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I Forge Iron

Some thoughts on what to do when material prices are spiking

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For those who aren't following the markets, it might come as a surprise to learn that some material prices are rising at an alarming rate.  Common commodities that have barely any price changes for years at a time, are currently doubling and tripling in as many months.  PVC pricing is through the roof.  This has triggered a lot of panic-buying which has made materials scarce, which only compounds the problem.

Contracts are typically written based on the assumption that materials pricing will be "locked in" upon signing.  Indeed there are lots of risk-averse companies that will place a material order for everything they need immediately.  Other firms will make strategic purchases when markets appear low, so as to maximize their profitability.

Sadly, the bulk of contractors tend to hold off on buying materials until they're actually needed, hoping that the market shifts will even everything out sufficiently to make the books balance.  Some of these contractors will not be granted any additional funds to cover the price hikes, which is going to hurt.  

I'd like to address this challenge from two perspectives, what to do about ongoing work, and what to do about securing work in the future.

Starting with ongoing work, it's obviously critical to take stock of your situation.  Nothing less than honesty will do here.  If you've got a problem, define how big a problem that is.  Take the opportunity here to learn from your mistakes by accurately defining what the mistake was.  Keep in mind that some contracts will require quality assurance processes/bureaucracy before the contractor is given approval to place an order.  This means that you may have been under contract according to the terms of your bid, but not actually permitted to place a material order until such time as the market increases took effect.  One lesson that should leap out here, is that it's good policy to do a material pricing check at every contractual inflection point.  Let's say your proposal was good for 30 days.  If the client calls to accept the project on day 31, check the material pricing before you accept.  Now, let's say you get a "notice to proceed" letter because the client needs time to process the contract stuff.  Do a material pricing check.  If things are trending upwards, you might find yourself in an untenable position before your contract is ready.  Communicating early and often will give everyone the best opportunity to make smart moves.

Along that same line, it's significant to note that market volatility can work in both directions.  If the project will run for a long time, there may be a case to be made for a "wait and see" approach.  Material prices often decline just after the seasonal rushes.  One of the most common logic mistakes I see in this business is when entrepreneurs consider the price hike on a project against the contract value for that project.  This leads them to overlooking some significant facts.

For simplicity's sake, let's say that material is half the project cost, and labor is the other half.  Now I wrote cost, not contract value, because we haven't added for overhead or profit yet.  Keeping things simple, let's say overhead equals 10% of cost, and profit equals 5% of cost plus overhead.

OK, now for the first of many things that people routinely screw up.  Working from 100% of  contract value, what percent is left when you remove the overhead and profit?  See, a lot of people would respond with 85% because 100% - 10% -5% equals 85%.  That's wrong.  Starting from 100, we must back out profit.  100/1.05 = 95.24, now we back out overhead 95.24/1.1 = 86.58%.  Divide that in two and it's now obvious that material is worth 43.29% of your contract value.

Lots o' math there.  What's my point?  Let's say your contract is for $100K, and material prices for that job have spiked by $10K.  Many knuckleheads will focus on the job getting 10% more expensive.  They're not wrong, they're just looking at it as though they're not the one actually doing the job. 

Keeping all my percentages from the original example, we know that material was worth 43.29% of the contract, which means the material budget went from $43,290 to $53,290.  That's a 23.1% material price hike.  This difference in perception is important because the scope of work didn't change.  Comparing the change against the contract total spreads the material price difference across material, labor, overhead, and profit.    That conceals the real truth of what's going on.

Now let's say you're in a situation where nobody will help to cover that difference.  Where does that money come from?  See material, labor, and overhead are all costs attributed to the job which hasn't changed.  You're still going to have to pay for all of that.  The only thing left is profit.  Now let's consider profit in the bigger picture.  

Revenue is the sum total of all the sales for a year.  At 5% profit, there's a 21 to 1 ratio between revenue and profit assuming everything goes to plan.  Let's say you have to pay that $10K out of your profit.  At a 21  to 1 ratio, you'll need to complete $210K worth of revenue to earn that back.

Staying with the simple theme, let's say that most of your work is at that $100K contract level.  Getting stuck paying for that $10K material price hike is equal to all profit from two+ jobs.  

Circling back, can you see why "the price went up 10% over contract value on this job" sounds very different from "this 23.1% material price hike will cost us all of the profit on this job, all the profit on the next job, and 10% of the profit on the one after that, assuming there will be any work to pursue, now that prices have spiked."

Moving onto securing future work, we can build on the lessons regarding ongoing work, to make better decisions in pursuit of securing new prospects.  Right off the bat, anyone who was left "holding the bag" on material price increases is likely to be in bad financial shape.  "Make it up on the next one" bidding tactics don't work unless the market is booming for whatever you sell.  Competitive markets encountering price hikes will typically lead to a decline in demand.  

This often means that there will be less work to go around, with an ever increasing number of competitors operating on the brink of survival.  Desperation is a poor posture against the lowest common denominators operating in readily accessible markets.  The key to survival, is to find quiet market sectors where your business is viable.  This is easier said than done.  But bear in mind that you've got more time to find a solution before you've made a mistake, than after.  Many firms would be better off by "hibernating" than to do business at a loss.  Where that's not possible, adapt to what is going on.  Honesty is huge here.  I've been in plenty of situations where the only paying work I could find was with dullards and scoundrels.  Demanding cash up front, and putting everything on the record, kept us solvent while we made our way through difficult times.  Dishonesty is a huge warning sign that is best heeded.  Most contractors don't go under because of a job they lost, they go under because of a job they won.  

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