The impact of inflation and industrial strife on the construction industry in Australia

Engineering Costs and Production Economics, 5 (1981) 179-192 Elsevier Scientific Publishing Company, Amsterdam - Printed in The Netherlands

THE IMPACT OF INFLATION INDUSTRY IN AUSTRALIA*

AND INDUSTRIAL

179

STRIFE ON THE CONSTRUCTION

Francis J. Bromilow CSIRO Division of Building Research, Melbourne

(Australia)

(Received

17, 1980)

August

19, 1980; accepted

September

Abstract The impact of inflation and industrial strife in general and in the construction sector in particular in Australia during the period 196878 has been examined in quantitative as well as qualitative terms. The effects of inflation on time dependent costs of construction are severe in themselves, and they are exacerbated both by the abnormal extensions of time generally required for construction works to be completed and by the uncertainty of occupation resulting from industrial strife, which add to construction costs and to the costs of finance. Inflation of costs and of interest rates has inhibited a significant proportion of the population from ownership of dwellings. The effects of inflation, and abnormal extensions of time and uncertainty of occupation arising from industrial strife, have added approximately INTRODUCTION We are all familiar with the effects of inflation - goods cost more, wages go up, strains are generated for those operating on fixedprice contracts and those on fixed incomes, and modes of expenditures and savings change. We are also familiar with the effects of industrial strife - days without trains or petrol, ex*Basis of an address to the American Association Engineers, 10 December 1979, in Melbourne.

0167-188x/81/0000-0000/$02.50

o 1981

of Cost

Elsevier Scientific

$400 million on average to construction costs of major building projects each year over the 197 l-76 period. They have played a significant part in the collapse of the construction market and the increase in insolvencies in this sector; enterprises remaining have maintained or improved net operating surpluses on average, although whether this has flowed through to net profit is doubtful. Indexation of construction contracts has proved practicable and indeed of value to an industry with profit margins small in comparison with un-indexed risks. There is a school of economic thought that general indexation of many transactions in the community would be an economically useful aid to general inflation management, although whether this would lead to a reduction in the rate of inflation and what the long term consequences might be are hotly debated.

ports and imports held up, road transport stalled, building and construction works held up, and above all what appears to be a continuing upward push on wages which follow through to the inflation of prices. The aim of this paper is to indicate some of the effects inflation and industrial strife have had in Australia, particularly in the building and construction sector (this will be referred to as “construction” in conformity with the

Publishing

Company

180 Australian Standard Industry less otherwise indicated). THE EXTENT

Classification

un-

OF INFLATION

Consumer price index

The commonly accepted indication of inflation is the Consumer Price Index (CPI) which in Australia is measured by the Australian Bureau of Statistics (ABS) from the weighted average effects of a “basket” containing many individual items of personal expenditure rents, meat, etc. The way the CPI has moved since 1967 is shown in Fig. 1 [ 1] , using as an indicator of year-to-year changes the annual rate of change. This reveals that from a general level in the region of 2-3% p.a. it shot up after 1970 to a peak of 16% p.a. in 1975 and subsequently declined again to about 8% p.a. in 1978 and 1979. The content has changed a little over the years, but not enough to affect the broad picture. The 1970s have therefore been marked by exceptionally inflationary conditions (for Australia) and these conditions have been highly variable into the bargain. Australia is of course not unique in the experience.

I

1960 69

70

71

72

73

I

74 Year

I

1

I

I

I

75

76

77

78

79

Fig. 1. Rates of growth of building and other material prices, Melbourne. wholesale prices of materials used in building other o---c consumer price index. than house building; A---a

Wages

In Australia, these inflation patterns are highly correlated with wage increases. In Fig. 2 are shown the annual rates of growth of average weekly earnings (male units) for Victoria [ 21 and the on-site loaded building wage index for Melbourne [ 31. This is a specific series which is not available on a national basis but the Victorian trends in both average earnings and building wages are similar to those for Australia as a whole. The annual rate of growth of wages was relatively low in the late 1960s (6 to 7% p.a.). Then it increased further during 1970 and dramatically in the mid 1970s. It is worth noting that the on-site loaded average building wage increased at a far higher rate than average weekly earnings of the community as a whole. It reached a peak of 50% p.a., compared with 24% p.a. for average weekly earnings. The peak was reached a year earlier in building than in the community in general, indicating that at this time inflation in building wage rates played a part in generating the subsequent general inflation. Even so, over 1975-76, well into the current economic recession, building wage rates increased by 28% p.a. before the rate of increase declined to 4% p.a. in 1978-79. Since 1978 building

1968 69

70

71

72

73

74

75

Fig. 2. Rates of growth of labour costs. site-loaded building wage, Melbourne; o-----c average weekly earnings, Victoria.

