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Protecting Yourself from Rising Material Costs

Current economic conditions and shifts in public policy by the Trump Administration concerning tariffs on imports have the potential to dramatically impact the prices of certain materials critically important to roadway construction projects, namely fuel, steel, and asphalt. Although fuel, steel, and asphalt prices have fluctuated significantly over the past 10 years, it appears that prices will continue to rise over the next several years (and perhaps beyond). This article provides risk management strategies for contractors seeking to mitigate the impacts that rising materials prices have on profitability.

Sharing the Risk

Contractors that execute a lump-sum contract (in the absence of specific language addressing price escalation) generally assume the financial impact of fluctuations in material prices. As contractors well know, once the lump sum contract is executed, the contractor is committed to the original price. Although a  contractor stands to benefit if material prices decrease, in the more likely scenario of rising material prices, the contractor’s contingency, overhead, and profit may all be at risk. Accounting for this risk at bid time may not be an easy task. At times, prices may fluctuate rapidly, making it extremely difficult for a contractor to accurately assess and account for this risk before submitting the bid or proposal. Of course, the obvious way to address the risk of price fluctuations is to include a significant contingency in the bid; however, this is likely a longterm losing strategy in a highly competitive industry where the margin between a winning and losing a bid may be 1% or less.

In the absence of a massive contingency, how can contractors protect themselves from rising material costs? One strategy is “sharing” the risk by including a “material escalation” clause in the upstream contract.

Material Escalation Clauses

The basic principle of drafting and negotiating construction contracts is to fairly and appropriately allocate risk to the party in the best position to handle and manage that risk. The degree to which a contractor may be protected from the significant risk of rising material costs (or exposed to this risk) depends on the language in the contract.

There are three basic types of escalation clauses: (1) a “day one” escalation clause, (2) a “threshold” escalation clause, and (3) a “delay” escalation clause.

A “day one” escalation clause requires the upstream party to pay for any increases in material costs once the contract is executed. This type of escalation clause states:

The prices of materials contained in this contract are those in effect as of (date); Contractor shall be reimbursed for all increases in the cost of material as of the date of purchase plus overhead and profit.

The contract must define exactly what materials are subject to this clause (e.g. structural steel, rebar, concrete) as well as the baseline prices for those materials.

Although a “day one” escalation clause allocates all risk to the upstream party, a “threshold” escalation clause shares the risk by requiring the upstream party to pay for material price increases above a defined threshold:

In the event the price of certain materials (e.g. structural steel), increases 10% between the date of this contract and the date of installation (or purchase by the contractor), the contract sum shall be equitably adjusted by change order in accordance with the procedures of the contract documents.

In this example, the contractor is reimbursed only for significant price increases which occur between the bid (or contract date) and the date of installation or purchase or materials. This clause shifts the risk of significant price increases to the upstream party, but vests the contractor with the risk of price increases up to the threshold level, effectively capping the contractor’s potential exposure.

Finally, delay escalation clauses hold a fixed price for a limited period of time, but allow the contractor to receive an equitable adjustment if the project is delayed or, more commonly, it is not feasible to purchase all materials for the project at the start of construction. A delay escalation clause typically states:

This Contract contemplates that the Contractor will complete its work by (date). In the event the Contractor’s work is not completed by that date, through no fault of the Contractor, the Contractor shall be reimbursed for all increases in the costs of the following materials: (e.g. steel, asphalt) plus overhead and profit.

Other Strategies for Managing Risk

Contractors may not be able to negotiate and include cost escalation clauses in upstream contracts, especially for public contracts that leave little room for negotiation.

Under these circumstances, contractors can still protect themselves by implementing these strategies:

  • Limit the time underwhich bids and proposals may be accepted. Depending on the size and scope of the project, a small increase in material prices can have a dramatic impact on profitability.
  • Attempt to lock in suppliers early and at fixed prices. Shifting the risk downstream to the supplier can be a successful strategy.
  • Limit the suppliers’ rights to only those rights the contractor has upstream for material price increases. Alternatively, limit the suppliers’ ability to raise prices to a fixed amount, thereby capping the risk.
  • Buy early. If it is feasible to buy, ship, and store materials before they are needed, purchasing materials at current prices limits future exposure to price increases.

Conclusions

Rising material prices present a serious and significant risk. Contractors can address this risk head-on by negotiating price escalation clauses into their upstream contracts and by implementing other strategies in the bid/subcontracting/procurement phases of a project. Risk identification and management is the key to successfully handling the impact of rising material prices.