Material price escalation: strategies for coping

By David R. Hendrick and Jared W. Heald
July 22, 2008
COMMERCIAL : FINANCE, LEGAL

Material price escalation is a business risk faced by all contractors. Given current economic circumstances, this risk is roaring back into prominence with double-digit annual rates of price increases for many types of construction materials, according to the May 28 issue of DataDigest from the Association of General Contractors of America.

The increases are due to multiple unforeseeable and unpredictable causes. Risk materializes when the price of necessary materials increases between the time a job bids and when the materials are actually purchased for construction. Increased cost of procurement directly erodes the contractor’s profit margin in a fixed-price contract or guaranteed maximum contracts. It is of particular concern in contracts that are substantially delayed in award after bid submission, contracts with performance periods extending over a long duration or in contracts entered into long before the materials are to be purchased.

When material cost increases occur due to delays in performance caused by compensable causes, such as changed conditions of performance, most construction contracts will permit corresponding contract price adjustment.However, in general, the contractor providing the materials bears the risk of material price increases when they occur within the anticipated or stipulated periods for bid acceptance or contract performance.

The fact that the contractor’s performance has become economically burdensome or advantageous in the face of such an escalation does not generally excuse the contractor’s performance or entitle the contractor to adjustment of the contract price. Typical contract adjustment provisions such as changes clauses, force majeure or time extension clauses, and changed or differing site conditions clauses are generally not considered to address and allow relief for such circumstances.

The risk of some material cost fluctuation is inherent in construction and can be taken into account in projecting and estimating. However, in periods of rapid and unpredictable swings in cost of essential materials and supplies, contractors face a dilemma in estimating their costs and formulating their bid and contract pricing. If they aim too high in projecting material cost in formulating their bids, they will price themselves out of contention for contract award. If they aim too low, they may well be awarded a contract at a price that will not adequately include the actual costs, resulting in reduced profit or even a net loss.

The risk of significant, unpredictable and unforeseeable cost escalations should be borne by the ultimate beneficiary of the work, namely the owner, as a risk of the venture and not by the individual contractor or subcontractor. It can be addressed either by inclusion of sufficient price protection in the contract pricing or by adjustment of the contract pricing to cover such increases, but only when and if they actually occur. The latter is generally the best option, as it eliminates the crystal ball approach to predicting price escalation, and only increases the contract price to the owner when necessary to compensate the contractor for actually incurred significant price increases.

Price adjustment clauses

Price adjustment clauses mitigate the risk of significant material price escalation by providing for an adjustment in the contract price if certain agreed upon events occur. The typical price adjustment clause allows for an adjustment when the actual cost of a certain type of material or an industry-wide price-index for a certain type of material increases or decreases by a specified percentage.

From the standpoint of the contractor, price adjustment clauses are the best hedge against unanticipated significant price changes. The main difficulty is that such a clause has to be included in the construction contract. This may present problems when a contract is the result of a procurement process in which modifications of contract terms are not permitted in the bid or contract, such as on public works projects, or when an owner fails or refuses to include a price escalation adjustment clause in the contract.

For subcontractors, this difficulty is magnified since the contractor is unlikely to agree to such a clause unless a comparable provision is included in the prime contract documents, which are typically fixed before the subcontracting process is finalized.

Nevertheless, if you don’t ask for it, you certainly will not get it. Even if the other party will not agree upon its inclusion, such a bid condition may well allow an “escape hatch,” allowing a contractor to walk away from a bad deal where prices do rise before actual contract formation.

Best bidding and contracting practices

Even if a contractor is unable to negotiate an acceptable price adjustment clause into the construction contract, the contractor remains able to utilize some alternative means for reducing the risk of material price escalation. There are several strategies that afford contractors some protection from significant and unpredictable materials cost escalation. The following is a list of best practices that a contractor should attempt to incorporate into its standard operating procedure for pricing:

• Condition bids and proposals upon acceptance within a specified and limited period of time when permissible

• Obtain firm price commitments for the anticipated period of performance and procurement from key material suppliers for the duration of a project

• Tie purchase contracts for key purchases of materials or fabrication to the same terms and conditions relative to term or price adjustments as will apply in the contractor’s upstream construction contract

• Procure essential materials and supplies early for a job that is expected to stretch out over a long time

• Walk away from a job if protection from price escalation cannot be negotiated, provided the contractor has not legally or contractually bound itself to performance.

When a contractor is justifiably concerned about material price escalation, the best approach is often an open, good-faith dialogue with the involved parties prior to engaging in any firm contractual relationship regarding how and by whom the risk of material price escalation is best able and most appropriately to be borne.

Hendrick is a senior partner, and Heald an attorney, at Hendrick, Phillips, Salzman & Flatt, P.C., Atlanta. They can be reached at drh@hpsf-law.com, jwh@hpsf-law.com or 404/522-1410.