76

a----h

77

78

79

181

wages have grown at a lower rate than the CPI - we have yet to see whether this is the result of lags in the system or a sign of a more permanent downward push on wages compared with inflation. A detailed analysis of the crossimpacts between industries has yet to be undertaken.

tion as measured by gross domestic product (GDP) and interest rates. The real rates of growth of GDP each year are shown in Fig. 3, using for this purpose values at constant 197475 prices. The devastating drop in 1975 and 1976 stands out clearly. Investment

Materials prices Wage increases generally flow on into the prices of materials, and the 1970s have been no exception. Price indices for materials used in building other than housebuilding are shown in Fig. 1 [4]. Materials used in housebuilding followed generally similar trends. It will be noted that during the 1970s the wholesale price of materials used in building escalated even more rapidly than the CPI, particularly in 1974 and 1976, but with a quicker fall-off in 1977. The maximum rate of growth in CPI, 16.3% p.a., was well exceeded (and probably affected) by the maximum of 20.1% p.a. in building materiahs the previous year. National product Not surprisingly, other aspects of the Australian economy have interacted. Two of particular importance are the volume of produc-

-15. 1968

1 69

1 70

1 71

I 72

I 73 Year

I 74

1 75

I 76

I 77

Also shown in Fig. 3, on the same basis, are the rates of growth in private and public gross fixed capital formation from year to year, including dwelling building and other construction. These reveal the collapse of capital investment firstly in 1973 when industry, particuIarly the construction sector, was in an excess demand situation, and again in the years since 1974. The latter period is marked by one extraordinary anomaly, namely the enormous surge (15% p.a.) in the public sector in 1974-75 (mainly in non-residential building and construction) which is in contrast to the like collapse (- 12%) in the private sector (mainly in dwelling construction). Gross fixed capital formation in the nonconstruction sectors also declined markedly in similar fashion. It is not always recognized that, under inrational conditions, production processes in which there are substantial investments in stocks and capital plant are vulnerable to the adequacy of provisions for depreciation and for replacement of plant. This is because stocks need to be financed, and so does plant itself, which in the longer term should be regarded as an input which is subject to inflation. Appropriate cost accounting methods have been under discussion in the business community for some years, and replacement accounting procedures are now being used to some extent. Fig. 3. Rates of growth of domestic product and fixed capital formation, Australia. +-+ gross fixed capital formation, public; C----X gross fiied capital formation, private; A---A gross domestic product.

182 In view of its significance, an example 1.51 follows to illustrate. A condensed set of accounts for an enterprise with modest fixed capital assets is set out for 1975 and 1976 in Table 1. It is assumed that inflation caused the cost of sales to increase by 20% between 1975 and 1976 and that contractual arrangements permitted sales prices and profits to be increased accordingly in an endeavour to retain the same position in real terms in 1976. The monetary and percent’ age changes which apparently show that the reported profit did go up as planned, however, are misleading. Firstly, a cash flow problem is implicit in the results because the increase in debtors and inventory by 20% amounts to $ 98,400, which is in excess of both the increase in profit (S 13,800) and the whole profit ($ 82,800). The deficit could be financed from the de-

TABLE I Condensed accounts

Sales

Cost of sales Profit Tax Profit after tax Debtors Creditors Inventory

1976 ($1000)

1977 ($1000)

1200 I080

1440 -I296

%

Interest rates

240 -216

21!

144 61.2 w-

24 10.2

20 20’

82.8

13.8

20

240 (108) -360

288 (129.6) --432

48 (21.6) 72

20 20 20

492

590.4

98.4

20

74.4

10.2

120 .z 69

Fixed assets Less depreciation

240 -

Capital employed

732

806.4

9.4%

10.3%

Profit~capitai employed

Increase ($1000)

preciation fund, but this means that capital is being eroded to provide annual book profits, and moreover thereby becomes subject to tax, and is bad practice from other points of view. Secondly, to maintain a situation where the fixed assets could be replaced, (assuming the replacement cost of similar plant also increased by 20% over the year) the sum of $48,000 would have to be provided. Thus the apparent $ 82,800 profit was in reality $ 38,800 loss if the enterprise aims to keep going on a long term basis. The higher the ~apitalisation of the enterprise the greater the probiem. Building contractors are notoriously low in capitalisation in general, but the larger enterprises, particularly those with plant and manufacturiilg subsidiaries, do have a significant degree of eapitalisation. So do civil engineering contractors. It seems likely that business failures have occurred over the past few years through inadequate provisions for replacement of capital items, and because the enterprise can go on for some time before the effects become catastrophic. No doubt more will fail in the future.

