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