A Key Battleground: Material Price Escalations and Supply Chain Disruptions

Colm Nelson | Stoel Rives

Material price escalations and supply chain disruptions are hot topics in the industry, with many clients inquiring about their rights and how these risks should be shared. Some have even questioned whether their projects should proceed given the volatility in the market.

For instance, I saw at least one project’s price increase by over $10 million in a matter of months due to the precipitous price increase in lumber. The resulting sticker shock was mitigated somewhat by the recent drop in lumber prices. However, the developer and contractor team were not alone in asking whether the project should proceed and, if so, who carries the risk of future price changes and/or supply chain delays.

Generally speaking, under a standard Guaranteed Maximum Price (GMP) contract, such as the American Institute of Architects’ A102/A201 combination, the contractor is guaranteeing its price against price escalations – i.e., this is a contractor risk. This risk allocation can be adjusted through a variety of methods, including the use of: 1, allowances; 2, contingency; 3, savings bonus; or 4, specifically tailored risk-sharing provisions, addressing both compensation adjustments and/or time adjustments.

How allowances and contingency work in concert, and what those terms mean, differs even among sophisticated contracting parties. For many in the Pacific Northwest, an allowance is merely a placeholder for the expected “Cost of the Work.” If the allowance item costs more than the placeholder, the GMP is increased. If it is less, then the owner should get a deductive change order.

However, industry standard forms like the AIA A201 don’t treat allowances this way and in fact state that “Contractor’s costs for unloading and handling at the site, labor, installation costs, overhead, profit and other expenses contemplated for stated allowance amounts shall be included in the Contract Sum but not in the allowances” – i.e., no increase in the GMP for additional time or labor related to the allowance item.

Under the AIA approach, the contractor would get more, for example, for the price of the door, but wouldn’t be allowed to seek an increase for the time it took to install it. Contingency for some owners and contractors is simply padding to cover additional costs of the work until the GMP ceiling is exhausted. For others, contingency is solely for discrete items, and only to be used upon advance written approval by the owner. Many contractors prefer to list price escalations in materials as an approved use of contingency.

When contract discussions become logjammed over risks that neither party can control, finding an outcome where both the owner’s and contractor’s interests are aligned is sometimes the best way to advance discussions. That often means a sharing of risk to some degree, full transparency by both sides, and even sharing in any savings for effective materials and subcontractor buyouts. Alternatively, if the owner is not willing to share in the risk, which is not uncommon, it should expect the contractor to ask for a higher fee for taking on that risk, or price padding on certain line items.

Supply chain disruptions and resulting delays are treated differently and separately from price escalation risks. Unusual delay in deliveries is generally a basis for a contract time adjustment under most industry-accepted contracts. This is important to contractors because, without the adjustment, they could face liquidated damages or other delay liability.

Who pays for the extended costs resulting from the delays is a more difficult question and not squarely addressed in the AIA A201. Owners feel they are already losing money because of the late delivery (time is money), and contractors question why they should carry the costs.

Historically, given the economic risks to the owner resulting from delay, contractors typically agree to limit their recovery to a time extension and/or expressly negotiate a contingency line item to cover this risk. Also, because contractors are in a better position to control timely subcontractor buyouts and coordination of work among subcontractors, including through the use of float, some argue that contractors should carry this risk. In other words, the party in the best position to control a risk should be the party who bears it.

While not uncommon in other industries, insurance products to cover price escalations in materials are not commonly used in the construction industry. However, sensing the stress in the marketplace due to lumber prices, insurance products are now being offered for those interested in “hedging” risk against future price fluctuations. As we work through the consequential effects of the pandemic on supply chains, it will be interesting to see if the use of these products proliferates through the market. As with bonds, which are rarely used on private projects below $100 million, the cost and ability to timely collect on such products will dictate whether owners and contractors are interested in hedging their bets in this fashion.

Soaring Construction Material Prices: Tips for Reducing Ever-Increasing Costs

Freddy Munoz and Brett Moritz | Peckar & Abramson

The impact of these price increases is being felt across a wide spectrum of projects and is beyond what could have reasonably been expected.

Between the onset of the COVID-19 pandemic in March/April 2020 and mid-May 2021, lumber prices have risen an incredible 308% according to Yahoo News. Steel prices have also risen over 60% according to Trading Economics. These increases, among others, led the Associated General Contractors of America to issue a construction inflation alert, something that the group had not done since 2008. While the reasons for the price increases are too numerous for this article, the question remains: how can construction industry participants minimize the risk of ever-increasing prices?

