As profit margins are thin and lead times for construction projects are long, contractors have to closely follow the price movements of building materials and use hedging policies to minimise losses. There are several strategies that companies can follow. All of them have their pros and cons en most large building companies make use of a combination of the strategies:
Use a price escalation clause: This makes it possible for contractors to pass on procurement price increases to the customer. This is mainly done in larger infrastructure projects and non-residential ones where the customer is a local or civil government or a (large) company. Price clauses in the residential market where customers are often private consumers are more difficult to achieve and therefore not common.
Directly procure building materials: Contractors can directly procure the building materials at the moment the building project deal is closed. This secures them the calculated procurement price of the moment of closing the deal. They can do this in two ways: Firstly, they can agree on the price with a supplier and ensure delivery of the materials at the moment needed in the building process. However, it must be said that suppliers are sometimes reluctant to such long term contracts as the price risk is handed over to them. The second is that contractors can buy the building materials directly, let them be delivered directly and store them until needed. This is also a remedy against impending material shortages. Yet, this results in (high) storage costs and a decrease in working capital.
Commodity futures: If those two strategies are not possible, a hedge with a commodity future is an option. However, this also has its difficulties. Price futures exist for some raw materials but not for the semi-finished products that contractors often use. In addition, the duration of the future and the amount has to match. Finding “the perfect hedge” with commodity futures could therefore be challenging. Futures are also complicated financial products which have to be constantly monitored. Therefore not many building companies use futures to hedge their procurement price risks.
Do nothing: The last option is to “take it as it is”. This has the advantage that it gives the firm a competitive advantage as it takes over the price risk of the client. However, it makes the profit volatile.