Why construction costs rise: the economics behind escalation
Building costs tend to rise faster than general prices over the long run, and they do not rise smoothly. Understanding why helps you explain a budget, time a tender and put a sensible figure on escalation. This article walks through the forces at work.
By the Caprix AI team · · 9 min read
Key takeaways
- Input costs and tender prices are different things. One is what the contractor pays, the other is what the client is charged, and the gap between them moves with the market.
- Tender prices follow the building cycle: they outrun costs when work is plentiful and fall behind when it is scarce.
- For an economy that imports much of its steel, plant and fuel, the exchange rate is a direct cost driver.
- Construction productivity has grown slowly for decades, so its costs rise relative to industries that have automated.
- Escalation should be reasoned from these drivers, not added as a habitual percentage.
Two prices, not one
When people say construction costs have gone up they usually mean one of two things. Input costs are what a contractor pays for materials, labour and plant. Tender prices are what clients are charged for finished work, which is input cost plus the contractor's overheads, risk allowance and margin.
The two can move apart for years. In a busy market contractors can be selective and price risk generously, so tender prices rise faster than their costs. In a quiet market they cut margin to win work, and tender prices can fall while materials are still getting dearer. This is why a tender price index and a cost index are published separately and should be read together.
The building cycle
Construction is more cyclical than the economy around it. Demand for buildings depends on investment decisions, which are postponed quickly when confidence falls and bunch together when it returns. Supply cannot respond at the same speed: skilled labour, plant and management capacity take years to build up.
The result is a market that swings between shortage and surplus. At the top of the cycle, subcontractors are fully booked, lead times lengthen and prices carry a premium. At the bottom, the same firms bid at or below cost to keep their teams together. Where you are in that cycle often matters more to a tender than the price of cement.
The cost drivers
Materials
Steel, cement, copper, bitumen and timber are traded commodities. Their prices follow global supply and demand, energy costs and freight, largely regardless of local conditions.
Exchange rate
Where materials, plant and spares are imported or priced against the US dollar, a weaker ringgit raises their cost even if world prices are flat.
Labour
Construction depends on site labour, including foreign workers. Changes in labour supply, levies and wage floors pass directly into trade rates.
Energy and fuel
Fuel moves materials and runs plant. Cement, steel, glass and bricks are energy intensive to make, so energy prices reach every element of a building.
Interest rates
Higher rates raise the cost of financing work in progress and, more importantly, reduce demand for new projects. The first pushes prices up, the second pulls them down.
Regulation and standards
New requirements on safety, energy performance or building standards raise the specification, and with it the cost per square metre.
The productivity problem
There is also a slow, structural force. A widely cited McKinsey Global Institute study in 2017 found that construction labour productivity had grown at about 1% a year over two decades, against 2.8% for the world economy and 3.6% for manufacturing.
The consequence was described by the economist William Baumol. When wages across an economy rise with productivity in the fastest improving sectors, industries whose productivity grows slowly must pay those wages anyway, so their costs rise relative to everything else. Building is assembled on site, one project at a time, in the weather, by a temporary team. That is hard to automate, which is a large part of why construction grows steadily more expensive than manufactured goods.
It is also why industrialised building systems, prefabrication, BIM and now AI attract so much attention: they are attempts to change the productivity trend, not just the price of an input.
Reading the signals
No single figure tells you where prices are heading. A practical watch list:
| Signal | What it tells you | Typical lag |
|---|---|---|
| Commodity and material prices | Direct pressure on material rates | Weeks to months |
| Exchange rate | Cost of imported materials and plant | Months |
| Producer prices for building materials | Broad material cost movement | Months |
| Construction output and orders | How busy contractors are | Quarters |
| Interest rates | Future demand for building work | Quarters to years |
| Tender price index | What the market is charging now | Published in arrears |
Two cautions. A relationship that looks obvious may be weak in the data, so measure it before relying on it. And leads and lags matter: a fall in steel prices today reaches tender prices only after existing stock and contracts have worked through.
From drivers to an escalation allowance
Escalation is the allowance for price movement between the date an estimate is priced and the dates the money is spent. A reasoned allowance has three steps.
- Fix the base date of the estimate and the mid-point of construction. Costs are incurred across the programme, so the mid-point is the usual reference.
- Take a view on movement between those dates from index trends and the drivers above, as a range and not a single figure.
- Apply it to the cost that is exposed. Work already let on fixed prices carries less risk than work not yet tendered.
Then record the reasoning. An escalation allowance with a stated basis survives a client's challenge. A round percentage does not.
Seeing this in the data
In Caprix AI, Trends charts the Tender Price Index and the material, labour and machinery cost indices by state. Research reads official statistics from the Department of Statistics Malaysia, Bank Negara Malaysia and the Ministry of Finance alongside them, and where one series may influence another it measures how strong the link is and how long the lead time has been. After a building estimate you can ask what escalation to allow to the construction mid-point.