Of all the parties affected by the ongoing trade war with China, perhaps few are as directly or severely impacted as U.S. government contractors.
By the very nature of their business, government contractors have come to rely upon a consistent supply of raw materials and finished goods imported from China. Any disruption to that supply chain has an immediate and direct impact on contractors’ bottom line and their ability to compete and fulfill contracts that serve the public good.
While these issues are constantly evolving, the following are some of the most common implications that current and potential contractors will face as the trade war continues.
The obvious effect of U.S. tariffs on Chinese goods is increased cost. What many contractors may not realize is that tariffs have been imposed on hundreds of goods that extend well beyond what can be considered raw materials. While the cost of iron, steel, aluminum, and other building materials has been discussed at length, what may not be well-known is that tariffs also apply to a wide range of products that are necessary for the completion of government contracts, particularly ground-up construction and renovation projects. Bulldozers, backhoes, and front-end loaders are affected; as are ball bearings, thermostats, trash compacters, furnaces, dishwashers, and a broad array of machine tools and component parts. The price of Chinese glass has also risen — a product that was in short supply before tariffs were imposed.
One example of a product class getting caught in the crosshairs of this trade war is LED lighting. In recent years, many government agencies have begun specifying LED lighting in construction bids for their lower energy requirements. The problem is that the vast majority of LED lighting manufacturing exists in China. As tariffs bring higher costs, fewer and fewer contractors are able to purchase these products, which leads to Chinese manufacturers cutting production—which in turn leads to lower product availability. The same applies for secondary products like digital switches to control lighting.
Sudden price hikes affect government contractors differently than most companies that make use of Chinese imports. From the bidding process to project completion, every phase of a U.S. government contract is planned down to the letter to minimize cost for the agency and ensure completion on time and within specified quality standards. These plans are established well in advance — and do not leave room for seismic disruption to the supply chain or sudden price increases. Unlike other companies that make use of imports, government contractors cannot turn on a dime, push completion dates forward, or renegotiate prices with key stakeholders. When faced with sudden price hikes for products necessary for the completion of their projects, contractors have to absorb the impact themselves. In most cases, this eliminates any preconceived margin for profit and forces the contractor to operate at cost or at a loss to maintain its momentum in the marketplace.
One example of how far U.S.-based contractors have progressed in relying on Chinese imports can be found on Deer Island, Maine. Widely known as the granite capital of North America, Deer Island has provided quarried granite for many of the best-known building projects of the past century, including the Empire State Building. One landowner, however, completed a large residential construction project in recent years using granite shipped from China—underscoring how that material was less expensive than the granite that was literally underneath the building itself. While this may be an extreme example, it’s clear how the economics of Chinese trade have changed overnight. For U.S. contractors, the party is over, and these prices no longer exist.
As with any obstacle, prior knowledge provides contractors with options. When dealing with lower margins due to price increases, some contractors are seeking lines of credit that give them breathing room to manage the price increase and hopefully wait out the storm until trade disputes are resolved and tariffs are eliminated. However, if the contractor is unaware that tariffs will affect its cost structure and plans to mitigate the effects are not in place, repercussions could prove especially damaging.
For example, if a typical contractor accepts a bid from the U.S. Navy for the construction of a new facility, it’s not unusual for the contractor to build in a contingency fund (e.g., $500,000) into its bid to account for factors such as bad weather, product delays, personnel issues, etc. The trade war has dramatically increased the need for contingency planning, but contractors may bid themselves out of the competition if they double their contingency margin to account for the costs and uncertainty that tariffs bring to the table. Lines of credit allow for contractors to adjust to unplanned costs, but they do not add to the bottom line of a contract bid — allowing contractors to stay competitive while responding to market changes in real time.
Even for government contractors that plan ahead to mitigate the effects of increased costs for goods affected by tariffs, many are unprepared for delays in receiving the goods they ordered in the first place. In many cases, increased cost for goods has led to lower production levels in China, which has in turn led to much longer timetables for delivery in the United States. For government contractors that have grown accustomed to relying on just-in-time delivery and lower inventory to reduce overall cost structures, these delays can have a multitude of negative effects.
