As you may know, material prices have been climbing. And they continue to climb based on the volatility of the material market. On top of that, there are lead times in getting material due to supply chain and other related concerns. The question is, how are you addressing these risks? These are risks that need to be addressed in your contract.
As it relates to climbing material prices, one consideration is a material escalation provision. The objective of this provision is to address the volatility of the material market in economic climates, such as today’s climate, where the price of material continues to climb. Locking down a material price today will be different than locking down the same price months from today. This volatility and risk impacts pricing and budgets. Naturally, an owner and contractor would like to be in a position to lock down supplier prices as soon as possible—both to secure pricing and to account for items with long lead times or that recent data forecasts a long lead time due to supply chain concerns. However, this is not always possible or practical and can depend on numerous issues such as when the owner contracts with the contractor, when the owner issues the notice to proceed (and permits are issued), final construction documents and revisions to the construction documents, the type of material, whether there is staging or storage available for the materials, and the current status including climitazation of the project.
With a material escalation provision, you are negotiating the risk of material escalations based on how this risk is addressed in your construction contract. This allows parties to be on the same page when a material escalation claim or price adjustment is submitted. Please make sure you work with construction counsel to draft, negotiate, and explain the material escalation provision to you.
If you entered into a fixed sum contract, the reality is that within that fixed sum the contractor should be factoring in this risk into the fixed sum. Under a fix sum contract, the sentiment is an owner is paying “X” for its project and whether the contractor can deliver the project for well under “X” or well over “X” is of no moment because the owner agreed to pay the fixed sum of “X” for the project. As a result, the contractor should bear the risk in a traditional fixed sum contract. However, contractors are trying to address this risk with allowance items by identifying in the contract certain items that constitute an allowance. If a contractor does this, they need to understand that they need to demonstrate the costs for the allowance items because if the cost is less than the allowance item, that amount is credited to the owner. If the cost is greater than the allowance item, than that overage would increase the fixed sum.
A cost-plus contract, on the other hand, is different because there is more transparency in costs than a traditional fixed sum contract. In a cost-plus arrangement, an owner is paying the cost of the work (inclusive of a contractor’s overhead-related items) plus a mark-up for profit. If the cost-plus contract does not contain a cap, known as the guaranteed maximum price, than the owner is going to pay the actual costs so that if there are demonstrated material escalations, that will be a cost passed on to the owner. A prudent owner however shall still require the contractor to demonstrate actual escalation costs (from time of contract to time of procurement) because the escalations should impact the contractor’s control estimate that forms the basis of the cost-plus without a guaranteed maximum price contract.
If there is guaranteed maximum price, then a material escalation provision is a must. (In my opinion, it is good to address this risk even without a guaranteed maximum price.)
There are numerous ways a material escalation clause can be addressed because it involves a negotiation on the frontend as to how the parties will address this risk. Here are some considerations:
- Do you want to address the specific materials / items subject to material escalations (e.g., lumber, PVC, steel, aluminum, copper, etc.)? This way the parties understand those materials / items where the provision can apply. In other words, how specific do you want to be in the material escalation provision?
- Do you want to consider certain pricing for materials? For instance, this contract is based on the specific pricing set forth in Exhibit “A,” and pricing that increases “Y”% from this pricing shall support the basis of a change order. The specified pricing is the budgeted pricing that forms that basis of the contract but any increase over that pricing over a certain percentage will result in a change order.
- Similar to the above bullet point, do you want to include an exhibit for certain material pricing and identify that this pricing is secured through a set date. Any material price increase beyond this date (or above a certain percentage) shall result in a change order.
- Similar to the above bullet points, if you are identifying certain pricing for materials for which the contract is based, what if the material prices decrease? Is the owner entitled to a credit?
- Is there a contingency in the contract and are buy-out savings rolled into the contingency? If so, does the contractor have full discretion to use the contingency to fund material escalations up to the balance of the contingency? Or, is there a separate contingency solely for purposes of material escalations that reverts 100% to the owner if there are no escalations?
- Does the contractor include allowances for certain materials such that there will be a decrease or increase in the contract amount based on the allowance items?
- Is the material escalations provision tied to delay?
A material escalation provision is grounded in fairness and allocating risk in an equitable manner. Do not neglect this discussion and including a material escalation provision in the construction contract.
Please contact David Adelstein at firstname.lastname@example.org or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.