractors Can Manage
Cost Escalation Risk
2. Prequalification
5. Materials pre-purchase
Financial Prequalification is critical to insulating a
contractor’s projects from the impact of cost escalation on
subcontractors. If subcontractors bear this risk – and most
do – financial analysis becomes an even more important
component of a contractor’s overall prequalification effort,
allowing greater assurance that they can absorb the cost of
an anomaly in escalation on a given project. Subcontractors’
financial ratios, especially days of cash, pipeline and their WIP
can speak volumes about their enterprise risk.
As builders, contractors have options related to the
procurement of materials when they know that a cost
escalation is likely. They may wish to have a strategic
delivery/product storage plan to enable them to have
materials purchased and staged in advance of need.
Strategies could include contractors purchasing materials
in advance or paying subcontractors to do so via payment
for stored materials. Both approaches have potential issues
to work through, including cost, contract, insurance and a
variety of logistical implications.
3. Schedule
Construction schedules also present potential to reduce
escalation exposure, or mitigate its impact. To reduce the
time exposure on a project, and therefore potential exposure
to many forces contributing to escalation, contractors may
wish to examine their schedule for potential acceleration, or
stacking of activities, which can reduce its overall duration
and therefore exposure to potential escalation. Alternatively,
any time saved by compressing the schedule may increase
the float to allow for situations that would potentially lead to
cost escalation. Again, time is money, and if contractors have
some time, they may be able to save some money.
4. Purchasing
To remove some exposure to escalation, it often makes
sense to put effort into identifying key scopes with potential
for it, collaborate to get the related design documents early,
and expedite buying these scopes to lock in pricing as early
as possible. Focused, phased bidding may allow a contractor
to do this in a more aggressive fashion, as the need to wait
for complete documents for all scopes prior to bidding
and procurement is eliminated for the most concerning
scopes. There is some downside here, as later scopes are
perhaps more exposed to escalation if the time frame
for procurement overall stretches out, so a contractor’s
approach should be very strategic in nature, if used. And while
it is comforting and familiar to use subs that a contractor
“knows so well,” it is more advantageous to cultivate a deep
field of bidders, prequalify them responsibly, spread the work
around, and build strong working relationships with the larger
community of subcontractors.
6. Value engineering and alternates
Subcontractors are on the front line, and they have the
advantage of proximity to suppliers and labor to see
emerging escalation potential, whether from manpower
issues or supply chain dynamics. Working with subs to
identify value engineering and alternates when a specified
material or practice exposes a construction firm to potential
escalation can be invaluable.
7. Awareness of safety, code, or project
certification requirements during
estimating
It is necessary to consider both internal and external
factors to ensure that this type of escalation is controlled.
If a construction company’s protocols (internal) or OSHA
requirements (external) for safety measures change, it’s
important for estimating to consider those additional
costs as well and/or ensure that subcontractors have them
included in their bids. Compliance with these requirements
can cause internal or external cost escalation, and must be
accounted for in some way. Furthermore, any changes a
contractor might be forced to make to the project after the
subcontracts are signed will certainly cost money above and
beyond what is budgeted and subcontracted.
5
Five Insurance Considerations for Managing
Cost Escalation
The most common form of escalation
familiar to Risk Managers is the rising cost
of insurance. Project-specific policies
typically give the benefit of fixing rates
through the duration of the project,
however they are often more expensive
and can carry additional limitations, like
a limited completed operations period.
Most contractors and subcontractors
will find their most favorable rates, terms
and conditions in their main insurance
programs. Since many projects will span
multiple policy periods, a renewal premium
increase can result in cost escalation.
This is primarily a concern on fixed price
contracts.
General Contractors and Construction Managers are
also susceptible to the increased cost necessary for a
subcontractor to meet minimum insurance requirements.
