Managing Commodity Price Escalations

Managing Commodity Price Escalations

How electrical contractors can learn to anticipate price changes on materials

What do steel, copper, aluminum, cement, petroleum, natural gas, lumber, and gypsum all have in common? Ask most electrical contractors or suppliers involved in construction that question, and you'll likely get the same answer — that their price fluctuations are wildly unpredictable. Such volatile pricing escalations inevitably pose challenges in terms of settling on a final bid price. Depending on the contractor, the strategy for overcoming this obstacle varies.

Do you plan for a price increase and include that contingency in your bid, possibly causing you not to get a job? Do you include a price escalation clause in your proposal/contract to cover unforeseen cost variations? Or, do you just ignore the issue entirely and hope for the best?

Most jobs you bid on are based on a fixed price, calculated on material price estimates made before the start of the project, even though it may take a year or more to complete. Therefore, it's logical to expect material prices to rise from bid time to completion. Although you can't anticipate or estimate major price variations, you can protect your company and the outcome of the job in question by being more proactive.

Contributing factors

What has caused this level of volatility in commodity pricing? Many world events have changed the commodity market. For example, rapid economic development in Asia (especially China) has stressed the market for steel. China consumes about 25% of the world's steel, and it's willing to pay top dollar for it. Then there's the steel that went to build the infrastructure for the 2010 Olympics in Vancouver and the 2010 World Games in Austria. Growth in other parts of the world, such as India, Russia, and the Ukraine, have also limited exports from these countries in order to meet their own domestic demand.

In addition, storms and natural disasters impact the commodity market. For example, Hurricane Katrina and other storms that hit the Gulf Coast region over the last few years have stressed the market for PVC. Material shortages, high energy and transportation costs, coupled with consolidation of production facilities, contribute to price increases as well.

The bottom line is that the magnificent rise in commodity pricing over the last several years has resulted in market changes, such as job-site theft, lack of firm price quotes, higher project costs, delayed or canceled projects, increased litigation, liquidated damages, and extended overhead.

Escalation clauses

There are a number of things you can do to help combat and manage price escalations. By being proactive in the pre-construction phase, you can add a material cost escalation clause into your proposals/contracts. This approach should be based on specific cost indexes for specific products reaching a specific price point. Doing so avoids large contingencies you would have to build into your bid price. On the flip side, if your company chooses not to address the issue of material price escalation, a number of scenarios could occur. A retroactive quantification of material price escalation will involve “forensic” material escalation analysis, using cost indexes, material lists, and trigger points not quantified in advance.

Essentially, a material escalation clause shifts risk from a supplier of goods and services back to the owner. Fair and efficient sharing of risk can save many projects from future legal battles. If you communicate the unexpected in advance, the unexpected becomes the expected — leaving less room for the dreaded surprise.

Material escalation clauses can be “cost-based” or “index-based.” A cost-based clause compares actual incurred costs with initial bid costs. The Association of General Contractors (AGC), Arlington, Va., has handled material cost escalation with the following cost-based clause. AGC Document No. 200.1, Amendment No. 1, requires “the parties to establish a series of baseline prices for material identified by them as potentially ‘time and price’ impacted and to provide a method for adjusting the contract price as a result of fluctuations in those baseline prices.” An index-based clause tracks and adjusts prices based on numerous existing material price indices, such as the Producer Price Index (PPI) published by the Bureau of Labor Statistics.

It makes sense for a general contractor or construction manager to provide some relief for unforeseen material escalation to a subcontractor that's experiencing extraordinary price increases rather than face the reality that the sub may not be able to finish the job, ultimately requiring the GC to find a replacement contractor.

Relief clauses help avoid claims, breach of contract, or contract termination, which saves everyone time and money. A replacement contractor will pass the price escalations onto the owner anyway — and probably won't guarantee the previous contractor's work. Time delays due to remobilization and a drop in job quality are possibilities as well. Owners who allow a price escalation clause are wise, because it's unlikely the sub will be able to avoid price escalations altogether.

Following is a sample material escalation clause you may want to use on future projects. “If during the performance of this contract the price of significantly increases, through no fault of contractor, the price of shall be equitably adjusted by an amount reasonably necessary to cover any such significant price increases. As used herein, a significant price increase shall mean any increase in price exceeding % experienced by contractor from the date of the contract signing. Such price increases shall be documented through quotes, invoices, or receipts. Where the delivery of is delayed, through no fault of contractor, as a result of the shortage or unavailability of , contractor shall not be liable for any additional costs or damages associated with such delay(s).”

