If you own a business within the construction industry and are looking to understand and manage inflation better, you’ve come to the right place. This guide will walk you through inflation, its effect on construction businesses, and how you can soften its impact. During the past 6 months, 60.7% of U.S. businesses in the construction industry have reported a noticeable increase in the price of goods and services. What Is Inflation and Why Is High Inflation Bad? Inflation refers to an average increase in prices for goods and services over a period of time within an economy. In addition to higher prices, it lowers the value of the currency used in that economy. For example, let’s say you purchased a hammer three years ago for $10, but when you go back into the hardware store now, the exact same hammer costs $12. The hammer itself has not changed or developed new features or benefits, but it now costs 20% more. Inflation and the dollar’s devaluation are the reasons you now pay $2 more for the same hammer. Inflation typically has a negative connotation because we see it as the reason we pay more for gas at the pump or why house prices have risen so much. But inflation in and of itself isn’t necessarily good or bad—it’s simply a natural process within the lifecycle of an economy. In fact, inflation is often considered a sign of a healthy economy. Prices tend to rise to offset the increase in demand for goods and services. Demand for goods and services often rises because of financial surplus or more disposable income. Now, that disposable income can come from a thriving economy or it can be the result of government aid like the recent COVID-19 stimulus to consumers and businesses. In other words, context matters when determining whether inflation is a good or bad sign—but, in either case, it’s normal. The Federal Reserve (Fed) says the acceptable (normal) rate of annual inflation should be 1.5% to 2%. This level of inflation allows the US economy to adapt incrementally and helps avoid the need for drastic changes in business or consumer behavior. Unfortunately, inflation has exceeded this 2% rate every month since March 2021. For 13 consecutive months, the US inflation rate has been higher than 2.6% and an average of 5.725%. In fact, in February 2022 the inflation rate was 7.9%, which was the highest it’s been in 40 years. Chart: US Inflation Calculator The rise and fall of inflation within an economy is normal and healthy, but when there are longstanding periods of elevated inflation, it can create problems. For construction businesses, inflation can lead to cash flow management issues, lower sales volume, decreased profit margins, longer production timelines, and other stresses within your operations. That’s why it’s important to not just understand what inflation is, but to know how it affects your business and how you can manage it. Let’s take a deeper dive into inflation and its role within the construction industry. How Does Inflation Affect the Construction Industry? How much has costs rise? Here's a sample of construction-industry price changes over the 12 months ending in January 2022: Energy: 25.6% Electricity: 9.0% Other items: 12.3% New vehicles: 12.4% Gasoline: 38% Construction materials: 28.7% Softwood lumber: 85% Concrete contractors: 9.9% Truck transportation of freight: 18.3% Construction machinery and equipment: 11.4% Gypsum: 23% Construction businesses often work on many different projects—each having several moving parts and people involved. From supply chain partners providing materials and equipment to skilled labor executing the projects, it’s a process that requires careful consideration and precise execution. As you know, construction projects can encounter many hurdles and roadblocks from their conception to completion. Inflation is just one of the many wrenches that can be thrown into the plan, but it’s an important one because it doesn’t just impact your business, it affects your employees and clients. Here’s how inflation can affect the people within and related to your construction business. Clients (negative): If you choose to offset inflation by increasing your prices or extending your project timelines, you are passing on the burden of inflation to your clients. Sales team (positive): If you have a sales team that earns a commission per project, they may benefit from inflation only if you raise the prices of projects and if you don’t see a drop-off in clients. Hourly/Salaried skilled labor (negative): Your labor is likely to be affected negatively by inflation because their pay is not rising at the same rate as other costs like food and shelter. This may even lead to your workers pushing for higher wages and better working conditions. Supply Chain Partners (negative): Your supply chain partners are also feeling the effects of inflation and are likely passing that on to you. In 2021, construction material inflation spiked to 17.5% higher than in 2020. By increasing their costs, they are potentially straining the long-term relationship with you. Construction business owners (negative): Unless you are willing to adapt, inflation can put your construction business under duress because of higher expenses and lower margins. How Does Inflation Impact Your Construction Business’s Operations? Inflation, directly and indirectly, impacts your construction business and can cause supply chain and production disruptions in addition to lower profit margins. Elevated material costs are the most obvious and often critical impact of inflation on your construction business. For example, the price of lumber is roughly 3x what it was prior to the pandemic. The National Association of Home Builders (NAHB) estimates that this results in an average increase of $18,600 in the price of a newly constructed home. Lumber is a critical part of the home-building process and the construction industry as a whole. From structural framing, flooring, interior walls, finishes, furniture, cabinets, doors, fences, and more—lumber is a material most construction companies need to have available. As the price of lumber rises, so does the cost of projects that involve lumber, chipping away at your profit margin. A recent study from CoConstruct found that the average residential construction company maintained a profit margin of around 14.9% per project in 2021. So, on a $100,000 construction project—you would earn roughly $14,900 profit in 2021. If inflation were to raise your total expenses even 2% from 2021 to 2022, your profit would go from $14,900 to $12,900, which is a decrease of 13.42% in your total profit for that project. Beyond the direct costs, inflation also affects supply chain partners, project timelines, and construction demand, and it can even lead to pressures from workers to increase pay to offset their higher cost of living. For example, construction companies rely on skilled labor to complete projects in a given timeframe as outlined in the contract, and the more intricate the project, the more important the experience of the worker. This