20

240 --(24)

Interest rates have shown marked movement over the decade since 1968. Two indicators have been used - one is the savings bank lending rate on first mortgages, the other the rates charged by finance companies, which are closer to rates which developers have had to pay. These are tabulated in Table 2. It is immediately apparent that the cost of money nearly doubled between 1968 and the peak, and moreover that it has not decreased much below its peak since then. (The record escalation of interest rates in the USA and UK in November 1979 suggests that in Australia they are more likely to go up than down in the immediate future at time of writing.) At first sight it might seem that an increase

183

TABLE

2

Interest

rates (% p.a.)

Year ending June

Savings bank on housing

1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968

8.75/ 9.50 8.75/10.00 9.25/10.50 9.25/10.50 9.25/10.00 7.25/ 8.00 6.251 7.00 6.251 7.00 6.251 7.00 6.251 7.00 5.50/ 6.25 5.00/ 5.75

loans

Finance company loans on housing

15 17 16 18 18 13 12.5 13 12 12 12

of 5% p.a. in interest rates should not be all that onerous - it could be thought that it would add a bit to costs, but should not have severe effects. Unfortunately this is not the case as far as effects on dwelling and other forms of construction are concerned, as we shall show. EMPLOYMENT As with other economic factors, the 1970s have been marked by extremes in employment levels. During the early 1970s the labour force responded as well as it could to the high demands for building, but neither it nor materials supply could cope with the volume of demand without strains. The effect was that the time requirements extended and productivity declined, with other effects described below. Then, when the collapse followed, the labour force also collapsed. Measures of these effects are revealed from statistics relating to the site work force in building excluding other construction [ 63 . Table 3 shows the on-site labour force over the years 1967-78. The rapid rise to 180,000 in 1974 is marked, as is the fall to 143,000 over the following 12 months, and the continuing decline since. There has been a striking long term

decline in the number of site workers per unit value of work done at constant prices, described in detail elsewhere [ 61, but the gross decline since 1974 is related more to the collapse of the building market revealed by the value of building work done at constant ( 1978) prices.

TABLE

3

Work done and persons Year

Persons working (X 103)

working

Work done

on building (X

$109 p.a.) (constant (1978) prices)

(current prices)

jobs Work done (constant prices) per person working (X $10”)

1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967

6.510 6.445 5.595 4.713 4.215 3.542 3.132 2.816 2.557 2.193 1.914 1.745

120.7 131.2 142.4 142.9 180.1 180.8 170.1 171.6 172.1 171.5 160.1 150.8

6.510 6.813 6.521 6.309 7.132 6.825 6.392 6.108 5.838 5.184 4.668 4.256

53.9 51.9 45.8 44.1 39.6 37.7 37.6 35.6 33.9 30.2 29.2 28.2

TABLE 4 Unfilled building 1966-78

vacancies and unemployment and construction occupations

data for skilled in Australia,

Year

Unfilled vacancies

Unemployment

Excess demand

1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978

1034 1055 1107 1156 908 879 1003 1719 1159 1181 706 549 457

1366 1427 1334 1052 1390 1386 1938 1029 994 7833 6792 8426 12807

-332 -372 -227 +104 -482 -507 -935 +690 +165 -6652 -5611 -7877 -12350

184 Concomitant with this fall in demand for employment there has been a rise in unemployment. Statistics compiled by the writer’s colleague Mr. G. Butler (Table 4) show both the positive excess demand for building and construction works in 1973 and 1974 and the enormous growth in unemployment after 1974, reaching over 12,000 in 1978.

INDUSTRIAL

STRIFE

Wages in turn are correlated with industrial strife which has been brought about, ostensibly at least, by efforts to secure these wage increases through pressure on employers and the Arbitration Commission, which has the statutory responsibihty to arbitrate industrial disputes in Australia. A measure of the extent of industrial strife is provided by figures for the numbers of working days lost through industrial disputes each year [ 7, 81. These figures probably severely understate the amount of disruption, because of secondary effects on the public affected by the particular dispute and because, as described later, techniques have been devised to disrupt work without much reduction in employment. In Fig. 4 is shown the numbers of working days recorded as being lost in the construction sector expressed as percentages of days lost in all industry. This ratio was particularly high during the early 197Os, with a peak in 197 1 of 36%. That these rates are not merely reflections of changes in the relative magnitudes can be ascertained by examining the total employed labour force engaged in the construction sector [ 7,8]. This has been done and Fig. 4 also shows that the proportion in this sector has been relatively invariant, in the region of 89%. Comparing these results with those for days lost, it appears that the contribution of the construction sector to industrial strife in Australia has been 2-3 times its proportionate share.

