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Pricing uncertainty in the construction industry is one of the great risks of hard bid jobs. Guess right, you make a profit. Guess wrong, you lose money. The longer the duration of the project, the more price uncertainty and the greater the risk of guessing wrong. Consider the following.

• The current administration has imposed or is threatening to impose a 25 percent tariff on imported steel and a 10 percent tariff on aluminum;
• Although arguably slowing down, there has been a boom construction market, particularly in Texas, coupled with a skilled labor shortage in which workers are willing to move for higher pay and better hours; and
• Oil prices have slowly been creeping up causing increases in the prices for gas, diesel, asphalt cement and other critical construction materials and components.

Prices for other construction commodities, such as concrete cement, have also been on the rise. So what is a bidder to do?

1. Price Adjustment Clause

The first and perhaps most common strategy is the use of a material escalation or price adjustment clause (PAC). Typically, PACs are used on projects that will last a year or more where there is price uncertainty for a commodity. A 2012 study by the Texas A&M Transportation Institute noted that 47 state Departments of Transportation (DOT) have used some form of PAC.

Materials subject to the PAC are typically separately priced from installation cost. The price of the material at bid time is used as the base line cost for the material and tied to some sort of index. As the index fluctuates, the material price is periodically adjusted. This may be on a monthly, quarterly or annual basis. Quarterly may be preferred because the timing is not overly burdensome but still allows the contractor to periodically capture additional amounts owed for the material or the owner to periodically capture overpayments.

Various indexes can be used. For example, the U.S. Department of Labor’s Bureau of Labor and Statistics publishes Producer Price Indexes (PPI) for various types of materials used in construction on a monthly basis. Using a simple formula, a percentage increase in the average price of a material with a published PPI can be derived over time.

Many PACs contain a threshold before a price is subject to adjustment. Typically, this is one to two percent before the adjustment clause is triggered, but higher thresholds exist. Wisconsin DOT, for example, uses a fifteen percent threshold for fuel used in certain pay items. Regardless, once the threshold is exceeded, the price paid per unit of material can be adjusted upward or downward. Some clauses do not kick in until after the first year of performance—the bidder guarantees the material pricing for the first year.

In two way clauses, if the owner is willing to take the risk of an increase in material cost over time, the owner should also receive the benefit from a decrease in material cost over time. On a private project such as an industrial facility, use of a two way clause makes adoption of the clause an easier sell to the owner.

PACs can be used for labor rates too, provided a baseline is established. What owner wants to risk a delay to completion because a key foreman is shopping his crew to the job next door that pays a few dollars more per hour?

2. Allowances

Although rare for public works contracts, many private construction contracts contain allowances. An allowance is typically a place holder in a schedule of values that is subject to adjustment based on actual cost incurred for the allowance item. In a market where some material costs are highly variable, using an allowance in lieu of a hard bid number for the price of a material (structural steel or rebar, for example) eliminates the risk of price volatility for the contractor. In return, the owner receives the benefit of price decreases and better bids with less contingency.

3. Force Majeure

When confronted with a sudden price change, contractors should review any force majeure provisions in their contracts. Force majeure translates to “superior force.” Generally, changes in market conditions are not considered force majeure events. However, when the source of the change is due to an act of government, a material shortage due to a hurricane or some other catastrophic event, depending on the language, it may be applicable. If your force majeure clause contains a “changes in law” provision, the clause may entitle a contractor to price relief based on the recently imposed steel and aluminum tariffs. This will, of course, depend on the contract and the lawyers’ interpretation.

4. Hedges

Most commodities that are traded can also be hedged. This involves purchasing or selling commodities futures to ensure stability of future costs. Southwest Airlines was able to remain profitable during the 2000s, notwithstanding high fuel prices, because it hedged its fuel costs. The same can be done for a large contract that requires the operation of heavy equipment or purchases of steel or cement over a period of years.

Advice

Gazing blindly into a crystal ball is fraught with risk. While predicting the future with certainty is not possible, there are steps that contractors can take to minimize the risk of increasing construction input prices. The key is to recognize the potential for price variability—whether labor or specific materials—before commitments are made. Once the price variability risk is recognized and assessed, the contractor can employ one or more of the tools and strategies identified in this article to mitigate the risk.

The likelihood of obtaining relief under a silent contract that does not address the subject of price variability is low. Obtaining express terms addressing the risk of price variability in the construction contract is a key component of the strategy to manage risk. Contractors should seek the advice of an attorney experienced in construction law to formulate a strategy for addressing price variability, including the development of appropriate language for their contracts.