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Lump sum contracts: has it gone on too long?

With the construction industry facing steep inflation, Conrad Egbert takes a look at the crippling financial situation, and what is causing it.

 Inflating overheads: Operational costs that are causing the inflation include a lack of labour accommodation
Inflating overheads: Operational costs that are causing the inflation include a lack of labour accommodation

Last week, Construction Week reported on escalating material costs, including the price of steel, which has gone up by almost 15% within the space of a week.

 

As good as the idea is for workers, paying salaries through banks is costing us a lot in bank charges

Raw materials make up about 30% of construction costs and if this wasn't alarming enough, it is not the only contributing factor to the inflationary bottom line.

Overhead operating costs are as much of a problem.

More worrying is the fact that these costs are affecting contract bids, which in turn could lead to a slowdown in the ongoing construction boom.

Apart from the obvious raw material costs, operational costs that are causing the inflation include a lack of labour accommodation and rent increases, the new mandatory health insurance policy costs, higher visa costs, a rise in costs for hiring equipment and additional bank charges due to a new labour policy that stipulates all employees, including construction labourers, will now have to be paid through bank transfers.

But what does this mean for contractors and what are the implications?

Freddy Lama, managing director and owner of Nova Electromechanical Contracting Company in Abu Dhabi has blamed it on the unavailability of office and residential space.

"Abu Dhabi in particular is facing a pressing shortage of office and residential space, which have caused rents to double over the past year. This in turn has caused our overhead costs to inflate. For example, let's say our dry costs [actual costs of labour and material] is US $1 million. Then our bid would be about $1.5 million. But due to inflation, our bid will now rise to $1.75 million and will probably go up even further if the inflation doesn't stop.

Lama added that the minimum increase on a contract bid is now 20%, which will result in more pressure on the client.

He also said that the cost of housing for workers has doubled over the past year.

"We used to pay about $68 (AED250) per head for semi-skilled workers. It has now gone up to $136. As for skilled workers, it was about $82 and is now $190. Engineers and foremen would cost us $109 in the past, whereas now they cost about $272.

Backing Lama's argument, Ani Ray, country director of Simplex Infrastructure, said that labour accommodation cost was one of the biggest issues, but additional expenses such as bank salary costs and the new visa costs were also compounding the situation.

"About six years ago labour accommodation was costing me around $218 per room per month for six people," said Ray.

"Now it is $1089 - $1306 for the same, which is almost six times the amount.
 

"Also, as good as the idea is for the workers, paying salaries through banks is costing us a lot in bank charges. It costs us $33 per worker to maintain a bank account for a year. Now try multiplying that by all the workers we have. It's a lot of money.

Ray added: "Previously, the authorities required companies to place a security deposit of $136,140 for hiring workers in bulk, whereas now it costs $816 per worker. So, for example, if a company hires 1000 employees, they're set back by $816,000, which can't be touched or invested.

The cost of hiring equipment has also gone up by 20% in the last year.

And health insurance has been another financial burden, according to Ray and Lama. "Insurance costs are hurting us as well, as it didn't exist before," said Lama.

"Now if a worker's salary is less than $1,089 per month, insurance will cost us $182 per year; while if the salary is $1,089 and above it will cost us about $408 per head per year. For management level staff, it's costing about $4,080 per month, which covers almost nothing.

Lama added that rising costs are hampering plans for the company's expansion. The company is unable to hire more workers because it is not financially viable until prices stabilise and profit margins return to normal.

Contractors could be faced with more costs with the expected introduction of a minimum wage and VAT.

"Contractors would have to bear VAT since the Subsequent Legislation clause in normal FIDIC contracts is overruled by a special condition in contracts here," added Ray.

Bishoy Azmy, CEO of contractor ASGC, said that the cost burdens could be handled in two ways.

"One way is by factoring inflation into our bids, as contracts here don't usually have escalation clauses; it's always a fixed lump sum price," he said.

"But this is more of a temporary and selfish way of handling it. In fact, this will only keep the inflation buoyant and maybe even inflate it further.

"The better and longer lasting way to deal with this would be an ‘open book' strategy with the client. Overhead costs could be fixed through a ‘cost plus' contract. This way the client agrees to take on any escalation in prices and the contractor won't submit an inflated bid.

"If material prices go up, the client will pay the difference. This is the best way forward. The way contracts here are drawn up needs to change.

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