6Ot

01

f

1967

68

8 69

I

8

70

71

1

72

I

73

1

74

I

75

1

76

t

77

Year

Fig. 4. Construction industry, Australia. +-+ value of building work done p-a. (1978 prices) per site worker; o-o working days lost through industrial disputes in construction industry (% of all industry); A-----A construction industry work force (% of all industry).

In view of the high rates of inflation during the 1970s and the high rates of industrial strife (and probably high in comparison to other countries), it is worth exploring the extent to which profitability was affected and indeed whether these conditions led to a higher rate of insolvency. To these ends, statistics on bankruptcies and schemes of arrangement were extracted [9] as shown in Table 5. The results show that over all industries the numbers peaked in 1972 and again in 1978, with a minimum in 1974. The building and construction share of these, however, increased from 12- 16% prior to 1973 to 16-21% thereafter, with a peak in 1975. The pinch has certainly been felt in this regard during the 1970s What then was the effect on pro~tability of construction companies? The statistics on gross operating surplus of enterprises and others in the construction sector were extracted from the Australian National Accounts f 101 and compared with the amount of work done as measured by annual expenditure on gross fixed capital formation in that sector (Table 6). Rather to the writer’s surprise, the net operating surplus seems to have increased rather than decreased during the decade, with little evidence of the changes in profitability that

1

78

185 Australian economy as a whole it has decreased from 32% to 29% over the same period. Net operating surplus still requires deduction of tax and otherprovisions to arrive at net profit, whether net profits have increased in line with net operating surplus requires further investigation.

might have been expected from the surrounding economic circumstances. Likewise, when net operating surplus is compared with gross domestic product at factor cost, the ratio for the construction industry has increased from 22% to 29% over the period whereas for the

TABLE 5 Bankrupts, deceased debtors, and debtors who entered into deeds of assignment or arrangement, or compositions (Australia) Year

Bufding and construction

(ending June)

industry

All

(a)

(b)

Cc)

Cd)

(e)

(0

(c)/(O

Business

Non-business

Total

Business

Non-business

Total

(%)

1978 1977 I976

514 333 344

109 83 60

623 416 404

1975 1974 1973 1972 1971

410 265 339 n.a. n.a.

73 78 91 n.a. n.a.

1415 950 687 826 704 915 n.a. n.a.

3461 2452 2 177 2 332 1 964 2 660 3 036 3l.a.

18.0 17.0 18.6 20.7 17.5 16.2 12.3

1970 1969 1968

n.a. n.a. n.a.

n.a. n.a. n.a.

483 343 430 374 n.a. 339 356 400

2 046 1502 1490 1 506 1 260 168.5 n.a. n.a. n.a. n.a. n.a.

n.a. n.a. n.a.

2 542 2 550 2 580

13.3 14.0 15.5

TABLE 6 Construction Year (ending June)

statistics (X $106, current prices) Australia

Gross domestic at factor cost

product

ALI sectors

Construct.

All sectors

Construct.

Wages, salaries and suppl.

(a)

(b)

(c)

(d)

(e)

Net operating

surplus

Gross fixed capita1 formation

(D

Dwellings

Other building construct.

(d)/(h) (%)

(e)/(h) (%)

n.a. 16.2 14.6 13.8 13.4 13.9 12.9 12.5 12.9 12.5 12.4 12.5

n.a. 36.4 31.6 39.9 37.4 37.6 37.5 37.4 36.1 35.7 36.2 37.9

Total const. (h)

Q) 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967

n.a. 13 441 63 632 54 630 45 714 38 295 33 692 30 201 27 262 24 597 21 736 20 416

n.a. 6 003 5 333 4601 3 597 3 115 2 801 2 509 2 239 1 995 1 784 1 673

n.a. 21 138 17 405 14 522 13 978 12 042 10 090 9 031 8 620 7 932 6 6.58 6 572

n.a. 1 726 1391 1096 862 770 644 553 528 455 399 360

n.a. 4 114 3 804 3 386 2 628 2 250 2 066 1 867 1630 1462 1313 1 245

4 213 4 363 3 560 2 738 2 697 2 197 1861 1 644 1580 I 370 1 183 1 055

1547 6 937 6 569 5 155 4 334 3 788 3 653 3 350 2 931 2 723 2 449 2 231

11 760 11 300 10 129 8 493 7 031 5 985 5 514 4 994 4 511 4.093 3 632 3 286

186 The statistics on days lost etc. are not a good measure of the extent of results of industrial strife. The real impact would, if it could properly be measured, be better measured by money lost through delays, go-slow tactics, interruptions to critical activities such as concrete pours or crane driving. (Some of these effects at least can be measured, as described later.) The result appears to be not only the loss of productivity consequent upon such tactics but also in deterioration of humarrfactors. This is manifest in both the staff and thz operative group by such things as extreme frustration, poor morale, disenchantment with the industry, and a loss of good people from the industry. The economics of large commercial building investment in Australia have become so uncertain that it is said that some Australian investors are finding it preferable to invest in buildings in other countries such as the USA. There are now signs of a school of thought that the effects of industrial strife in depressing the industry are wrecking the future prospects of people working in it. This gives some hope that the recently proposed two-year national award system throughout Australia will be accepted and become as effective a stabilising factor as it was in Victoria in the form of the Building Industry Agreement some years ago. EFFECTS OF INFLATION TRIAL STRIFE

