How to stop price increases eroding your profit margin

Have you noticed that material prices are going through the roof lately?

It’s honestly hard to send out a fixed rate contract at the moment and know your material prices are covered. Rates are changing so quickly that it’s easy to eat all that precious profit margin on these price hikes.

In this blog, Professional Estimator, Anna Turner looks at ways we can mitigate our risk around price hikes and outlines the advantages/disadvantages of cost-plus contracts.

How to manage price changes in ‘normal’ times.

I usually check the prices of all resources in January and July (materials, plant and subcontractor prices). I check at these times of the year because if a supplier is going to put their prices up, they usually do it at the start of the Financial or Calendar year. This regular routine usually gives me confidence that I am pricing as accurately as I can. It goes without saying (but I will, to be clear) that I ALWAYS get a quote for bespoke or fluctuating products (e.g. steel fabrication, expensive stone, concrete) for each individual project I price.

But these are not normal times!

Prices are increasing on a weekly basis across the board. The only way to know your prices are accurate is to source them for every project, which is crazy time consuming. Even then, the client takes 2 months to accept the quote (if we’re lucky) and another 2 months before the job starts (we’re all busy, get in line!), so the prices are a minimum of 4 months out of date before we start. The price hikes in that time could cost you your whole net profit margin!

So, what are our options?

COST-PLUS CONTRACTS

A simple way to mitigate the costs is to pass them onto the client. With cost-plus contracts you agree to get paid a % above the actual cost of the resources (materials, plant, subcontractor), usually between 15-25%.

Cost-plus does mitigate the risk, but it also demolishes the reward. An article just out from the US show that fixed price contracts earn on average 28% MORE profit margin than cost-plus contracts, and the gap is greater the smaller the size of the contract. You will not suffer a loss on cost-plus contracts, but you will struggle to do much more than break even too!

If you decide to mitigate the risk of increasing resource costs by using a cost-plus contract, please remember:

• The percentage you add onto the cost of purchasing resources needs to cover Overheads
• Purchasing materials costs money (loans/ overdraft etc), you need to recoup that cost.
• You need to get paid to manage the project (through the profit margin or by charging your time directly to the client)
• A 20% markup on resources DOES NOT equate to a 20% profit margin, it equals a gross profit margin of 16.67%. Remember, you still need to cover overheads with that 16.67%.

FIXED PRICE CONTRACTS

Given that fixed priced contracts, on average, are much more profitable than cost-plus contracts, let’s look at ways to mitigate our risk with a fixed price contract. Here are some of the things you can do:

• Make it clear to the client that prices are changing rapidly at the moment, so it is in the client’s best interest to sign the contract asap.
• It is standard practice to make a contract valid for 30 days, stick to it! If/when the client doesn’t sign after 30 days take the opportunity to update the costs in the contract.
• Pre-empt the price increase by adding 1-5% onto the contract sum to cover the cost increases.
• Single out resources that are particularly volatile to price changes, like steel, in your terms and conditions. Make it clear to the client that any changes in these prices will be passed onto them.
• Try to secure long term (6-12 months) fixed prices from suppliers where possible. This is possible if you guarantee to purchase large quantities over the course of that time from the supplier.

Between 2017-2020 we only saw moderate price increases, and for the last 18 months the world has held its breath. I am not sure if the pandemic has caused these recent price increases, or if they were in the post anyway, or if it’s a combination of the two. Either way, prices are increasing rapidly across the board, and we need to implement ways to cover these costs. It’s impossible to predict what prices will do moving forward and if you try and price for the future you run the risk of not being competitive. Instead, the best option is to mitigate the risk by bringing it to the attention of the client and passing the increase on.

Anna Turner
Gauge PM