Construct Contracts to Ease Increasing Prices and Tariff Risks

Next year, total U.S. construction starts are projected to be $808 billion, according to Dodge Data and Analytics. As compared to this year’s numbers, the slight increase in projected real estate and construction activity across the country is being pinned against the risks of tariffs, increased building costs and disruptions in the supply chain—all resulting in increased prices for key construction materials, such as lumber, steel and aluminum.

There is no need for owners and contractors to go into sticker shock just yet, though. Overreaction to potential price surges involves its own set of pitfalls. Accelerating the project without careful planning could result in headaches down the road from hurried design, hasty preparation, and review of shop drawing submittals, last-minute changes in the owner’s program or excessive materials handling and storage costs. Amid the uncertainty, construction professionals should evaluate contract solutions to help limit and allocate exposure to price escalation.

Although owners may initially be loath to consider it, price escalation clauses promote cost transparency and can benefit owners and contractors in an unstable market. Typically, a contractor or subcontractor submitting a fixed price bid or guaranteed price proposal bears the risk of a commodity price increase once its bid or proposal is accepted. In the face of possible price increases down the road, a contractor will try to offset that risk by increasing its bid price to the owner. If the prices do not increase as expected, it may ultimately result in the owner on a lump sum project paying a premium to cover a contingency that did not occur.

The rationale for an owner to embrace a well-drafted price escalation term is that it will allay contractor concerns about materials price increases that may or may not occur, which would otherwise translate to higher lump sum bids or guaranteed maximum price proposals. By adding a price adjustment provision that suits the project and is benchmarked to a predetermined price or commodity index, prices can be kept within an agreed on range, allowing for an adjustment up or down based on the occurrence of stated events. In other words, greater transparency and risk allocation may result in lower prices. This type of provision is used commonly in the government procurement world, particularly on items such as fuel or asphalt. A price escalation clause can also work in private contracts with materials such as reinforcing steel, structural steel and the like.

To address owner concerns about taking on all the risk of price increases, it is important that contracts with price escalation provisions also include safeguards such as owner audit rights on cost documentation. It may also be appropriate for the parties to consider other contract options as well. For a price adjustment clause to work, transparency has to be a paramount aspect of the parties’ contractual relationship.

A similar contract approach to handle price fluctuation is budget allowances. An allowance caps the contractor costs at the stated budgeted line item. Costs beyond the budgeted allowances are borne by the owner; costs below the allowance item accrue to the owner. Contract budget allowances that are properly administered allow the owner to attain the desired product, service or system while protecting the contractor for owner selections outside of budget parameters. The concept is similar to a price escalation clause but allows more flexibility and can be used across a greater range of products, equipment or services.

Another option is the use of a budget contingency to address price increases. The contingency should be established at the outset of the contract. The contingency provision can be drafted to include a range of budget variables including price increases. If those increases do not materialize, the owner can allocate the contingency to other costs or as a credit to the project budget. Again, discussing this issue at the beginning of the project and memorializing the parties’ understanding in the contract establishes a level playing field and predictability for the owner and contractor alike.

To the extent that these contract modifications are not possible, contractors and subcontractors should consider another strategy to mitigate against cost increases: time. It is common to put time limits on price quotes. Instead of 30 days or more, why not push for shorter durations for leaving bids or proposals open? That, in tandem with an explicit reservation to adjust prices after that stated time period expires, should leave contractors and subcontractor less exposed to price jumps for shorter periods of time.

Before signing on the dotted line, participants in the construction market should review the contract carefully and understand how risks of price escalation are allocated. Transparent assessment and allocation of these risks provide benefits to the contractor in that it will not suffer losses outside its control due to commodity price changes. In turn, the owner benefits by knowing that the bid prices are not being unreasonably inflated as a guard against price escalation that may not actually occur. Often, frank discussion about these issues results in shared risks and reward and, ultimately, a more successful project.