AND

creases with inflation. On the other hand, those whose incomes or investments do not inflate, such as those on fixed pensions, or those who have undertaken to supply goods or services under fixed price contracts, have corresponding disadvantages. Inflation thus has an effect of re-distribution of wealth. Some of these effects are discussed in the following paragraphs. Is inflation housing?

an impediment

to accessibility to

The writer has elsewhere brought into being a quantitative approach to the concept of affordability in relation to housing [ 11, 121 . This has been used to estimate how much of the population has access to typical housing under the maximum loan conditions typical of lower and middle income families. Subsequent development of the concepts involved has enabled estimates to be made of the extent to which available housing choices fail to match the purchasing power of the population. The results lead to some conclusions as to what could be done to improve the match. The purchase of property by those without unlimited means usually is constrained by many factors, such as shown in Table 7. The effects of the interactions between income,

INDUS-

Inflation and industrial strife are commonly perceived to have deleterious effects, but it must be recognised that there are benefits as well as disadvantages. For example, those whose incomes or investments inflate have benefited from fixed or near-fixed price arrangements entered into at an earlier stage. Thus home owners pay off their investments in relatively constant periodic current dollar amounts which decrease in constant value terms as inflation increases, and they are able to re-value their assets as their current dollar value in-

TABLE

1

Factors

affecting

affordability

Supply of serviced land, and its price Supply of dwellings, and their prices Deposit requirements Lender’s valuation Loan ceiling Eligibility criteria Interest rates Term of loan Constant or variable repayments Transaction costs Borrower’s income and other commitments Taxation scales Availability of finance

187 taxation, housing loan conditions and housing prices have been modelled mathematically. Some results are summarised in Fig. 5 (from [ 121). This figure shows the percentage of families eligible for the maximum loans on housing of given value for various interest rates ranging from 5 to 12% p.a. The net effect of changes in these factors over a decade has been to reduce the proportion of families in any year able to finance such property (once they had the necessary deposit) from over 90% in 1968 to about 44% in 1978. This has left some two million families theoretically out of reach of popular housing under 1978 loan conditions. (The position has eased since mid-1978, but not much.) Fortunately,‘many of these families are already housed, and many have savings enough to require less than maximum loans. Nevertheless investigations suggest that those most in need do require maximum loans. Thus there is a significant, even if not precisely known, number of families who do not have the resources to acquire typical lower-thanaverage housing, particularly those with lower incomes.

80

-

s E

60-

‘0 ‘;j

_

s

:

40-

: b a

On the other hand, those who managed to obtain housing loans before the onset of high inflation have gained because their repayment rates have effectively decreased in relation to incomes which have inflated too. The exceptions here are those on fixed incomes, who lose out on this as they do in other inflation related matters. Effects on longer-term

building

Turning now to the rest of the construction sector, further factors come into play beyond the constraint on financing of loans which restricted ordinary dwelling construction. Projects in the dwelling category are usually of relatively short duration, commonly averaging about 3 months and seldom exceeding 6 months in general. On the other hand, many other types of projects are larger and more time consuming. Under these circumstances clients are faced not merely with the problem of financing funds to meet the initial contract sum and fees, but also the additional funds represented by other costs which are dependent on the time between undertaking the construction contract and receiving occupacy of the building or other works involved. Two such time-dependent extra cost categories are holding charges and “rise and fall” charges. Before examining these in detail we need to know something about the amounts of time involved and whether these have been effected by economic conditions.

_

Delays in building projects 20 -

0

I

0

10

I

I

I

I

I

20

30

40

50

60

Thousands

Fig. 5. Percentage

of dollars

of families

(1978

Equivalent)

eligible for maximum

housing of given value at interest and 12% p.a.

loans on

rates of 5%, 7%, 10%

The Division of Building Research some years ago published the results of investigations into the time performance of building contracts as measured by time occupied in construction, project cost, extent and types of variations, etc., in quantitative

terms [ 131.

