Don’t Let Price Escalation Hurt Your Bottom Line: How to Use Your Contract to Protect Your Profitability

By: Jackson S. Nichols and Nicholas F. Morello

Over the past two years, escalating prices of materials, equipment and construction components have created huge challenges for all types of construction companies. According to Construction Dive, after the temporary shutdown of supply chains in 2020 due to the COVID-19 pandemic, increased demand created supply shortages that led to a 24% increase in material prices, the largest annual spike of input prices since the data collection began in 1987. In 2021, many products like steel pipe and tube, structural metal, and metal bar joists experienced a price increase of more than 50%. Softwood lumber prices spiked almost 24% in December alone. These price jumps have created a hoarding effect for many contractors who are over-ordering materials based on a fear of future delays and increased prices.

With rising inflation and uncertainty in the global supply chain due to the war in Ukraine, unfortunately, the recent supply chain volatility is expected to continue for the foreseeable future. Senior analysts with the Gartner Supply Chain practice , causing prices to spike due to shortages and hoarding, similar to price spikes due to COVID-19. Construction Dive adds that Russia is a major producer of aluminum and copper, which had already surged 33% and 25%, respectively, year-over-year in January. In addition, Dun & Bradstreet’s new report notes that at least 374,000 businesses worldwide rely on Russian suppliers and at least 241,000 rely on Ukrainian suppliers, with over 90% of all of these businesses based in the U.S.

While it is difficult to estimate how much price escalation will occur and which materials will be most affected, experts agree that the conflict in Ukraine will further stress the already fragile global supply chains. Accordingly, prudent contractors and subcontractors can and should take certain steps in their contracts to protect their bottom line against such volatility and to avoid a potential dispute.

Future Contracts

One of the best tools a contractor has for addressing price escalation is an escalation clause. An escalation clause proactively contemplates changes in costs, fees and other payments. Contractors and subcontractors should attempt to include an escalation clause in all of their upstream contracts with owners or higher-tiered contractors. In doing so, there are several different types of clauses that can be used, each with its own advantages:

• Standard pro-contractor clause: A standard clause will state that in the event of a significant price increase of materials or equipment during the performance of the contract through no fault of the contractor, the contractor is entitled to an equitable adjustment of the contract sum and time of completion, which will be handled through a change order. If desired by the parties, a “significant price increase” can be further defined as an increase in price of more than a certain percentage between the date of the contract and the date of purchasing the materials. Additionally, a contractor and owner may choose to split the escalation past a certain percentage.
• Pro-owner clause that still allows for escalation: In addition to a standard escalation clause, an owner may choose to put additional requirements on permitting a contractor to recover for escalated prices. For example, an owner can state that to receive an escalation change order, the contractor must share with the owner a list of estimated costs for materials that may be subject to escalation before signing the initial agreement. Then, before purchasing any of those items on the list, the contractor must obtain at least three proposals or quotes from suppliers. If an escalation change order is issued, then the lowest must be chosen. An owner can also limit overhead and profit markups on the materials in which escalation is necessary. This type of provision puts stricter guidelines on the contractor and ensures that the owner is getting the best deal possible, but does not force the contractor to assume the entire burden of the price escalation.
• Price adjustment through an index: If the market price of an item can be readily determined through a public price index, parties may choose to include a formula in an escalation clause that references an index. The Virginia Department of Transportation, for instance, maintains Price Adjustment Indices for asphalt and fuel, as do other states. For a project in Virginia with a major expenditure of asphalt and/or fuel, it may be feasible to include a provision that if the price reaches a certain threshold on the index, the owner will pay for the increased cost of materials.

For downstream contracts, owners and contractors who want to maximize their protection against price increases can include a “no escalation clause” in their contracts. Such a provision specifically disallows the contractor or subcontractor from receiving any additional money for increases in prices that may occur as the project progresses. While this may generate push-back, it may still serve as a good starting point for negotiations.

Existing Contracts

For contracts that have already been signed, there are still ways for contractors to protect themselves. Contractors should review their contracts to determine if there is a price escalation provision. They should also consider adding language to change orders and payment applications specifically stating that the contractor will not pay for materials or equipment affected by industry-wide price escalations. Although the contract may not specifically address price escalation, providing repeated notice that you will not pay for materials and equipment with escalating prices can give you the upper hand in subsequent negotiations or litigation, particularly if this language is not objected to during the project.

Conclusion

The volatility of markets worldwide is affecting almost all industries, and construction firms can expect these conditions to persist for some time. By following the guidance above, contractors can help protect themselves against paying exorbitant fees for materials as prices fluctuate. Contractors should engage legal counsel to discuss the best options for protecting themselves from future escalations.

Jackson Nichols is a partner at Cohen Seglias, where he advises general contractors, subcontractors, sureties, owners, and other construction industry businesses in navigating disputes that arise during projects. He helps clients navigate day-to-day legal and business issues, mitigating risk and working to resolve disputes. Jackson can be reached at jnichols@cohenseglias.com.

Associate Nicholas Morello drafts, analyzes and revises agreements essential for business transactions, advising clients on potential risks and ensuring compliance with state and federal regulations. He can be reached at nmorello@cohensglias.com.