The impact of these price increases is being felt across a wide spectrum of projects and is beyond what could have reasonably been expected. It is not just owners, contractors, subcontractors, and material suppliers on commercial and civil projects who are feeling the brunt of this price inflation—average consumers are also being affected. As an example, if you recently purchased a house or are in the process of a small renovation project, you have probably been impacted by the rapidly increasing materials costs. But how can the risks associated with the increasing costs be managed effectively to mitigate the risk is the question? This article provides a few recommendations.

  • Read and Re-Read Your Contracts

The first step in analyzing most risks, and particularly those associated with rising material costs, is to look at the document(s) that addresses which party bears that risk. In most situations, it’s the written contract between the affected parties. In the case of an owner and contractor it’s typically the prime contract. However, downstream agreements between the general contractor and subcontractors may also include risk shifting provisions that bear on these issues as well. Often, project personnel responsible for managing these issues may not even be aware of the relevant provisions in the pertinent agreement, in part because materials costs have not risen this quickly in over a decade. Therefore, a careful and thorough review of your contracts should be conducted by personnel with relevant training and experience to determine how the risk of escalating material costs are to be borne by owner, general contractor, Subcontractor, or even the vendors. 

  • Active Cost Monitoring (Project Meetings)

Recommendation number two can be summarized as follows: Be proactive! One of the best ways to handle this unique situation is to ensure that all project participants have the most complete and up-to-date pricing information before decisions are made. While it may sound simple, weekly, or even daily project meetings/conferences can help companies manage the process. Frequent meetings/conferences keep project staff focused on managing this risk by, among other things, keeping in touch with vendors, potentially allowing for opportunities to lock in prices early by buying out the critical material supplies as soon as possible and perhaps most importantly, shortening the decision making process. In situations where vendors and suppliers can or will only keep a quote open for short time periods, it is imperative for responsible project managers and representatives to be able to make decisions quickly with the requisite approvals needed internally. 

  • Preparation of Template Change Orders/Notice Letters

Regardless of the contract provisions at play, it is a good idea for companies to be aware of and plan for the preparation of proposed change orders and notice letters for increased materials costs. Again, it is important to review the relevant contract language, but it’s an equally important to prepare template change orders and letters so they are readily available and easy for the project team to finalize and send out when needed. This is especially important when it comes to notice letters because contracts may require notices be sent within very short timeframes from the discovery of the conditions giving rise to the claim or request for a change order. In those situations, template notice letters can be a life saver for the project team and especially where multiple notices need to be prepared and sent in or around the same time. Oftentimes, these template notices can also be modified and used for other unexpected conditions, including, for example, COVID-19 pandemic related issues.  

  • Negotiate Price Escalation Into Your Contract

Now more than ever before you should make sure that you are addressing price escalation risks in your contracts. Be creative. Consider allowing for price increases between the time the contract is signed and when material orders will generally be placed. This can protect you when material prices increase significantly after the contract is signed but before the materials are actually ordered. The better prepared and more proactive you are, the more likely that other parties will be willing to work with you to find solutions for these increased risks. 

It is highly unlikely that anyone can predict with certainty when materials costs will stabilize, but the more proactive you are in dealing with this situation, the better equipped you will be to deal with its impact. Also, consider that these strategies can be modified and applied to other potentially disruptive events that can unexpectedly impact a project.

Mitigating the Effect of Construction Price Escalations

Jeff Reichard | Nexsen Pruet, PLLC

Over the past year, the volatility of construction material prices has wreaked havoc on construction budgets and caused many disputes between owners, general contractors, subcontractors, and material suppliers. For example, lumber prices have tripled, PVC and copper prices have almost doubled, and certain material suppliers have refused to hold pricing for more than twenty-four hours. This begs the following questions: Who bears the risk of these price escalations, and how can construction stakeholders mitigate these risks? 

The answer to the first question depends on the terms of the contract between the parties.  However, the party procuring the materials, i.e. a general contractor or a downstream subcontractor or supplier, usually bears the risks of material price escalations in fixed-price contracts and guaranteed-maximum-price contracts unless the price escalation is caused by a condition that is otherwise addressed in the contract. For example, the AIA A201-2017 and ConsensusDocs 200 Owner/Constructor Agreement typically allow additional time for unavoidable delays associated with construction materials and arguably allow additional compensation for newly enacted taxes and tariffs, but they do not specifically address price escalations caused by unidentified market forces. In any event, the better practice is to specifically address price escalations during the bidding process and include price escalation clauses in your construction contracts going forward to mitigate these risks.

