The volatility of construction cost

Construction cost volatility is a major factor threatening the viability of housebuilding and Build to Rent projects besides supply labour shortages. Contractors must maintain equilibrium in construction costs by controlling labour and material costs and managing delays in supplies because of material shortages, transportation delays, and other factors following the fallout from Brexit, Covid and the Russia/Ukraine war.

The price fluctuations of building materials from the time of bidding till the completion of the project impact the contractor's ability to balance construction costs severely. The very existence of a contractor today is underpinned by their ability to include price escalation clauses when drafting construction contracts.

A brief understanding of price escalation clauses in Construction Contracts

Most construction contracts include clauses that make the contractor endure spikes in construction costs. The contractor has to absorb cost escalation as the contract guarantees completion of the project at mutually agreed costs. Put simply a cost escalation clause aims to shift the impact of price increase to the owner.

These clauses include a mechanism to protect contractors against price volatility. The rise and fall mechanisms ensure that the contract price reflects price changes in construction materials, fuel, labour, and logistics. A drop in prices may lead to a reduction in costs.

Benefits and examples of price escalation clauses

Adding a price escalation clause to the contract is a proactive way of safeguarding your business against price fluctuations. These clauses help:

• Minimize disputes and litigation.
• Ensure better understanding between contractor and project owner
• Avoid unnecessary mid-term negotiations
• Mitigate the risk of contract termination

The following are a few examples of mechanisms for contract price adjustments in response to price escalations in input costs.

• Including schedules of cost indexation so that the contractor and project owner reach a consensus to calculate and adjust the listed construction inputs.
• Fixing a base date to calculate price adjustments by leveraging a Price Adjustment Factor for each assessment.

These factors refer to changes in weightings and indices that cause price fluctuations.

• Permitting changes to levies, taxes, and contributions that may occur after the base date.
• Provision to incorporate changes in material and labour costs
• Adopting formula rules to facilitate formula adjustments

Negotiating price escalation clauses

The final contract with escalation clauses results from thorough discussions and negotiations between the contractor and the project owner.

Seamless communication between the contractor and the owner is crucial for crafting a mutually beneficial contract for both parties. Enabling regulation mechanisms in the construction contract enhances the possibility of project completion within budget and as per the schedule.

Identifying the materials most likely to suffer from market conditions, international conflicts, and other factors by involving both parties is crucial to determine price escalation clauses.The contractor should educate the owner about the possibility of price escalation and the need to include price escalation clauses in the prime contract.

Periodic monitoring of construction material prices by the contractor is essential. Informing the client of the price increase without delay is paramount to preventing awkward situations. Purchasing construction materials when prices are lower help reduce the effect of future cost escalation.

The takeaway:

Assessing the final project cost is daunting because of the extreme volatility of construction material costs. But it also costs the Build to Rent developer or property investor when their contractor goes bust mid way through a project.

Price escalation clauses benefit owners because contractors submit realistic bids that are on the lower side. Project execution is also smoother with proper escalation clauses in place.

Besides incorporating price escalation clauses into the contract, there are several strategies to address price volatility concerns. Purchasing materials from manufacturers, identifying alternative suppliers, and bulk purchasing are a few ways to reduce price escalation risks.