Who Assumes The Risk of Material Cost Increases?On March 2, 2010 By Scott Wolfe Jr
Here’s the situation: During construction, the rise in material costs have impacted your ability to complete the project as originally bid.
Who is responsible for the change in material costs? The contractor or the owner?
Material Prices Are Going Up, Up, Up
While the economy has struggled for two years, material costs have remained quite steady in recent times. In fact, Ken Simonson, chief economist for the Associated General Contractors of America, documents a 2.3% decrease in material costs in the first 9 months of 2009.
Simonson speculates, however, that this drop in prices in materials is bittersweet. Between the months of October and November 2009, material prices rose 0.6%, and Simonson writes that the construction industry should treat this rise as a “warning call.”
Simonson is not alone.
The San Francisco Business Times reports that “Material costs continue to squeeze contractors.” Likewise, New Jersey Biz writes that “Spiking materials costs may puncture project prices.”
Prices Increases Creates Danger Zone for Contractors
The current economy presents a dangerous situation for contractors. On the one hand, material costs are on the rise. On the other hand, the lack of construction work makes the bidding process more competitive than ever.
So, how does a general contractor keep its bid low enough to win, without risking that price increases will render the job unprofitable?
This really boils down to the question of who is responsible for increases in material costs. If the owner, the project bid can be as competitive as possible given the current material costs. If the contractor, the project bid must take price increase into account.
Escalation Clauses In Contract
Here is the good news for contractors: there are ways you can protect yourself from being held responsible material price increases.
How? Well, your contract of course.
As every contractor and developer should know, the contract is the law between the parties. An “Escalation Clause” in your agreement will shift the burden of material price increases from the contractor to the property owner, or another party.
ConstructionExec.com has a great overview article on escalation clauses: Price Adjustment Clauses: A Solution for Dealing with Changing Material Costs. Or check out this equally good discussion at ModernContractorSolutions.com: Material Price Escalation Clauses: A Modest Proposal.
Essentially, if a contractor agrees to construct something for a lump sum price, the contractor typically assumes the risk of material costs increases. An escalation clause shifts this risk to the other contracting party.
Here is what it may look like:
The Contract Price is based upon construction material prices as of the execution of this Agreement. Any significant price increases in lumber, drywall, _______________, and/or other construction material that occurs during the period of time between contract execution and substantial completion of the Project, shall cause the contract price to be equitably adjusted by an amount reasonably necessary to cover any increase. As used herein, a significant price increase shall mean any increase in price exceed ____ percent (____%) experienced by the contractor from the date of signing.
Certainly, a contractor is motivated to have this type of provision in its contract…but why would the Owner agree? One reason an Owner may be interested in an escalation clause is that it would increase the Owner’s bidding pool and make contractors more comfortable to lower their bid amounts.
Responsibility for Price Increases When There Isn’t An Escalation Clause
So, price increases have affected your project’s bottom line and the contract doesn’t have an escalation clause….now what?
If you’re working under a lump sum contract, you likely have an uphill legal battle to get compensated for the unexpected price increases. While not the case law everywhere, most U.S. courts will take the approached expressed by the landmark Louisiana decision in Standard Oil Co. v. Fontenot, 198 La. 644 (1941), where the Louisiana Supreme Court stated that in a lump sum contract “It is possible that the anticipated and expected profit may turn into a loss because of a low bid or advances in the prices of materials or the cost of labor.”
So, how can you challenge this general principal? Here are a few possibilities:
- Mistake: The contractor must argue that its bid contained certain mistakes relating to the material prices….and that the mistake was both the contractors and the other party’s. This is a very tall order.
- Impossibility / Impracticability: These are legal theories that a party cannot be required to perform on a contract if it is impossible or impractical. While the contractor may feel like performance of a contract is impossible or impractical if material prices rise too much, courts will not likely share the feeling. Material and labor price increases are not a secret, and therefore, it will be difficult to show that the increases were not foreseeable when agreeing to the lump sum.
- Force Majeure: If prices increase significantly because of some act of God (i.e. New Orleanians can think of Hurricane Katrina’s effect on material costs), the the contractor may be on to something. Most construction contracts have a Force Majeure clause, and the contractor could potentially rely on this clause to escalate the contract price in the event an act of God effected material costs.