Mitigating the effects of price escalations should start in the bidding process. During the bidding phase of a project, contractors, subcontractors, and suppliers should identify which materials are most susceptible to price volatility and discuss them with the upstream contracting party. Downstream contractors and suppliers also should be wary of bidding requirements which require them to bear the sole risk of any price escalations and should modify their standard bidding forms and proposals to include general price escalation clauses. For example, a downstream contractor or supplier may include language in its proposal stating that any price increases after the date of the proposal are not included in the contract price and shall give rise to an equitable adjustment of the contract price and time.  If price escalation clauses are not included in the bids, contractors and suppliers may attempt to include allowances or large contingencies to account for potential price escalation or shorten the timeframe in which their bids are open for acceptance. Including price escalation language in a bid also may benefit the owner because it may reduce the bid amounts since large contingencies for potential price escalation can be avoided. 

The best way to mitigate risks associated with material cost volatility is to include price escalation provisions in your contracts. There are many different types of price escalation provisions that can be included in a construction contract, but the three most common types are: (1) any-increase escalation clauses, (2) threshold escalation clauses, and (3) delay escalation clauses.  Under the first type, a downstream contractor or supplier is entitled to reimbursement for any price increases that occur after the signing of the contract or submission of the bid. These provisions often identify the specific types of materials which are subject to the clause and set baseline prices for those materials. This also can be accomplished through allowances. Threshold escalation clauses, on the other hand, only allow the downstream contractor or supplier additional compensation for price escalations which exceed a certain percentage or dollar amount. A threshold escalation clause also may include a cap on the total amount or percentage increase allowed. For example, the Federal Acquisition Regulations (FAR) allow price escalation clauses in certain circumstances, but FAR §§ 52.216-2 and 52.216-3 default to a 10% maximum allowable increase in the contract price. State public project standard specifications may also include price escalation provisions. Like any-increase clauses, threshold escalation clauses typically identify the specific types of materials that are subject to the clause and include baseline prices, which often are tied to actual pricing, a published material cost index, established catalog pricing or other objectively verifiable ways to identify cost and market fluctuations. An example of a standard-form threshold price escalation clause is the ConsensusDocs 200.1 Amendment No. 1 Potentially Time and Price-Impacted Materials. The third general type of escalation clause, which is known as a delay escalation clause, holds a fixed price for a limited period of time and allows the downstream contractor additional compensation if the project is delayed beyond a given number of days or a specified date. It is intended to reimburse the downstream contractor for increased costs that occur during the delay. Of course, each of these types of price escalation clauses can be modified to provide more protection for an owner, contractor or supplier. We suggest consulting with an attorney to help craft a provision that is best for your situation. 

The price escalation provision included in the final construction contract often is the product of negotiation between the parties. For instance, Owners may require that a price escalation clause includes a cap on the amount or percentage of price increase allowed and ensure that the contract sum is decreased by any price decreases which occur after the contract is executed.  Owners also may request that contractors provide support for their contract prices, such as actual subcontractors’ bids, building cost indices, or catalog pricing, to ensure they reflect accurate market prices and specifically reference them in the contract. On the other hand, downstream contractors often would rather include broad price escalation provisions which do not limit their ability to receive extra compensation for any differences in pricing between their bids and the final costs incurred to procure the materials. 

Downstream contractors also can mitigate their risks during the construction and procurement phase of the project, regardless of whether a price escalation clause is included in the contract. For example, a contractor should regularly monitor its costs in relation to its estimate and provide notice of any price escalations as soon as they are identified and, in any event, no later than is required by the terms of its contract. A contractor also may mitigate some of the effects of potential price escalation by purchasing materials with the most volatile prices as early as possible or purchasing materials for multiple projects at once. However, early and/or bulk purchases may cause increased storage or material handling costs. As always, prompt and early communication is important to address and perhaps avoid a dispute related to cost escalations during the construction phase. 

Whether your project is in the design phase, contracting phase or construction phase, it is better to proactively implement the changes suggested in this article now than to procrastinate until price escalations affect your bottom line.