First, U.S. government agencies usually specify very strict timetables for project completion. In most cases, any delays in completion are viewed to be the responsibility of the contractor — regardless of any mitigating factors. This means that, even if a new building project is held up because the steel was unavailable for six weeks, or the contractor had to wait another month to receive elevator switches or plate glass for exterior windows, the agency will still hold the contractor accountable. Usually, this comes in the form of fines, which can reduce or eliminate any profit margin a company had planned to realize for the project itself.
Lack of availability can also have an additional effect on contractors. For those that are seeking to avoid excessive fines imposed by government agencies for missing critical deadlines, many contractors will opt to source needed materials from local suppliers. In most all cases, these materials come at a much higher cost — a cost that is not accounted for in the original contract and must be absorbed by the contractor.
Consider this real-world example: A mid-sized contractor was awarded a contract from a federal agency for the construction of a multi-story office building — before the trade war. While most of the building components had already been secured and delivered, a few key items had very suddenly been delayed indefinitely — including wall fasteners. These products are directly affected by tariffs and, before the trade war began, were readily available by the pallet load for large construction projects. Now, the combination of increased price and demand and lower availability has led this contractor to seek out domestic suppliers. What this contractor found out was that, once it was even able to find a supplier in the United States that made these fasteners, the domestic version was more of a specialty product — i.e., they’re prohibitively expensive for large projects, even without a trade war. Even worse, this contractor had to get in line behind several dozen other contractors in the same position. While it may seem ridiculous that a building may be held up because of one small component, that is the reality that many contractors are now facing for the foreseeable future.
Rising Insurance Premiums
For companies looking to enter the government contracting market, many may not realize that — especially compared to private contracting projects in the United States — government agencies are mandated to make every conceivable effort to bring a project to completion on schedule. For the contractor, this effort comes in the form of a surety bond that must be issued to give the agency proper assurance that the project will be completed even if the contractor becomes embroiled in litigation, material losses, employee injuries, or any other factor that may prevent project completion. For the insurance agencies that underwrite these policies, the trade war with China has led to a general feeling of uncertainty in the marketplace. The longer tariffs remain in place, the more insurance companies will have to account for the complexities that contractors are facing from product delays, increased costs, and ripple effects that make project completion less certain. This is translating to higher premium costs across the board for all government contractors — another cost that cannot be passed on to the agency but must be absorbed by the contractor’s already thin margin.
Another obstacle facing contractors is the fact that U.S. Customs is now requiring importers to take out surety bonds to guarantee payment of the tariffs themselves. For example, if a contractor is importing $100 million worth of steel from China, it must now take out a $25 million bond to guarantee the required 25% tariff payment. Not only is this having an immediate effect on profit margins for contractors themselves, but the sudden increase in volume for surety bonds is placing enormous stress on inventory from insurance carriers, which in turn is leading to higher prices for insurance premiums.
How can government contractors mitigate their risk in the middle of a trade war?
The first step is to plan ahead. Most contractors build in extra room in their timetables regardless, but they should take this a step further to account for product deliveries that take weeks or months longer than usual to arrive. Build your inventory if you can and don’t expect just-in-time delivery to be reliable until the crisis is resolved.
Broaden Supplier Networks
Another step contractors should take is to broaden their supplier networks. This will impact cost, but taking the time now to negotiate deals with domestic suppliers should reduce at least some of the effect. At the very least, the increase in cost of goods from local suppliers should be less than fines imposed by government agencies for missing critical deadlines.
Lines of Credit
Finally, government contractors should consider taking out a line of credit to account for price increases and costs associated with tariffs — at least until the trade war is negotiated to an end. Government contracts allow for favorable risk profiles to lenders, and the increased flexibility will allow contractors to meet deadlines, absorb costs, and ride out the storm in one piece.
The most disturbing impact of the current trade war is that, when faced with increased costs and unpredictability on critical supplies, many contractors are choosing not to compete for bids. Less competition has a negative effect on the entire ecosystem for government contracting and should serve as a powerful motivator for a swift resolution. CM
Co-Founder and Chief Executive Officer, Brevet Capital Management, a global specialty finance and solutions provider focused on the government sector.