The Contractor's Compass - July 2022

LEGALLY SPEAKING

Supply Chain Woes Don’t Have to Be Contracting Foes: Tips to Navigating Price Escalations

by Melissa Ogburn, Hall Booth Smith, PC

As I was talking to a friend the other day, he reminded me that it was not all that long ago that subcontractors were able to offer price guarantee estimates and bids. Now, it seems like materials costs are increasing on a weekly, if not daily, basis. How can we effectively estimate a project that is going to take longer than a week to construct, he asked. That got me thinking of some of the more recent contracts I have seen and revised, and some of the provisions we have crafted to handle the emergent problem of material cost shortages and price escalations.

To start, we can all acknowledge that the COVID-19 Pandemic has brought not only new challenges to the construction industry, but it changed the way the business is conducted altogether. As businesses and economies shut down in an effort to stop the spread of the virus, disruptions erupted across supply chains, including industry-wide material shortages. All across the United States, construction trades have been affected, and still are. Materials are in short supply and when materials are available, their delivery is often delayed. The inadequacy of supply has led to rocketing and volatile

prices, making estimating new jobs a near impossibility.

In an effort to control their own costs and budgets, contractors and property owners have historically been reluctant to agree to contract provisions that allow for fluctuations in pricing during the course of construction. Where materials are available and pricing is stable, offering not-to-exceed pricing or guaranteed pricing may be achievable. On the other hand, subcontractors and construction trades may not be able to absorb gross fluctuations in pricing and

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price escalation clauses are becoming more common. This article discusses four price escalation clauses and methods that may be used in construction bids and contracting that account for the unpredictable market and surging prices: the bucket method; risk-shifting provisions; storage upfront costs; and shipment re-pricing provisions.

Bucket method

Under the “bucket method” of pricing, subcontractors apportion construction costs into various categories according to certain criteria, usually stable pricing and unstable pricing. For example, there may be one “bucket” or category for labor and a separate “bucket” or category for materials. Even within the materials category, there may be separate buckets to account for the different types of materials needed for a construction project. The goal in the bucket method is to factor out those items that are likely to change in pricing during the course of construction while offering stable or not-to-exceed pricing on others. Where labor is a more stable price, the labor bucket may be a separate and distinct cost that can be guaranteed. On the other hand, where certain materials are likely to increase in costs, the materials bucket may be agreed upon at the time of contracting as a variable price. For any variable pricing, the contractor may agree on a passthrough cost with a percentage attached to account for overhead and profit. Taking the example above, a contractor may agree on a set price for labor and also contract for a separate calculation applicable to material costs, such as the manufacturer or supplier cost, plus 15%. It will be important during contract negotiations and during the construction of the project to be transparent and forthcoming regarding any fluctuations concerning pricing. It may be important to agree upfront to share invoicing received from the manufacturer or supplier so that the contractor can verify pricing for any material cost increases.

Risk-shifting provisions

In a risk-shifting contract, any price escalations are shifted to be the responsibility of the contractor

(and perhaps ultimately the property owner) upon a threshold limit. With these types of clauses, the contractor and subcontractor typically agree on a threshold limit under which the subcontractor absorbs the increase and over which the increase is either shared or shifted to the contractor completely. For example, a contractor and subcontractor may agree that any material price increases that occur after execution of the contract and which result in costs in excess of 10% above the contracting price are paid by the contractor completely. In this scenario, the subcontractor agrees to assume the increase up to the 10% limit. Any increases over that amount are paid by the contractor. The risk-shifting provision allows both the subcontractor and contractor to share in the risk of cost increases. In other risk-shifting provisions, the parties may agree to split the cost. Under this scenario, the subcontractor may still agree to absorb the increase for the first 10%; any increases in the 10% - 20% range may be shared mutually; and any increases beyond 20% are paid by the contractor. While contractors may not like to pay for the increased costs of materials, property owners should be made aware of the volatility of the markets so that a fair bargain may be had at the conception of the construction project.

Storage cost clauses

Another way to limit the risk and exposure of increased materials costs during the course of the construction project is to purchase all materials at the front end. For some trades, this may be more easily achieved than others. Some subcontractors may simply not have room to store all materials needed for an entire project and they may be more accustomed to purchasing the materials needed as the construction project progresses. This is especially true for large, phased projects. With a storage cost clause, the subcontractor can purchase all of the materials needed at the very beginning of the construction project in order to guarantee material costs and pricing. However, the parties would then need to decide how storage costs associated with storing the

materials for the project will be handled. It may be a cost line item included in the subcontractor’s bid, or it may be a separate obligation undertaken by the contractor. When using a storage cost clause, it is important to delineate responsibility for selecting the storage site, how routine storage fees as well as any penalties imposed by the storage facility will be handled, and how to terminate the storage agreement.

Shipment re-pricing provisions. In a shipment re-pricing agreement, the parties agree to adjust the price of materials upon shipping, or sometimes ordering, of the same. Here, a subcontractor would agree to provide a quote and pricing based upon current market conditions. However, the parties would agree to adjust the price of the materials based upon the actual cost of the materials at the time the materials were actually purchased or shipped. This provision places responsibility on the contractor to pay for any fluctuation of pricing based on the current markets. It is similar to the buckets method described above, but it is typically limited to adjusting price for limited or specific materials and shifts all cost increases to the contractor upon a certain event such as shipment.

Whatever method you may choose, I told my friend, just remember to be upfront and honest with the contractor. Never agree to a contract you ultimately can’t afford or can’t perform, and never be afraid to ask for a revision to the contract. After all, you’ll never know what you might get if you never ask for it. As John F. Kennedy’s once said: “Let us never negotiate out of fear, but let us never fear to negotiate.”

About the Author

Melissa Ogburn is a Partner in the Denver office of Hall Booth Smith, PC. She has two decades of legal experience with a concentration on construction, insurance and liability. Melissa regularly represents construction companies in contract negotiations, construct defect claims, and payment disputes. She can be reached at: 303-874-3494 or MOgburn@hallboothsmith.com.

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