Let Material Price Escalation Clauses Become Your Best Friend

Here it is 2023, and the construction industry is still grappling with the supply chain crisis and material price escalation. According to the AGC’s 2023 Construction Outlook National Survey, 36% of contractors canceled projects in 2022 without rescheduling those projects and cited “rising costs” as the primary reason for cancellations. In the same survey, contractors highlighted “economic slowdown” and “building material prices” as their top two concerns in 2023. Costs were continuing to rise across major US markets in Q4 of 2022 according to the construction cost index.

How are firms mitigating these material costs and supply chain concerns? Ultimately, construction companies are making earlier and smarter material purchasing decisions in the bid and contract phases to avoid supply chain turbulence during construction. Neither owners nor general contractors nor their suppliers want to carry the risk of escalating material prices. 

Will construction costs go down in 2023?

Since the pandemic began in 2020, we’ve seen boom and bust economics, which usually happen over decades, occur in three short years. As we climb out of what we hope was the worst of it, we’re seeing construction starts align with societal shifts post-pandemic. Office and retail construction starts are expected to decline in 2023, as employees settle into remote work arrangements and the novelty of returning to in-person shopping wears off. Data center and manufacturing projects will likely take the lead this year, reported Dodge’s Chief Economist to Construction Dive. Data centers will support the growing tech sector and thriving ecommerce businesses. The country’s shift to produce more goods domestically to avoid repeat supply chain catastrophes will continue to drive manufacturing construction. 

How will these trends affect building prices? When will building materials go down in price? While ABC’s Chief Economist reported that supply chains were improving at the end of 2022, high labor and material prices are still expected to cause a decline in profit margins for contractors throughout 2023. 

ABC’s February 2023 analysis of the Producer Price Index construction inputs shows material costs rising slower month-to-month than previous years, but 12-month comparisons and cost differences since February 2020 are still extremely high.

Inflation forecasts for 2023 aren’t helping. Construction Dive reported that even federal funding for infrastructure projects is barely making an impact with costs rising 20-40% on projects.  

Stephen Flora, National Sales Manager at Insteel Industries, sells welded wire mats for concrete reinforcement of commercial and industrial construction projects, like cold storage, data centers and large warehouse spaces. “At the beginning of the pandemic, the scrap market effectively crashed when all the scrap was sold in an attempt to not get caught on the wrong side of inventory. If the construction industry slowed down with the pandemic, this would have been a good play. But the construction industry only took a two-week pause then went back to work. So the scrap market was empty and demand was through the roof. Especially for our clients building more warehouses to meet their pandemic demand.”

As prices were escalating and supply wasn’t keeping up with demand, Insteel went from 30 day quotes to 5 day quotes. Their precast business went to “price-determined-on-day-shipped” pricing. The best deal for them and their clients was to buy and ship materials immediately, but for longer projects, that wasn’t realistic. Flora added, “Instead, all parties involved in the construction projects, up and down the supply chain, were placing escalators and contingencies into contracts to cover themselves. In a competitive environment this puts us, the material supplier, at a major disadvantage because relationship or service isn’t as important as price.” 

So how did they structure contracts to account for material price escalation? “What we end up doing on longer term projects is establish pricing for year 1, adding an escalator of 5-8% per year on top of that. We’d prefer to renegotiate materials pricing each year of the contract but then we open ourselves up to losing consecutive years on a job.”

How construction contracts can cover rising material costs

Contractors are not necessarily taking as much precaution as one would think, given how prevalent an issue this has become. In the contract negotiation phase, crafting a material escalation clause becomes even more critical but is too often neglected. 

For reference, a review of an anonymized, random sampling of contracts uploaded in 2023 into Document Crunch, our contract intelligence platform for construction, showed only 34% of construction contract agreements had clauses addressing price escalations, 66% did not. Our proprietary AI was able to scan all such contracts for language related to this issue.

As Flora noted, material cost negotiation starts way before the contract is drafted. In a volatile market, bids and quotes expire and change. The invitation to bid phase is the first step for general contractors in managing rising material costs. Even preconstruction teams should be coached on ideal purchasing and contract terms to get the ball rolling. Flora added, “We have even seen owners send out bids for projects to check costs, then put it on hold and repeat 2-3 months later to see if it’s worth moving forward with yet or better to keep holding.”  

Contractors can place language in their bid proposals that establishes a period of time in which their proposal must be accepted to be valid. This approach would allow the contractor bidding the job to update their pricing and proposal to reflect any increases or decreases after the allowed time has passed. Conversely, contractors need to watch out for any bid instructions or RFP documents that preemptively exclude any price increases or require bids to remain valid for a specified period of time.

When it comes to contracts, the material price escalation clause (and therefore the burden of risk) will depend on the pricing structure of the construction project. Below are three types of pricing structures in contracts:

• Fixed price contracts - The contractor bears the burden of any increased costs over the agreed upon price, subject to agreed to change events.

• Cost plus contracts - The owner bears the burden of any increased costs over the agreed upon price, but contractors have a responsibility to control and manage rising costs to the extent possible.

• Cost plus fee with guaranteed maximum price (GMP) contract - Contractors and owners share the burden, as owners cover additional costs but only up to the agreed GMP, subject to agreed to change events.

In an ideal world, contractors would lock in material pricing (or “buy out”) as quickly as possible, but this means owners must be willing to write checks immediately. A compromise may be identifying materials with the most price volatility and buying out those materials in advance and storing them, though this adds storage costs. After the chaos of the pandemic, we’re seeing an increased willingness of owners to share in price escalation risk as the above data suggests. 

Even if owners are unwilling to give contractors a blank check, they understand there’s really nothing a contractor can do to control construction prices in 2023 nor the speed of the supply chain. 

Other ways contracts can mitigate rising material costs

Beyond a material price escalation clause, there are certainly other common clauses in construction contracts such as Section 8.3--titled, “Delays and Extensions of Time”--that lists the types of delays which would entitle a contractor to relief from certain delays or Section 3.4 (titled, “Labor and Materials”) of the AIA A201, however, these are more general in nature and not specific to supply chain disruptions or material price escalations. In these types of provisions it’s not uncommon for them to generally state that a contractor get relief for events “beyond its control.” However this vague catch-all leaves a lot to interpretation and chance.

When it comes to contracts, courts and the law tend to favor specific provisions over general provisions. It makes the job of interpretation much easier and less susceptible to argument. Adding specific categories that may entitle you to relief, such as “material price  escalation” or “supply chain disruptions due to a pandemic” versus leaving clauses vague for all issues “beyond contractor’s reasonable control” is more likely to be interpreted favorably and help grant relief for events such as rising costs of materials. Without clarifying such language, you may be leaving  it to chance or argument by parties seeking to use the clause in their own favor.  Given how prevalent of an issue material price escalation has become (just like COVID-19 over the past several years), it is common sense that you ensure this is adequately covered by contract. And it would certainly be prudent to address this issue head on rather than leaving it to chance interpretation.

Finally, we have to mention Document Crunch. Our AI contract management software scans contractor agreements for issues and risks, including spotting a “Material Price Escalation” provision (or the absence of) and flagging it for your team’s Comprehensive Review. This helps our users identify 1) if your contract includes proper language and 2) how any escalations in costs to materials are to be handled between the contracting parties. Before, contractors had to rely on their contract professionals to spot these issues or they would  review the contract (particularly prebid) prior to executing. Now they can quickly assess contract terms and confidently lead the discussion themselves. They can advise their project teams to save overhead costs and material costs down the road and, most importantly, protect fee in the job. Get a demo of Document Crunch today and start protecting your construction company against material price escalation.

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