Cost escalation can have a serious impact on a company’s competitiveness and profitability. Cost escalation during a new product development project, for example, can impact the successful launch of the product. Cost escalation in the supply chain for an existing product forces a manufacturer to either raise prices and lose competitive advantage or reduce the profit margin to maintain price levels. Cost escalation can result from internal factors such as lower productivity or rising labor costs, or external factors such as rising costs of raw materials, components, transport or regulatory compliance.
Poor cost management is an underlying cause of cost escalation. Cost estimates based on incomplete or inaccurate information may lead to cost escalation during a project or production run. Companies also risk cost escalation if they do not monitor costs continuously to ensure that they remain in line with original estimates. Failure to include cost escalation clauses in a contract with a supplier leaves a company vulnerable to unforeseen cost increases during the period of a contract.
A change in the cost of raw materials is one of the main reasons for cost escalation. Raw material costs can rise because of shortage of supplies, excessive demand or a lack of alternatives. A raw material such as coal or natural gas may be in short supply because of production or extraction problems. Natural disasters or climate changes can create supply shortages of materials such as food or timber. Rising demand from growing economies such as China affects the cost of materials such as metals. Some scarce raw materials, such as precious metals, may have no effective substitutes or alternative suppliers.
Labor costs have a significant impact on manufacturing costs, particularly in companies where the production process is labor intensive. A rise in wages or employee benefits, additional training costs or an increase in the size of the workforce can lead to cost escalation. Falling productivity also creates cost escalation. Although labor costs remain constant, lower productivity reduces output per employee, leading to an overall increase in production costs.
Compliance with industry regulations can lead to cost escalation. In manufacturing, for example, compliance with health and safety regulations increases labor costs, while compliance with consumer legislation may require changes in product design or quality control, increasing manufacturing costs.
Changes in the supply chain can have an adverse effect on costs. If a company has to source its raw materials or components from another country, the additional cost of transport and import duties will escalate costs. Rising labor or production costs in the supply chain will also affect the cost of the finished product.