The most common example of this is requiring a
subcontractor to carry a higher limit of liability than they
currently purchase. Often a subcontractor will quote the
cost for a company-wide excess policy, as excess policies
are typically not adjustable. It is important to ensure that
any subcontractor bids include the cost of complying
with minimum insurance requirements of the contract. If
the contractor’s insurance requirements are included in
the bid documents, it may seem intuitive to require the
subcontractor to incur the additional cost at their own
expense, however when faced with the prospect of using a
significantly more expensive bidder, it rarely works out this
way.
1. Builders Risk
Builders Risk policies are designed to cover damage to the
construction project, and to a certain extent, the materials.
The final premium on these policies is subject to audit and
therefore may be impacted by material price escalation.
2. Ocean Cargo
Ocean Cargo policies are purchased to provide certain
coverage on materials while they are being transported
across the ocean. This is an important coverage to consider
when purchasing foreign material. Suppliers will often carry
their own policies, which may or may not be adequate,
regardless of responsibility. Reviewing any agreements to
see at what point responsibility for transported goods is
transferred is crucial.
3. General Liability / Workers Compensation
When considering General Liability and Workers
Compensation premiums, it should be noted that additional
wages and bonuses to attract skilled labor during shortage
may be subject to rating at audit. This risk is compounded
for those whose General Liability policies are rated based on
Contract Value (CV) instead of payroll. In this case, it is not
merely the additional labor costs that can impact the final
premium but additional materials costs as well.
4. Surety Bonds
Surety Bond premiums are adjustable at substantial
completion. This is of concern, not only on subcontractor
bonds, but on a bond provided to a project owner by the
General Contractor or Construction Manager. The bond
penalty amount is a concern as well. The bond penalty will
not provide for unanticipated costs. The Penalty is a fixed
amount, usually 100% of the contract amount. Escalation
costs may increase the potential loss in the event of a
default, as well as the premium, however the penal sum does
not increase.
5. Subcontractor Default Insurance
Cost Escalation should be considered during a
subcontractor’s prequalification. The “Single Project
Limit” assigned to a subcontractor by an SDI insured may
be exceeded by increasing costs. The assigned “Aggregate
Limit” for all projects may be eroded. It is important
to consider if the construction firm has a method of
communicating escalation to the team that manages these
prequalification limits.
Conclusion
The changes, good and bad, in the domestic and global
economies have had far-reaching ripple effects throughout
the construction industry and one of the most concerning
impacts is the risk of Cost Escalation. These unanticipated
changes in costs can occur at any point, pre-construction,
course of construction and post-construction. The costs
of labor, materials and even overhead can all be affected.
The one area where no one wants to see a reduction is
profit. Regardless of a construction firm’s risk management
philosophy, awareness and pro-activity are the best weapons
to ensure a profitable project and therefore a profitable
company.
About the authors
Cheri Hanes is a Construction Risk Engineer with XL Group’s
North America Construction team. She holds both LEED AP and
CRIS certifications.
Daniel Tolman is a Vice President at the Willis North America
Construction Practice and one of the National Market Experts
of their Default Insurance Group (DIG).
Contact:
Cheri Hanes
Construction Risk Engineer
Mobile +1 214 558 3137
cheri.hanes@xlgroup.com
14643 Dallas Parkway
Dallas, Texas 75254
xlgroup.com/insurance
XL Group is the global brand used by XL Group plc’s insurance subsidiaries. In the US, the XL Group
plc insurance companies are: Greenwich Insurance Company, Indian Harbor Insurance Company,
XL Insurance America, Inc., XL Insurance Company of New York, Inc., and XL Specialty Insurance
Company. Not all of the insurers do business in all juridiscictions, nor is coverage available in all
jurisdictions. Information and ratings (if listed) accurate as of January, 2015.
5039_01/2015
The information contained herein is intended for informational purposes only. Insurance coverage in
any particular case will depend upon the type of policy in effect, the terms, conditions and exclusions
in any such policy, and the facts of each unique situation. No representation is made that any specific
insurance coverage would apply in the circumstances outlined herein. Please refer to the individual
policy forms for specific coverage details.