How to Calculate Cost Escalation

ilkercelik/iStock/Getty Images

When your company undertakes long-term projects, you have to think about cost escalation. Over time, material and labor expenses escalate increase with inflation and other causes. If a project runs for a year or two, material and labor costs at the end may not match those reflected in your bid. It's important to factor cost escalation into your estimates, and to explain it to customers.

TL;DR (Too Long; Didn't Read)

Using indexes of cost inflation for your industry in your region, find out the average annual cost growth in recent years. Use that to project inflation's effect on your costs over the life of the contract. If you have a three-year project and cost escalation historically runs 3%, factor in three 3% increases.

The Causes of Cost Escalation

While you can find an inflation calculator online, it won't really work as an escalation calculator. In any given industry, factors unique to that field and to that part of the country will skew cost escalation so that it's different from general inflation.

Take the construction industry as an example. If inflation goes up 3% a year, a construction project will cost 6% more to complete two years from now. Other factors besides inflation will also escalate costs, though:

  • Construction all over the world uses the same materials, creating competition for construction materials. If, say, China doubles its need for steel girders, American construction's going to feel the pinch.

  • Skilled workers are in short supply in some areas of the country, which pushes the price of labor up.

  • If residential construction or major business projects are booming in your region, that can lead to cost escalation even if inflation in the general economy is negligible.

  • Suppliers may go out of business. They sometimes lay off workers or cut output to stay afloat. Either way, there's less material so demand intensifies.

  • Rebuilding after a natural disaster can suck up construction materials. Workers may migrate to the recovery area to make more money.

  • Changes to regulations or construction codes may require a higher project cost. 

With so many factors, you can't just rely on a "future cost of living" calculator to predict escalation.

Calculate Cost Escalation

Rather than use a future cost of living calculator or a general measure of inflation such as the consumer price index, you need cost escalation figures specific to your industry. In the construction industry, for example, historical indexes of price increases are your best source of data.

  • Input-based indices track the price changes for labor and materials. 

  • Output-based indices measure changes in bid prices, factoring in market conditions, business volume and contractors margins.

  • Some clients, particularly in government, may have their own index or measures for cost escalation. 

Suppose, for example, that you're working on a major highway construction project expected to run for four years. The cost for the project at today's prices is $11.6 million, but index research shows an average 4% increase in road project costs. You factor a 4% annual cost increase into the cost estimates you use to set your bid.

The Cost Escalation Clause

An escalation clause in a contract allows you to raise billing above your original bid price to reflect increases in product costs such as fuel, steel or asphalt. This allows you to keep your initial bid low, and to avoid losing money if costs spike up way beyond the historical average. This may take some negotiation as customers are often uncomfortable about terms that don't give them a guaranteed price.

Talking To Customers

No matter what your industry, some of your clients may not grasp that cost escalation is an ongoing issue. They look at what they paid for a project 30 years ago compared to what you're bidding and assume you're overcharging. Rather than bidding what the customer thinks it should cost, it's probably safer to explain why costs have risen.

References

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com

Photo Credits

  • ilkercelik/iStock/Getty Images