As the global economy tries to get a foothold for its recovery from the COVID-19 pandemic, those in the construction industry, especially contractors, are increasingly exposed to financial risk through material costs escalation. Material costs over the past year have skyrocketed, while demand for new builds has remained steady or even increased in some instances. The increase in material costs is mainly driven by shortages, and as the Wall Street Journal reported in June, these supply-chain imbalances could persist well into 2022.
There are a number of reasons for the current material shortages:
To make matters worse, there have been significant delays and unpredictability as to when the materials will be delivered. The uncertainty of delivery creates enormous challenges for those managing the project.
Price-change data over the past year are staggering. The most drastic year-over-year increases have been seen in diesel fuel costs, lumber and plywood, copper and mill brass shapes, and steel.
The financial risk is clear. Those in fixed bid prices situations are destined to suffer loses that will severely harm their business or be forced to not honor their bids. To avoid these situations, contractors, suppliers, trade partners and even owners must be creative and realistic about today’s construction materials market.
Fortunately, there are options for risk allocation that entities can employ to negate the ill effects of material cost escalation or at least mitigate the exposure to such increases so not to create devastating financial risk.
In a traditional lump-sum price arrangement it may appear that all of the financial project risk rests with the contractor and its subcontractors, and that’s true to a certain extent, but as projects grow in size, cost and complexity, a good portion of that risk ricochets back to the project owners, whether they are aware of it or not. Savvy contractors and subcontractors aware of the risk associated with fluctuating material costs will work in financial protection into their bids and pricing. As such, the project owner may be paying for the risk even if the material prices remain flat, which will only benefit the contractors, subcontractors or suppliers.
While a lump-sum contract provides a degree of certainty as to the total cost of the project, the lump-sum approach as a means of allocating risk is less than ideal. It is a static agreement incapable of dealing with fluid project parameters. Arrangements that set forth a guaranteed maximum price are better, as they provide a little more flexibility. Cost-plus arrangements provide for a kind of flexibility, but not one that most project owners would agree to since they are on the hook for virtually all manner of unforeseen expenses and overruns.
To address the ever-growing risk of material costs fluctuations, contractual provisions which provide some flexibility or risk sharing on material cost increases have become more popular. These provisions have been labeled “escalation clauses” and vary in form. The key components of these clauses are:
The triggering condition could be a certain percentage over the per unit price or total material costs set forth in the agreement. These “threshold” escalation clauses tend to be material specific, such as for fuel, steel or a project-unique material.
Another triggering condition could be a delay in the project. The idea behind the delay escalation clause is that contractor or its supplier carries the risk for a certain time. After that point of time has elapsed, the owner is obligated to pay the current price of the materials. The delay escalation clauses tend to cover all materials rather than specific materials, but it can also be focused on specific materials. Finally, another common escalation clause is a clause which places the cost escalation risk on the owner for a specific material, regardless of delay or amount of increase.
An alternative to the inclusion of escalating clauses into a construction contract is to have the project delivery structured so that all parties reap the benefit of cost savings and share the risk of cost overruns. This is precisely what the integrated project delivery method is meant to achieve. Both the AIA and ConsensusDOCS have published standard form construction contracts for integrated project delivery; the AIA C195 and the ConsensusDOCS 300.
The starting point for the integrated project delivery method is the calculated target cost when a project’s detailed design is complete. From there, if project costs stay below the target cost, then the parties on both sides of the deal share savings as allocated in agreement; however, in the event that costs exceed the target cost, either the owner bears the risk for so-called “pure” costs over target cost or the excess costs are shared based on percentages set forth at the beginning.
By tailoring the contract so that the project owner and contractor entities share risk and cost savings, and therefore their interests are aligned, there is higher likelihood that the costs will be more effectively managed.
The analysis of material cost escalation risk must start with an understanding of the construction contract price arrangement. Once a project owner or contractor understands their respective risk under the proposed contract, they must ask themselves whether it makes more sense (and is cheaper) to push the risk onto the other party or to share the risk.
With the consistent increase in material costs and the recent significant volatility, the utilization of escalation clauses and cost-sharing mechanisms will only increase. It is imperative that construction entities understand what is being proposed and what are the other available options to address the risk of material cost increases.
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