Construction projects: accounting for inflation

13 February 2018

Joe Martin of BCIS offers a clearer view of accounting for inflation in construction projects

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Recently, projects such as Crossrail, the Battersea Power Station redevelopment and the Hinkley Point C nuclear plant have all been in the news because of increased costs. Reports have tended to be negative; however, it is important to understand the causes of such inflation, many of which may have already been accounted for as part of the planned delivery and contracting process.

Likely causes of cost increases that may occur during delivery must be considered and correctly accounted from the a project’s outset, so a sufficient budget can be set. As Crossrail has noted, its Tier-One contracts – those that are directly employed by the client – were not awarded as fixed-price jobs and the contract value at award did not reflect the risks retained by Crossrail Limited, for which an allowance had been allocated.

Risks come in many forms, but RICS new rules of measurement: Order of cost estimating and cost planning for capital building works, 2nd edition, identifies and defines the following:

• inflation risk
• design development risk
• construction risk
• employer change risk
• employer’s other risk.

Inflation risk also comes in various forms of its own, including changes in the tendering context and in the cost of resources, so it is important to identify who will carry the risks of inflation and how they will be accounted for.

Identifying inflation risks

Inflation will affect the out-turn price in 2 ways.

• There will be inflation in market prices until contracts are agreed with the constructor.
• There will also be inflation in the constructor’s costs during the delivery period. Long contracts may contain market-price risk for major subcontracts as well, which are to be placed at various stages in the delivery period.

The different movement in tender prices, as measured by the BCIS Tender Price Index (TPI), and underlying resource cost, measured by the BCIS General Building Cost Index, is shown in Figure 1. This also demonstrates the BCIS Market Conditions Factor, which rises when prices are rising faster or falling slower than costs, and falls when costs are rising faster or falling slower than prices.

Figure 1: General example showing tender prices, input costs and market conditions

Inflation in market prices will reflect the underlying cost of resources, but will also be affected by tendering conditions and changes in the market, such as increased prices associated with demand, the availability of particular resources, and the effect of major projects on specialist works, trades, work-package and labour-only subcontractors.

These demand and supply pressures can be local, national and international, occurring, for example, when other countries buy major quantities of raw materials. Demand and supply can also be affected by how the UK is viewed by markets; for instance, the fall in the value of sterling has affected the cost of imported materials, while the supply and cost of EU labour will be influenced by how attractive it is to work here rather than in other countries.

It is important to identify who will carry the risks of inflation and how these will be accounted, although ultimately, the client will pay for the increased costs or the contractor’s assessment of them. The client will always bear the risk of inflation, too, up to the point where the contracts are agreed; they may or may not take this risk during the delivery period, but will always pay either for the inflation or for the constructor assuming the risk.

On projects with a fixed-price contract, the inflation risk should allow for the movement in tender prices to the point where the contract is agreed and for increases in costs that the constructor will bear during the delivery period, which may also include some market risk.

On projects that have a single fluctuating-price contract, the client also takes the risk of underlying inflation in resource costs during the delivery period. The most common way to reimburse this cost is by the use of indices.

On projects with multiple contracts let over a protracted period, the inflation risk should consider the delivery programme, and the risk of any changes to the content of the individual contracts and the timing of their award. This will shift the balance of the market-price and resource-cost inflation impacts.

On large, long-term projects, the forecast of the programme of the contract awards, the overall profile of expenditure and the expenditure profile in each contract are often as important as the forecasts of inflation.

Accounting for inflation

Contracts with inflation adjustment clauses differ in the way that they account for this, but most commonly they apply indices, agree a weighting of resources at the outset and calculate a single index for each valuation. This has a distorting effect on longer contracts, though, where the resources used at the beginning differ from those used towards the end.

Figure 2 shows the differential movement in the cost of ready-mixed concrete and steelwork over the period from January 2014. It shows that the effect of steel prices on the cost of the project would differ considerably depending on when it was incurred, but using a standard set of weightings might under- or over-recompense the contractor for inflation.

Figure 2: Structural steel and ready-mixed concrete (based on Price Adjustment Formulae Indices, Series 4 – Civil Engineering and Related Specialist Engineering)

BCIS produces the Price Adjustment Formulae Indices (PAFIs) that were devised by the industry for use with inflation adjustment clauses, but a variety of other indices are occasionally used.

The use of a single generic index may not represent the inflation experienced on a project; modelling an index based on the resources and expenditure profile of a particular project will therefore reduce the risk of inflation for both the contractor and the client.

BCIS has published 6 golden rules forchoosing an index:

1. be clear about what you want to measure and how you want to apply it
2. choose an index measuring the costs that most closely matches the characteristics defined in point 1
3. if you are using the index to link costs in a contract or agreement, be clear that it meets your needs, particularly in respect of:
   • the frequency of publication – monthly, quarterly, annual
   • your updating and revisions policy
4. understand the inputs to the index and the calculation methodology
5. read the notes and definitions
6. never choose an index because of its past performance.

The PAFIs have been designed to allow for price adjustment on contracts such as NEC, under its Option X1 Price adjustment for inflation; BCIS and Crossrail produced a case study on how PAFIs were applied on the latter’s contracts.

Separate PAFI series are available for:

• building
• civil engineering
• highways maintenance
• specialist engineering.

Forecasting inflation

Assessing the risk of inflation on a project requires forecasts of:

• the contracting profile, to identify when contracts will be let
• how inflation in the delivery period will be dealt with on each contract
• expenditure profile on each contract
• market prices reflecting the different resources for each contract
• inflation in costs for the resources to
• used during each contract.

Identifying when different forecasts should be applied will change the inflation risk. An assessment of the impact of delaying or accelerating the award of contracts should form part of the risk analysis.

BCIS publishes 5-year forecasts for tender prices, market conditions and resource costs for both building and civil engineering. In addition to these, BCIS produces bespoke forecasts for clients and contractors on individual projects, sectors and locations.

An inflation forecast that reflects the resources and the programme of a particular project will provide a better understanding of the inflationary risk than a generic forecast.

Joe Martin is Lead Consultant at BCIS

Further information

• Related competencies include Commercial management of construction, Design economics and cost planning, Procurement and tendering, Project financial control and reporting, Risk management
• This feature is taken from the RICS Construction journal (February/March 2018)
• Related categories: Feasibility and planning, Procurement, Risk management, Cost management