188 The equation describing the “average” construction time as a function of project cost was found to be T= K*CB where T = duration of construction period from date of possession of site to practical completion, in working days, C = final cost of project in millions of dollars, adjusted to labour and materials prices prevailing in September 1972, K = a constant describing the general level of time performance. Its value was 3 12 working days, with upper and lower quartile limits of +25% and -2O%, and, B = a constant describing how the time performance is affected by project size as measured by cost. Its value was 0.30. The constants quoted refer to conditions where interest rates were low and industrial strife was not a major factor. Thus, other things being equal, a $ 0.5 million building project would take on average 1 year, whereas a $ 50 million project would take 4 years (based on 1975 prices), and larger ones longer still, as the normal time doubled for every 1O-fold increase in value. Subsequent investigations (yet to be formalised and published) indicate that there has been a general and marked increase in construction time requirements bbove these values during the early 1970s in both the private and government sectors. Projects completed between 1974 and 1976 appear to have shown even greater deterioriation in time performance, to the extent of averaging possibly 30 % longer than a decade earlier. Some individual projects have been not so lengthy, and others much lengthier. A small number of very large projects, particularly in Melbourne and Sydney (e.g. Collins Place, Collins Wales, Qantas) are notorious for the way they have been delayed as a result of industrial strife.

Molding charges

Money paid out by clients to purchase land, together with progress payments on the building works, lead to continuing costs by way of interest charges, rates and taxes. The longer occupation is delayed the more the holding charges inflate the total investment before income (real or notional) begins to be earned from the productive use of the works. These items form the basic minimum sources of such charges - others are expenses on rental of alternative facilities or other substitution charges and the like. Based on research into the actual performance of contracts [ 141 a method was derived to give an estimate of holding charges as a function of the effective combined rate of interest and rates and taxes and the value of the project [ 131. If we take the effective holding charge rate at 15% p.a. (11% interest, 4% rates and other charges), the exemplar $ 0.5 million and $ 50 million projects would attract $ 30,000 and $ 12 million in holding charges respectively over the normal construction periods. Extension of these periods by 30% would lead to further charges on this account amounting to $ 10,000 and $ 4 million respectively. While the former amounts to 2% of the original contract sum, the latter amounts to S%, and by ‘its magnitude could be crippling to the investor. Rise and fall charges

The major components of building cost are commonly materials, plant, wages and overheads. The patterns of movement which they have exhibited over the past decade have already been described. Mechanisms set up in the 1960s for adjust-

189 ing output prices on account of changes of input prices under conditions of small and gentle change proved inadequate. Over any given contract period, the amount of escalation has been high under the conditions of instability prevailing since 1973. The extent can be illustrated by calculating the escalation in cost for notional contracts of any given size. Consider for example a modest building contract of say $ 0.5 million and a larger one of say $ 50 million (1975 prices). According to the observed industry standards of time performance without undue industrial unrest referred to above, these would take about one year and four years respectively to construct. Assuming a normal pattern of progress payments, the amounts of cost escalation for the average rates of growth of prices occurring over the periods 197 l-76 and the 1974 year have been calculated with results as shown in Table 8. Thus the smaller project would have attracted 12 per cent at the 1971-76 rates and 20 per cent at the 1974 rate. These are already large in comparison with the extent of variations and profit margins to be expected in such projects. As projects increase in size the consequences of price rises increase at a compound rate. This occurs not only because more money is in-

volved but because they take longer to complete. Thus the $ 50 million project would have generated an amount nearly half the original contract sum at 197 l-76 rate, and if the 1974 rates were to continue for the four years then the amount of escalation would be almost as large as the whole original contract sum. Slowing down of these projects by 30% would add further to the cost of the nominally $ 0.5 million project by $ 30,000 or $ 68,000 at the respective rates of escalation, and $ 7.2 million or $ 12 million respectively in the case of the $ 50 million project. Adding the combined effects of holding charges and escalation costs, the results are as shown in Table 8. Thus the $ 50 million project becomes a $ 95 million project by the time it is finished, of which $ 11.2 million is the result of 30% slow-down, even at the 197176 average rates of inflation. The picture would be even worse were the 1974 rates of inflation to continue for the full project duration. The consequences of this behaviour for the Australian economy are substantial. At the 1971-76 average rate of price movements, the writer has estimated that the bill to the building and construction sector would have been

TABLE 8 Time dependent costs Inflation rates assessed

1971-76

average

1973-74

Ye=

Original contract ($ million) Normal duration (years) Holding charges ($ million) Rise and fall ($ million) Total ($ m~ion) Duration extended by 30% (years) Additional holding charges ($ million) Additional rise and fall ($ million) Additional total ($ million) Additional total (% of original contract) Total cost ($ million) Increase over original contract (%)

