What makes up construction cost?
The Cost of Construction is on the minds of contractors, real estate developers, and construction lenders alike. Many careers in construction have construction cost as a major focus on their jobs. For example, project managers hire or have a cost estimating professional on their team to measure and help manage the expected cost of the construction project. For many owners and developers, the accuracy of the cost estimation reports is vital for assessing a project’s financial risk and how well their investment will perform in the long run.
Construction cost is only part of the total cost for developing properties. Land acquisition, planning, feasibility studies, and getting through the entitlement process make up a sizable portion of the total development cost. But construction is often the critical last major capital investment before the property owners and managers begin reaping the asset’s utility and/or return on investment. Whether the developer hit or missed their construction cost target will ultimately impact the real estate pro forma. Before construction starts, cost estimating professionals are called upon to verify that their targets are feasible and reflect reality.
Accurately forecasting future costs of construction is not easy, however by learning the principles and forces that comprise construction cost, anyone with basic research skills can get a rough grasp on construction cost trends and plan accordingly.
Fundamental Factors Of Construction Cost
While there are many models in the industry & academic space, at the most abstract level there are three major components to construction cost:
- Overhead & Profit (O&P)
This isn’t the only way that people categorize the factors of construction cost. Most often cost estimating professionals break down the total cost of a project into these three elements: Direct Cost, Indirect Cost, and Markup. The relationship between the two models is Labor & Materials components are considered direct costs, overhead is indirect and profit fits in the markup category.
The two models for breaking down construction cost serve different purposes. The latter is used by cost estimators and project managers since it fits their needs to manage the budget. The first model outlined in this article is useful for performing cost factor analysis – understanding the trends and economic forces affecting construction cost.
The reason why Labor-Materials-O&P breakdown works better in cost factor analysis is that each component is affected by distinctly different market forces or behaves differently depending on where we are in the market cycle. The following is a summary of what factors influence each component in construction cost.
Construction Labor Cost Factors
Construction labor includes all the man-hours that are worked on the construction project, from supervision by the project owner to subcontractor apprentice.
From a bird’s eye view, labor costs in construction are driven by three major factors:
- Local Labor Demand & Supply
- Labor Force’s Cost of Living
Out of the three factors, productivity is the one that project managers have the most control over. This includes matching the right skilled workforce with the work, creating an effective project schedule, and overseeing the day-to-day craftsmanship. Many construction management associations develop and publish techniques aimed at managing productivity, including handling Absenteeism & Overtime, worker morale, and how to plan concurrent operations on the job site.
When productivity is mishandled, it often leads to construction delays which can quickly balloon the cost of the construction project. Usually, delay claims will follow as stakeholders try to recover that cost.
Local Labor Demand & Supply
With rare exceptions, most construction today depends on the labor force located in the area of the building project. Those who have taken a microeconomics class can probably recall how demand-supply curves work. In short, the construction laborer’s wages will go up or down depending on how much work there currently is and how much competition contractors and subcontractors face.
For construction labor supply, there isn’t one labor pool – there are a wide variety of contractor trades and professions, some of which only work on certain types of projects (usually called a construction sector or market segments). Some professions have trade unions depending on where the project is located, which also influences the cost. Cost estimators usually have a good handle on which contractor trades can work on a proposed construction project and data on the local trade labor rates.
When a market gets “hot,” in some cases the labor supply can be outstripped by demand – like what is happening in some states like California – the project owner may have to solicit contractors from neighboring areas to perform work. Of course, they will end up paying a premium for the extra commute.
Labor Force Cost Of Living
The cost of living is closely tied to the demand-supply of labor since it acts as a natural “floor” to the laborer’s wages.
In order for the construction industry to be sustainable, the people working in the project’s area have to make enough to cover their cost of living. If their pay is unsustainable, they will move elsewhere or leave the industry for a higher paying job (if they can). Inflation is the diver in the cost of living and any rise in housing, food, or gas costs creates upward pressure on labor rates in collective bargaining agreements.
Factors Affecting Material Cost In Construction
Construction material cost is the component most exposed to the international marketplace, although not every product crosses a border. This means in order to effectively forecast material cost, both local and global markets for different items have to be looked at. Another impactor is the local building code requirements, which can greatly impact the materials specified for construction. Experienced construction cost estimators will often have data sources on hand to see not only what the materials cost is today, but what it will likely trend in the future.
In the past decades, the cost of raw materials, finished materials, or manufactured systems or components are more and more affected by the international markets. The value of the dollar, the commodity market, and the worldwide market for raw construction materials are major factors affecting the cost. And in recent years, tariffs have become a driver on increasing construction cost.
Not every material going into the project comes from the global marketplace. While steel can come from China and lumber from Canada or Washington, it’s much more cost-effective to have heavy raw materials like concrete aggregate come from the local quarry. Local producers of heavier unprocessed construction materials have a competitive advantage due to transportation costs. The caveat is some regions can have material markets that are economically inefficient (ie: low competition) and be very susceptible to supply shocks.
The project’s design team (architects & engineers) work diligently to fit the owner’s vision to comply with the local jurisdiction’s building code. The code has progressed over the past century to make buildings safer for occupants. The code requirements, when they do change, usually impacts the material cost of construction.
For example, in California, the recent updates to Title 24 Section 6 & CalGreen have increased performance requirements for new building construction in order to achieve greater energy efficiencies. The changes have driven architects and contractors to design and build more complex and higher performing building envelopes, HVAC, and electrical systems. The result is more components and higher quality materials need to be purchased, installed, and inspected (which also affects Labor cost).
How Overhead And Profit Impact Construction Cost
The third major factor that influences construction cost is Overhead and Profit (O&P). Much like how individuals have a cost of living, companies in the construction industry have overhead that they need to cover to stay open: office rent, contractor’s insurance, and employee wages & costs. When a design firm, contractor, or construction consultant bids on a project, they also include a profit margin, so their business can grow.
Overhead and Profit is unique to the other two components in that it is firmly rooted in the competition level and economic health of the local market. When a market is trending up or down, O&P acts as an accelerator in construction cost changes. Unexperienced cost estimators often miss how strongly O&P would impact construction cost when labor and/or material cost trends strengthen or change direction.
In an upward market, many contractors find themselves with plentiful work; they add employees to cover more jobs and might move to a larger space to accommodate them, adding more overhead. If they have a healthy pipeline of current and future jobs, they can add a greater profit percentage to their upcoming bids since lost assignments wouldn’t put the future of the company in danger.
Conversely in a downward market, the competition becomes much stiffer and companies “go lean” and reduce their profit margins, overhead, and, if they have to, lay off employees to try to stay in business.
Staying On Top Of The Factors That Influence Construction Cost
With a good grasp of understanding the elements of construction cost, you can effectively perform some basic cost factor analysis. Of course, the insights of an experienced construction cost estimating consultant can help you dive deeper and develop strategies to manage and deal with construction cost escalations. VERTEX brings to the table both experts in real estate economics and cost estimating.