Inflation in the construction industry

[edit] What is inflation?

Inflation is the rate at which the price of goods and services rises, and as a result, the purchasing power of currency decreases. In order to maintain the stable functioning of the economy, the government aims to limit the rate of inflation and avoid deflation (negative inflation).

The inflation rate is reported as the annual percentage growth of a broad index of prices representative of the economy as a whole.

[edit] How is inflation measured for consumers?

In the UK, the predominant measure of inflation is the Consumer Price Index (CPI). This is the rate at which the prices of goods and services purchased by households rise or fall. The Consumer Price Index was first published in 1996 as the Harmonised Index of Consumer Prices.

The Consumer price index includes a wide variety of household spending across approximately 700 representative items.

The index must be representative and up-to-date and therefore the goods and services included are reviewed each year. The information used to determine the contents includes surveys of household spending, external market research and feedback from price collectors.

As more is spent on certain items than others, the components of the index are ‘weighted’ to reflect the importance of different items and the amount spent in different regions and in different types of shops.

Once the price information has been checked and processed, the price indicators are combined. The changes in the prices of services and goods are measured by undertaking a comparison of their levels in the preceding year. They are then weighted to produce an overall annual price change. The annual rate of inflation is the percentage change in the latest index, compared with the value recorded the year before.

Each month, the figures are published on the Office for National Statistics website.

There are a number of other measures of consumer price inflation including:

• CPIH. A relatively new measure of UK consumer price inflation that includes owner occupiers’ housing costs.
• Retail Prices Index (RPI). A measure of UK inflation that has historically been used for a wide range of purposes, such as the indexation of pensions and rents and index-linked gilts.
• RPIJ. A variant of RPI which is calculated using a geometric (Jevons) formulae, adopted following the National Statistician's decision that the RPI does not meet international standards.

[edit] How is inflation measured in the construction industry?

The Department for Business, Energy & Industrial Strategy publish construction price and cost indices which are used for estimating, cost checking and fee negotiations on public sector construction projects.

Private sector organisations such as the Building Cost Information Service (BCIS) also provide cost and price information to the construction industry to help estimate the likely cost of construction works.

For more information see: Construction price and cost indices.

[edit] How do construction contracts allow for inflation?

Inflation can be a serious issue on construction contracts, as they they can last for several years, and so prices may change significantly between the contract sum being agreed and the works being completed.

On smaller projects, the contractor will generally be considered to have taken into account inflation when calculating their price (a firm price).

However, on the larger projects, the contractor may be asked to tender based on current prices (prices at an agreed base date) and then the a fluctuations clause within the contract makes provisions for the contractor to be reimbursed for price changes to specified items over the duration of the project. This is referred to as a fluctuating price.

Contracts may offer a number for alternatives for how fluctuations are calculated and what is included. JCT option C for example is based on the Price Adjustment Formula Indices (PAFI), and are maintained by BCIS, and the specification of a base month against which changes are to be calcuated.

See Fluctuations for more information.

Other provisions in construction contracts that might be used to account for inflation include:

• A provisional sum is an allowance (or best guess), usually estimated by a cost consultant, that is inserted into tender documents for a specific element of the works that is not yet defined in enough detail for tenderers to accurately price. Provisional sums are replaced by valuations of the work actually done as the project progresses.This is not intended to be a provision for inflation, but there will be an inflationary element if prices have increased since the contract was agreed.
• A cost reimbursable contract (sometimes called a cost plus contract) is one in which the contractor is reimbursed the actual costs they incur in carrying out the works, plus an additional fee.
• Bespoke contracts or clauses to deal with specific circumstances. This is generally not recommended as the clauses will not have been tested in the courts and so the exact meaning may be open to interpretation.
• Performance bonds, parent company guarantees and vesting certificates, making provisions for the possibility of suppliers becoming insolvent.

[edit] NRM definitions of inflation

The New Rules of Measurement (NRM) are published by the Royal Institute of Chartered Surveyors (RICS). They provide a standard set of measurement rules for estimating, cost planning, procurement and whole-life costing for construction projects. According to NRM1: Order of cost estimating and cost planning for capital building work, the term ‘inflation’ refers to:

…an upward movement in the average level of prices and or costs (i.e. the opposite of deflation). It is included as an allowance in the order of cost estimate or cost plan for fluctuations in the basic prices of labour, plant and equipment and materials.

NRM1 also offers definitions for tender inflation:

'...an allowance included in the order of cost estimate or cost plan for fluctuations in the basic prices of labour, plant and equipment, and materials during the period from the estimate base date to the date of tender return.'

And construction inflation:

'...an allowance included in the order of cost estimate or cost plan for fluctuations in the basic prices of labour, plant and equipment, and materials during the period from the date of tender return to the mid-point of the construction period.'

[edit] Related articles on Designing Buildings

• Base date.
• Budget.
• Cash flow estimate.
• CLC plans to ease impact of construction inflation.
• Construction inflation.
• Construction price and cost indices.
• Contract conditions.
• Contract sum.
• Escalation.
• Fluctuations.
• Procurement route.
• Tender.
• Tender inflation.