Federal statutes

Some contracts, especially those for state and federal procurement and public works, contain escalation or price adjustment clauses. Federal Acquisition Regulation FAR § 16.203-2 allows for “fixed price contracts with economic prices adjustments to be used when there is serious doubt concerning the stability of market or labor conditions that will exist during an extended period of contract performance.” FAR § 16.203-2 recognizes three types of escalation clauses, including adjustment clauses tied to established prices, adjustment clauses tied to actual costs versus bid prices of labor or materials, and adjustment clauses tied to indexes of labor or material. The concept behind these is that the government agency ultimately will save money when contractors cannot predict commodity prices with assurance, because the agency will avoid the large contingencies contractors would need to build into their price quotations.

If a contract in which the provision of goods predominates, the Uniform Commercial Code UCC § 2-615 excuses performance if the rise in cost is due to some unforeseen contingency, such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply, or the like, which either causes an increase in cost or altogether prevents the seller from securing supplies necessary to his performance. If a contract involves providing services as well as goods to a job site, the UCC will not apply.

Finally, the American Institute of Architects AIA Article 4.36 allows a contractor to make a claim for additional compensation if he incurs additional costs for several stated reasons and “other reasonable grounds.” In addition, AIA Article 8.3.1 states that “contract time shall be extended if contractor is delayed for labor disputes, fire, unusual delays in deliveries, unavoidable casualties, or other causes beyond his control.”

Managing material escalation

In the course of negotiations, what if the owner will not agree to a material escalation clause? Purchasing materials in advance or buying material for several projects at once may be helpful. You can also try to get the owner to pay for the storage of materials in a bonded warehouse, which would eliminate future price escalations. Including a contingency budget or an adder to your bid would also cover future price escalations.

Monitoring your progress on a job will bring potential issues up early, hopefully avoiding profit loss or job stoppage. Strong pre-construction service is essential for setting costs, scheduling, determining alternative methods and solutions, and providing early identification of issues and risk management. In other words, while you might not be able to control the costs of commodity items, you can manage them. Historical escalation rates can also help you predict long-term material escalation rates.

There are a number of issues to consider when bidding a job in this tricky economy. First, you should address the issue of material price escalation during the negotiation phase of a project. Review and revise your proposals/contracts now, because procrastination will not pay off down the road. Another practical tip is to not wait until escalations begin affecting your project, your profitability, or your company's sustainability to try and convince the owner that he should absorb the price increases. Early and constant communication is the key to the success of any project, so involve the owner as early as possible on these types of issues, acting as partners to complete the job on budget and on time.

Candels is president of Candels Consulting, an electrical estimating consulting firm in Niantic, Conn. She can be reached at [email protected].

Sidebar: Legal Terms and Doctrines

If and when a contractor is faced with having to confront the owner with a material escalation issue, he may or may not have a legal battle ahead. Many lawyers rely on the Latin phrase pacta sunt servanda, which roughly translated means “the contract is law.” In other words, the contract binds parties to absolute liability for the unconditional contractual promise.

The term force majeure relates to when an event occurs that is beyond a party's control, which could lead to the non-performance of a contract. A contractor who attempts to use the force majeure clause in order to help with escalating material costs is likely in for disappointment, as it only allows a contractor additional time to perform rather than additional monies.

Additional legal doctrines a contractor may be able to use as justification for material cost escalation include:

Commercial impracticability deals with an unforeseeable change in a basic assumption upon which the contract was based. However, because commodity construction prices have been fluctuating widely since about the year 2000, this might be a difficult doctrine upon which to base your argument.

Impossibility happens when defects in the plans and specifications occur for which the contractor is not responsible. However, courts will not apply the doctrine of impossibility just because performance of the contract has become more expensive than previously anticipated.

Frustration of purpose must be a substantial claim, requiring demonstration of certain facts to satisfy legal criteria. This is difficult and rarely successful. A party's purpose of the contract must be completely, or almost completely, frustrated by a supervening event. Without it, the transaction would make little sense.

Regardless of a contractor's situation, the burden of proof lies with the contractor. Either the contractor has to make the owner/developer buy into the price escalation and compensate him for it through a change order, or he'll have to fight for it in court.

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