0.5 1 0.03 0.06 0.09 0.3 0.01 0.018 0.028 6 0.618 23

50 4 12.0 24.0 36.0 1.2 4.0 7.2 11.2 22 97.2 9.5

0.5 1 0.03 0.10 0.13 0.3 0.01 0.03 0.04 8 0.67 34

50 4 12.0 40.0 52.0 1.2 4.0 12 16.0 32 118.0 136

190 in the region of $ 400 million per annum at 1976 prices (and more in the 1974 year). This is a substantial transfer of funds from those paying for building and construction work to other sectors of the economy; the net effect on those whose supplies of funds are indexed may not be so large, but it is significant even to the point of catastrophe to those whose funds are not indexed. For all that, the amount of effort devoted to. control of these enormous sums is minute compared to the effort devoted to control of other aspects of construction works. This obvious disparity is only now being recognised and, even so, inadequately for proper equity between the parties [ 151. Price flow in the construction

industries

The complications arising from input price changes are compounded in a complex process like construction, where there are many layers of operation. These form a network through which both products and prices flow, being processed at several and not infrequently many stages, each stage receiving the output of the last as its own input. Moreover, each stage comprises an independent party with considerable discretionary powers in fixing its prices, each having its own contractual arrangements with those who supply its inputs and those who receive its outputs. It would seem obvious that those arrangements relating to price changes require to be mutually compatible if the whole industry is to operate without strain [ 151. Unfortunately, they do not seem to have been so. For example, when wages rose so rapidly during the 1973--75 boom, many materials could only be obtained at prices ruling at date of delivery instead of at date of order. Yet many contractors buying these materials were on fixed price contracts which forbade the passing on of costs to their clients, and they had to absorb the extra costs as best they could. Profit margins

and working capital being notoriously low in contracting firms, some had inadequate resources to absorb these price increases and became insolvent. Others have only just managed to escape liquidation. Even when the head contract has had cost escalation provisions, these have often been incompatible with material supply escalation provisions. Incompatability might not have mattered much when cost escalation was a minor factor, but this is not so now. Much more attention needs to be paid to this aspect if strains are to be reduced in the future. Mechanism of inflation

Writers such as Trevithick [ 161 have pointed out that economists are not yet able to agree on the mechanisms operating between prices, demands for goods and services, value of money, etc. which affect inflation. One school of thought is based on the view that an increase in money supply leads to an increase in prices, the volume of physical goods involved remaining constant. The other school of thought is based on the view that rising prices are not the outcome of excessive demand but are determined by sociopolitical factors such as trade union wage actions, any increase in money supply being a passive effect rather than an active generation of change. Many other schools of thought lie between these extremes, including the various varieties of Keynesians. Granted that the effects of the union movement are to a considerable extent ratchet-like, in that it is very difficult to achieve any downward movement in wages, there seems to be more evidence to support the first school than the second. In Trevithick’s view most economists recognize that inflation is the outcome of excessively expansionist monetary and fiscal policies which arise from attempts by the authorities to run demand at levels beyond the full employment

191

level of output. Unfortunately its remedy does not rely on the reversal of such policies. “What is needed is a package of inter-locking and mutually reinforcing policies, in which demand restraint and prices and income policies are regarded not as alternatives but as complementary. Even this cannot avoid a rise in unemployment in the short term.” A policy of unaided demand restriction can be expected at best to achieve a mild reduction in the rate of inflation, and at worst an increase in unemployment without reducing inflation at all. Prices and incomes policies fail without sufficiently restrictive demand policies, as British experience has persistently shown. Indexation of contracts is one means which has been proposed for avoiding some of these difficulties. Proponents of this approach consider that indexation may go a long way in enabling the economy to live with inflation, and some monetarists believe it could even be useful in reducing inflation (a view hotly contested by cost-push theorists, who believe it would have the reverse effect). If all money contracts were to be indexed, including taxation as well as debitor - creditor contracts, incomes and prices policies become less relevant except to the extent needed to keep the scale of wage differentials more or less in balance. This could be a practicability in Australia with its formal arbitration system for wage fixing and some measure of union support for indexation policies. However experience in Australia with indexation of wages has led to narrowed wage differentials between skilled and unskilled workers, so that the latter have become less attractive to employers, and probably the youth unemployment problem has been exacerbated because they are predominantly unskilled. Longer term effects of general indexation on Australia’s competitiveness as a trading nation would also need to be considered, opposing schools of economic thought again taking radically different views. Indexation does form one commonly accepted means to manage inflation of building and construction contract sums in Australia,

