How can construction data reduce the risk of insolvency? 

Last month the news of the rise in the collapse of construction firms was of little surprise to an industry that has had to bear the brunt of exceptionally high inflation and costly financing, which have added pressure to already tight profit margins.

However, the figures were still shocking. According to the most recent figures from the Insolvency Service, construction firms accounted for 18.2% of all insolvencies in England and Wales in December 2023, with 364 registered construction businesses becoming insolvent.

This brings the total number of construction firms that became insolvent in 2023 up to 4,378.

This is an increase of 5.1% on the 4,165 insolvencies recorded in the year to December 2022, and a 36.0% increase on the 3,218 in 2019. Scotland appears to be faring better with 201 insolvencies from January 2023 to January 2024 – a 2.4% decrease on the 206 insolvencies, reported in the previous year.  Overall, this is 1.2% of the total number of construction firms in the UK.

As previously discussed in ‘Why are contractors in the construction industry vulnerable to insolvencies’ construction firms operate on very tight profit margins that are often exacerbated by fixed price contracts. With double digit cost inflation in 2022 and 2023, even short projects that may have been commercially viable when tendered were under cost pressure when they came to be delivered.

Index linking some, or all, of the costs in a contract is one way of mitigating the risk of price volatility, as it introduces transparency in sharing the risk of inflation.

Improve cash-flow and attract more clients

From interest rates to inflation, and market demand, construction costs are inevitably affected by the overall economic landscape.  When the economy is strong, the construction sector tends to grow, as people invest in new projects and infrastructure. 

Recently, UK interest rates have been rising and have hit their highest point since the 2008 financial crisis. While high interest rates have dampened people’s appetite to borrow and rocked the housing market, they’ve also had a significantly negative influence on construction financing. This is because a rise in borrowing costs will result in increases to the total cost of a building project. Throughout 2023, EY Parthenon cited rising interest rates in their profit warnings ‘the main driver of warnings’, with ‘credit-related warnings hitting their highest level since 2008.’

It’s become harder than ever to ensure a steady flow of cash. This will be exacerbated if the contractor is under-recovering their costs due to inflation. This is especially true on long-term projects but is still relevant to short-term projects in periods of crisis. 

Using construction indices that are specific to a project can help to improve cost certainty. They will help to mitigate the risk of any shortfall that can occur due to projects affected by inflation. Clients should be reassured that, by sharing the risk of inflation, all parties are protected from the dire consequences which will result if any contractor in the supply chain fails.

Services, such as BCIS’ Price Adjustment Formulae Indices (PAFI) streamline the payment process with easy access to cost data, which also help to ensure more efficient working and cost savings.

Mitigate the impact of unpredictable events

From the pandemic to the war in Ukraine and the unfolding crisis in the Middle East and the Red Sea, there are a host of geo-political events that can cause supply chain disruptions and trade disputes, which all impact demand. These can result in extreme fluctuations in materials prices, which we’ve seen reflected in the cost of raw materials in recent years.

It’s not always possible to predict the next impending geo-political disaster that could send materials and energy prices soaring or constrain labour supply. But it’s possible to mitigate risk with the help of reliable construction cost data that links back to, and reflects, your specific project requirements. The recent fall in cost inflation may have tempted contractors to accept the risk of inflation. But the current geopolitical situation has inherent risks to construction inflation, even in the short term. It’s not in anyone’s interest if firms go bust and are unable to complete the contract, as the client will bear the additional cost.

Our six golden index rules cover how important it is to choose an index that measures the costs that most closely resemble what you need to measure and how you want to apply it.

For example, there are indices for different sectors of the industry – building, civil engineering, and maintenance – as well as individual trades and particular materials.

In recent years, steelwork has been singled out for adjustment due to its volatility.

It’s also important to use an index that can be applied monthly, quarterly or annually.

PAFI track cost inflation for more than 200 buildings, civil engineering, specialist engineering and highways maintenance activities – some are all in and some are specified by resource type.

Use Price Adjustment Formulae Indices, rather than a general measure of inflation

From concrete to brickwork and structural steelwork, construction costs will move differently to general inflation – in recent years, these variations have been particularly dramatic, due to market reaction to global events. Construction indices make it possible to adjust for inflation on materials that are specific to your project.  

Although using a generic index such as Consumer Price Index (CPI) may seem like a tempting shortcut, the cost of everyday essentials found in a shopping bag bear no comparison to the cost of building materials. To reiterate this point, here’s an example – if you entered a 24-month contract between February 2021 to February 2023, there were months in that period when the difference between CPI and Civil Engineering Cost index were over 11%, while the difference between CPI and General Building Cost Index were 7%.

Conclusion

Unfortunately, it’s not always possible to predict or control the impact that seismic, geopolitical events can have on the economy or the subsequent shockwaves they can send through the industry. Therefore, it’s likely that businesses will continue to be vulnerable to fluctuating prices across materials, energy and labour. However, construction data can help to protect contractors, and therefore clients, against these risks.