A key factor for a contractor to consider in pricing its goods and services at an amount that is both palatable to the purchaser and profitable for the contractor is an astute evaluation of the underlying costs and any expected increases. Accuracy in evaluating and forecasting these figures is important because even a minor deviation could effectively render a profitable contract unviable. Of course the problem facing contractors is that a construction contract may cover a project spanning several years during which unforeseen circumstances, both micro and macroeconomic, may result in increases to costs that were completely unexpected at the time the contract was originally executed.
For example, in 2004 the price of steel rose 50-60% as opposed to prior years when it had remained flat or had even decreased. In 2005 the price of asphalt jumped 40% despite there only having been an increase of 4% over the course of the two preceding years. In addition to such dramatic increases in material costs, the construction industry has also been significantly impacted by the volatility and overall increase of fuel costs. The result is that contractors are left with no choice but to abandon those jobs that have been rendered untenable. This, in turn, has lead to the unfortunate fracture of sometimes long established business relationships and the onslaught of litigation. In an effort to avoid such a turn of events, more and more contractors are incorporating “price adjustment clauses” in their contracts.
The 3P’s of Price Adjustment Clauses – Protect Profits, Preserve Business Relationships, Prevent Litigation
These clauses take into account the current volatile nature of both materials and fuel costs and allow for a certain degree of flexibility as a response mechanism to price fluctuations over the course of a construction project. Three types of such adjustment clauses are generally considered and used to determine what triggers a price adjustment:
Price Adjustment Methods to Consider
Invoice method: This requires the contractor to produce documentation reflecting any increase in materials costs which may have occurred between the time the contract was signed and the time that the materials were actually purchased, passing same on to the owner.
Index method: Under this sort of price adjustment clause, certain material costs are tied to an index for that applicable commodity, allowing the contract price to fluctuate in accordance with any regional or local changes to the price index for that commodity. Contractors should be aware that unlike the invoice method (which passes on increases in costs), the index method can result in a loss (when the cost of materials decreases).
Hybrid method: This combines the invoice and index methods and is based on a “certified bid cost” where the contractor certifies its estimate of the costs of certain materials and/or fuel based on current supplier prices or an index price listing. If the certified bid cost changes by a pre-set percentage, the contract can be adjusted accordingly.
In the end, what contractor isn’t interested in protecting its profits, preserving its business relationships and preventing litigation? When drafted properly and equitably, price adjustment clauses can provide contractors some of this protection. Rather than solely bearing the burden of unforeseen and sometimes dramatic cost increases, contractors can look to share the risk as well as the possible benefits.