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Price Adjustment Clauses: A Solution for Dealing with Changing Materials Costs
Price fluctuations affect nearly all construction materials. In the first half of 2004, the price of steel rose 50 percent to 60 percent, following years of flat or reduced prices. A year later in August 2005, the price of asphalt jumped close to 40 percent compared to the previous two-year period—a time marked by price increases of only 4 percent.
At the base of cost volatility in the construction industry are the constantly changing prices for oil and diesel fuel. During the past year, oil sold for close to $150 per barrel; at its low point it was priced below $40 per barrel. For diesel fuel, the construction industry paid from $2.30 per gallon to $5 per gallon.
Currently, economists and analysts are at odds about how long the current recession will last. At the same time, oil-producing nations are applying pressure to again raise the price of fuel to jumpstart their own economies, increasing the risk of inflation.
This presents a range of challenges and consequences for the construction industry, such as high contractor bids that include a cushion that can render the bids uncompetitive. Consequences also include dramatic contract losses and defaults, severely impacted and delayed projects, and litigation resulting from efforts to mitigate, shift or recover unanticipated losses.
Cost control has become a tug-of-war as owners, which benefited from the protection of extended contracts based on firm prices, question whether margins have become too favorable for contractors as commodity prices drop.
In this context, litigation sometimes seems the only option for owners and contractors to obtain relief from extreme cost escalation in a construction contract, although it may lead to increased costs, damaged relationships and risk. With this in mind, consideration should be given to the incorporation of price adjustment clauses in construction contracts.
Three Types of Price Adjustment Clauses
Price adjustment clauses take into account the volatility of commodity prices at the outset of a project and allow a certain degree of flexibility to respond to price fluctuations. Price adjustment clauses already are permitted in certain federal, fixed-price construction contracts pursuant to the Federal Acquisition Regulations. At the state level, highway departments commonly use such clauses for asphalt, paving, steel, cement, diesel fuel and other materials.
Price adjustment clauses must be approached with care and should be diligently drafted, specifically identifying the individual building materials most at risk for price fluctuation. Equally important is the need to establish a notification procedure in the contract, in which the contractor is responsible for notifying the owner of a price increase.
This procedure also should identify the price guide to be used to measure changes in price, and it should detail how often a price adjustment clause may be triggered during the project.
Three options can determine what triggers a price clause adjustment and when:
- Invoice method. A contractor uses documentation in the form of an invoice or certification from its supplier to substantiate the changes in a material price. It must demonstrate the change in the material price from the time the contract was signed to the time of actual purchase.
- Index method. An increase in the contract price is tied to a price index guide for a particular commodity and documented as such. This method should allow the contract to adjust the index price to regional and local fluctuations and conditions for major commodities such as steel, diesel fuel, cement and asphalt. This is often the best option when a supplier is unwilling or unable to provide a fixed price quote until the material is actually purchased.
- Hybrid method. Combining the invoice and the index methods, this method is centered on a “certified bid cost” in which the contractor certifies its estimate of a specific material’s cost based on its current supplier price or an index price listing. Should this certified bid cost change by more than a preset percentage—such as 5 percent or 10 percent, positively or negatively—the contract would be adjusted accordingly.
Properly drafted, price adjustment clauses in construction contracts minimize risk to both contractor and owner, reducing conflicts and promoting cooperation. The clauses are created with the full understanding that commodity prices are at risk of fluctuation between the time a contract is signed and the completion of the project. And best of all, they provide a way to protect everyone’s interests and preserve valuable business relationships.
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