March  12, 1999



Bulletin # 24: The Subcontractor vs. The World

Every subcontractor has experienced the time and other pressures in bidding new work. The general contractor or construction manager may have waited until the last minute to solicit bids. The plans may be sloppy or incomplete. The bid work may include a design-build component without clear performance specifications. The proposed form of contract may be outrageously one-sided. The successful subcontractor deals constantly with such job-specific challenges and, hopefully, still completes most projects with a profit.

On the other hand, with the evolution of an international economy, the subcontractor must also confront many factors having nothing to do with a particular job or the market in which the subcontractor does business. Events across the world can impact everything from interest rates, to the availability of financing, to the cost and availability of insurance. However, one area where the international impact can be most dramatic relates to materials costs.

ZZZ Sheet Metal was in the process of bidding an airport expansion project that would take up two years to complete. The plans and specifications were quite detailed and the subcontractor had been given sufficient time to put its bid together. The project would involve an immense quantity of sheet metal and the subcontractor obtained current pricing from its primary supplier. Having assessed all the necessary elements of the work, ZZZ Sheet Metal submitted its bid in the required “stipulated sum” format. Its subcontract price was locked in, except to the extent that the general contractor approved change orders. ZZZ management felt confident that the bid was solid and allowed for a reasonable profit margin.

Meanwhile, an international trade dispute was simmering over the alleged dumping of steel into the U.S. market by foreign manufacturers. The imported steel had contributed to a stable, and even decreasing, price for sheet metal over the prior year. Several weeks after ZZZ started the new project, the trade dispute evolved into an all-out trade war. The U.S. Government set quantity restrictions on imports of steel from certain major producers and imposed high tariffs on steel imports from those countries. With the resulting reduction in steel imports and a continuing high level of demand in the U.S., domestic steel producers immediately and significantly raised their prices. The ripple effect ran quickly through the markets all the way to the sheet metal supplier with which ZZZ was doing business.

At almost the same time that the import restrictions were imposed, ZZZ submitted its first purchase order for sheet metal. Hearing rumors of possible price increases, ZZZ management pre-ordered half of the sheet metal that it would need for the entire two-year project. The supplier called back to inform the subcontractor that it had been compelled to raise its prices by 30 percent because of the “spike” in the price of steel. When ZZZ’s president complained to the supplier, he was told that the prices being quoted were as good or better than what would be obtainable from other suppliers and that ZZZ could cancel its order and purchase elsewhere if it wished to do so. The subcontractor called other suppliers and confirmed that pricing had jumped dramatically across the board. ZZZ management found itself with little choice but to buy the sheet metal at the much higher price even though the increased cost would wipe out much of its profit on the job. In fact, the subcontractor decided to order all of the sheet metal that it would need on the project to protect itself against further price increases, even though it would have to carry much of the extra sheet metal in inventory for almost two years (further eroding its profit).

In a final attempt to preserve some profit on the job, ZZZ management contacted the general contractor requesting a change order to offset the impact of the sheet metal price increase. The general contractor informed ZZZ that it was subject to a contract with the owner that would not permit the general contractor to pass through the increased materials cost and that the general contractor was not prepared to absorb the impact of that cost increase. ZZZ was told that it had assumed the risk of materials price increases in submitting its fixed price bid and would have to live with that bid. The representative of the general contractor asked rhetorically whether ZZZ management would have offered a decrease in its subcontract price if steel prices had gone down in the middle of the job. Despite all of its efforts, the subcontractor had gotten nowhere and was stuck with the full impact of the price increase. As a result, two years of effort contributed little, if any, profit to ZZZ.

Materials cost fluctuations have always been a fact of life in the construction industry. However, the world-wide ripple effect is a more recent phenomenon. An increase or decrease in steel production in Brazil, Korea, or China can affect prices in Indiana. A building boom or economic collapse in Malaysia and Indonesia can impact materials costs in New York or Los Angeles. When governments and trade disputes are involved, the effects can be even more sudden and unpredictable. While the subcontractor can try to stay alert to factors that might impact its business, it cannot buck the world-wide trends.

However, there are some things that a subcontractor might do to protect itself against unexpected and significant changes in materials costs. These include:

1. Negotiating “cost plus” contracts whenever possible. This approach permits the subcontractor to pass through increases in its materials costs. However, this contract structure is typically a tough sell with general contractors. 2. If an overall “cost plus” approach is not acceptable to the general contractor, the subcontractor may try to negotiate a price adjustment mechanism targeted only toward key material costs (i.e. sheet metal). The subcontractor would still retain all of the risk as to increases in labor cost and other materials costs. It is to be anticipated that the general contractor may still want to impose some limit on the overall price increase that could be passed through, but this approach would certainly be preferable for the subcontractor compared to a “fixed price” approach. 3. The subcontractor could attempt to establish an allowance for the particular category of materials, with the general contractor realizing the savings if the actual costs are lower and paying the additional costs if the price rises above the allowance amount. 4. The subcontractor could attempt to lock in its pricing with its materials supplier before it submits its bid. Whether or not the supplier will agree to a committed price would likely be a function of the strength of the relationship between the subcontractor and supplier, the size of the order, the length of time covered by the order, and the supplier’s ability to lock in its cost or hedge against price increases.

Being a construction subcontractor has always been one of the most challenging and difficult undertakings in business. The evolution of a “world economy” has added to that challenge. The successful subcontractor now has to keep its eyes open not only to what is occurring on the job site, but also to what is going on across the world.

 

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