In the traditional “fixed price” or “lump sum” mode of contracting, a construction project must be delivered by the contractor for the agreed price, subject to whatever contract provisions may justify a price increase – and if increased materials costs are not one of them, the contractor bears all of the risk of those increases. In the “cost-plus-a-fee” or “time and materials” mode of contracting, materials price increases are generally passed on to the owner – but even here, guaranteed maximum price (GMP) provisions often cap the contractor’s ability to pass on price increases to the owner.
As a hedge against price increases on projects expected to last many months, some contractors buy the bulk of their materials as early in the project as possible, a strategy that works if storage is available at relatively low cost, and the purchases are immediately reimbursable (the AIA’s popular A201-2017 General Conditions, for example, allow for payment for materials store off-site “[i]f approved in advance by the Owner”). Another approach is to negotiate with subcontractors or suppliers to lock in prices for an extended period of time, thereby kicking the price increase risk downstream – but in the present volatile market, subs and suppliers are increasingly reluctant to hold their prices for long, typically not more than 60 or 90 days. Any delay in the start of construction puts the contractor in a tough position here.
One way to share the risk is through a price escalation clause in the parties’ contract, allowing some or all of a cost increase to be shifted from contractor to owner (or from subcontractor to contractor). Generally these clauses will have one of two triggers, either a delay or other event beyond the contractor’s control occurring during the project that pushes off the anticipated date of materials purchases, or a stated percentage increase in actual costs compared to some agreed benchmark. Often the benchmark is indexed costs, for example the producer price index or “PPI” published by the Bureau of Labor Statistics. Sometimes the benchmark is budgeted costs, i.e., the contractor’s actual buyout costs at bid time (or those of their subs if the subcontract prices are similarly allowed to fluctuate). That choice is more common in cost-plus contracts as a mechanism to increase the GMP than it is in fixed-price contracts, where the contractor is often reluctant to share its budgeted costs with the owner, thereby revealing its margins.
Owners go along with price escalation clauses for the same reason they go along with differing site conditions clauses; they want to disincentivize contractors from padding their bids to cover themselves for unknown contingencies. Uncle Sam was among the first to catch on, and for decades has authorized price adjustment clauses for fixed price contracts in the Federal Acquisition Regulations, 48 CFR § 16.203-1, as long as they are “based on increases or decreases in labor or material cost standards or indexes that are specifically identified in the contract.”
Whatever the chosen trigger, price escalation clauses are products of negotiation that can cabin the contractor’s ability to pass on price increases in various ways. I have seen clauses with floors (e.g., price increases below 5% will be absorbed by the contractor) and/or ceilings (e.g., price increases up to a limit of 15% can be passed on to the owner). I have seen clauses that adjust the contract price in both directions, affording the owner a price reduction if input costs decrease (probably a waste of ink in the present economic climate). And almost always the change order process must be invoked, with its timing limitations and waiver possibilities.
While price escalation causes are more common in commercial than in residential construction contracts, the National Association of Home Builders has put out a sample addendum for residential contracts. Worth a look..