under the name “rise and fall”. Certainly, it is the present writer’s view that during the 1970s the time-dependent costs of building and construction contracts have been largely beyond the control of contractors and in magnitude beyond their financial capabilities without some appropriate devices for their management. In 1974 the writer made a series of recommendations [ 151 to improve the management of cost escalation. These formed an interlocking set which recognised the quantitative flows of materials, wages and salaries, and other components through the various sequential steps via subcontracts into the main contract and so through to the investing client, aimed at giving equity to each party at each stage. Although many of them were regarded as too radical at the time, some of them are now being implemented. CONCLUSIONS The effects of inflation and industrial strife in Australia have been pronounced during the 1970s both in magnitude and in variability. They have been largely coincidental in their occurrence, and appear to have interacted strongly. As to which drives what, there is considerable argument; there seems to be some greater weight favouring the view that industrial strife is to some extent a result of rather than an initiating cause of inflation, in general. The consequences of inflation appear to have been particularly extreme in the construction sector, and here there is no doubt that industrial strife has played a major part in adversely affecting the market for work and at times generating inflationary pressures. Interest rates have nearly doubled over the decade, resulting in a substantial proportion of the population losing the ability to afford housing loans of the size needed for average housing - a result compounded by increases in technical requirements by regulatory authorities. This in turn has played a part in adversely affecting the housing market. Increases in interest rates have also

192 magnified holding charges on works under construction, particularly major projects. Likewise increases in the rates of inflation of wages and materials prices have magnified rise and fall charges on projects so indexed. The combined effects would add $ 36 million to the cost of a typical $ 50 million building project (at 1975 prices) under otherwise normal construction conditions. But conditions have not been normal because of the pronounced degree of industrial strife during the 1970s. This has lengthened the average duration of projects overall by an approximate estimate of 30%, so adding a further $ 11 million to the exemplar $ 50 million project. This is bad enough, but the effects have not stopped there. Disruption techniques have become much more efficient during the decade, so that by holding up critical activities on a small number of major projects, on a rotating basis, a small number of strikers has been able to cause a greatly magnified amount of disruption and pressure on employers for higher direct or indirect remuneration. This has led to increased uncertainty of timing of occupation by the investor, to an extent far beyond the average 30% lengthening of construction time. Doubling the duration of construction of the exemplar $ 50 million building (and worse has happened) over the average 197 l-79 period conditions would add $ 52 million to its cost. Uncertainties at this price have undoubtedly played a part in the collapse of the non-residential building market in the large building sector. Clients are preferring more smaller buildings, or better still to buy existing ones. Indexation seems to be one of the more effective theoretical ways to manage inflation. It does appear to be necessary in the construction sector where time dependent costs from inflation and industrial strife are far beyond the reasonably predictable financial capability of contractors. While those remaining in business seem to have generally kept up their gross profits, the rate of insolvencies has nevertheless increased. There are those schools of

thought (such as the ~nonetarists) who suggest that general indexation of all transactions could reduce inflation, but this is contested by others (such as the cost-push theorists) who suggest the result would be reverse. REFERENCES 1 Consumer Price Indices, 1967-79. Australian Burau of Statistics, Canberra. 2 Wages and Earnings, 1967779. Australian Bureau of Statistics, Canberra. 3 Building Cost Index, 1979. The Building Economist, 18: 76. 4 Price index of materials used in building other than house building, 1967-79. Australian Bureau of Statistics, Canberra. 5 Bennet, R., 1976. Evaluation of profit, Seminar of Price Escalation, Institute of Purchasing and Supply Management, Brisbane. 6 Bromilow, F.J., 1979. The building labour force in Australia, Construction Papers, (in press). 7 Year Books, Australia, 1973-79. Australian Bureau of Statistics, Canberra. 8 Labour Report No. 57, 1972. Australian Bureau of Statistics, Canberra. 9 Annual reports on the Bankruptcy Act, 196878. Australian Government Publishing Service, Canberra. 10 National income and expenditure, 1967-78. Australian Bureau of Statistics. Canberra. 11 Bromilow, F.J., 1977. What is an affordable house? Paper 1 in: Productivity and the Affordable House, Housing Industry Association of Australia, 12th National Convention, Canberra, April 1977. 12 Bromilow,F.J., 1979. Accessibility of housing. The Australian Builder, 31 (3): 26-33. 13 Bromilow, F.J., 1974. The impact of contract performance research an building in Australia. Proceedings 6th CIB Congress, Budapest. 14 Bromilow, F.J. and Henderson, J.A., 1977. Procedures for reckoning and valuing the performance of building contracts, CSIRO Division Building Research Special Report, 2nd edn. 15 Bromilow, F.J., 1977. Cost escalation of building contracts, CSIRO Division Building Research Special Report 2nd edn. 16 Trevithick, J.A., 1979. Inflation, Penguin Books, Ringwood.

BIOGRAPHICAL

NOTE

Dr. Bromilow is head of the Building Operations and Economics Research Section of the Division of Building Research, Commonwealth Scientific and Industrial Research Organisation, Australia.