gives your workers a little more leverage than other industries like retail or restaurants, because they know you need someone with experience, and they may also know you’re on a tight turnaround to complete the project on time. As general inflation increases their cost of living, they may push back to you to raise their pay. Because many construction projects are bid-based with pricing determined beforehand, an increase in pay for workers during the project can decrease your profit. This hurdle can obviously affect your profitability and delivery timelines, but more importantly, it can strain the relationship with your most important resource: your workers. So, inflation’s impact on your business goes far beyond just increased material costs. Ways to Mitigate Inflation’s Effect On Your Construction Business A lot of construction business owners are hands-on and are accustomed to controlling all aspects of their business (and construction projects). Unfortunately, you can’t control inflation. Inflation is part of the economy and a process influenced by factors out of your control. While you cannot prevent inflation from affecting your construction business, you can take steps to lessen its impact. Here’s how to handle inflation within your construction business. Control What You Can Control As we mentioned above, you can’t control inflation. But you can control other areas within your business that may have a significant impact on your bottom line and that can influence the severity of inflation in your construction business. For example, construction companies usually work off bids and project proposals. These project bids look at the scope of the construction project against factors like timeline, material costs, labor, etc. Taking all these into account, you provide the client with a proposal that includes the maximum cost to complete the project. Depending on the length of the project, scope changes, and other factors like inflation, the actual costs to complete the construction project can be more or less than what you originally expected—which influences your profit. While you may not be able to control most of those factors, you can control a few key areas within a typical construction project. Track and control your costs better: It’s estimated that roughly 40% of construction companies don’t understand or track their expenses effectively. If you’re not monitoring and controlling your costs, you’re going to struggle to run your business profitably and you’re going to have a hard time accurately bidding out your proposals. Don’t bid away your margin: Speaking of bids, you can control the price you put in front of your clients for a project. If you’re trying to compete on price alone, you will shrink your margins and put yourself in difficult situations if inflation or other costly issues arise. Bring non-monetary value to the table: Instead of focusing on the lowest bid, communicate value beyond the price. Lean into your experience, your quality, or even your speed. Price may be important, but clients also value these other factors, too. Purchase materials ahead of time: If you want to mitigate inflation’s effect on your projects, purchase all the materials needed at the start. Even if you can’t predict the price of lumber tomorrow, you know what it is today—and you can purchase what you expect to use upfront if you have the cash or a line of credit. Provide flexibility in the contract: You may be able to add a cost escalation clause to your contract to provide the option to share expenses if they rise uncontrollably due to inflation or other unforeseen circumstances. Manage Inflation with Consistent Cash Flow Consistent cash flow is one of the best ways to mitigate inflation’s impact on your operations. Cash flow is a term that defines how much liquid cash you have coming in and out of your business. If you are bringing in more money than you are spending for a period of time, you are considered to be cash-flow positive. If you are spending more than you are bringing in, you’re cash-flow negative. A consistent cash flow gives you more stability, which is always important—but especially during uncertain times like we’re currently facing. Unfortunately, cash flow management is and has always been a huge pitfall for most construction companies. For example, most construction projects require a down payment of 10% to 25% paid to the contractor beforehand, but the remaining is paid upon completion and sometimes even on net terms beyond the delivery date. This creates a negative cash flow scenario because you are paying for materials, labor, equipment, and other expenses directly needed to complete that project before you recognize 75% to 90% of the cash. This means you’re bearing most of the financial risk and using your working capital (cash) to do so—often leaving your business cash flow negative until the client pays their contract in full. If you don’t have cash on hand, it can make it difficult to manage payroll or pay other necessary expenses needed to run your business. Fortunately, you can use small business borrowing solutions like a business line of credit and a merchant cash advance to maintain consistent cash flow when your business needs it. A business line of credit, for example, can provide you with a financial safety net. You can qualify for up to $500,000 and pull as much (or little) as needed from that amount. The best part is that you’re only charged for what you borrow and not the full amount. So, if you need $50,000 to cover expenses for a $75,000 project, you can pull from your line of credit and repay it and the interest after the client pays you. This and other small business loan options allow you to continue running your construction company as usual. Financing can help if you’re struggling with inflation, late-paying clients, or the many cash flow hurdles of running a construction business. If you’re considering loan options for your construction company, try looking through Lendio’s network of vetted lenders, which offer several different, flexible financing options for construction businesses. You Have the Blueprint for Success Running any business successfully is difficult and throwing high-inflation into the mix doesn’t help. But there are solutions that help you keep your cash flow consistent and prepare for almost anything. Interested in financing? Find out what your small business is eligible for with Lendio’s 15-minute, online application. Data sources: https://www.ers.usda.gov/data-products/food-price-outlook/summary-findings/ https://fred.stlouisfed.org/categories/33583 https://www.bls.gov/ppi/ https://www.nbcdfw.com/news/local/construction-costs-hit-highest-spike-in-50-years/2891677/ https://www.agc.org/sites/default/files/users/user21902/PPI%20Tables%202022_01.pdf https://www.cnbc.com/2022/03/10/rising-airfares-are-giving-people-spring-break-sticker-shock.html https://www.macrotrends.net/countries/USA/united-states/inflation-rate-cpi Disclaimer: The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.