Recent price fluctuations in building materials threatened to destroy otherwise well-planned and well-managed construction projects. Economists and industry experts have identified numerous factors that are causing or contributing to these fluctuations, including COVID-19-related closings and restrictions, ongoing tariffs and quotas, increased construction activity among single-family homeowners, and even cases of hoarding and greed. Regardless of the underlying cause, fluctuations in the price of materials represent a profound and permanent risk for construction projects. These fluctuations not only lead to unforeseen increases in construction costs, but also threaten to delay project completion dates due to material rationing or unavailability. This article examines two basic ways to manage the effects of material price fluctuations: (i) assignment of risk and responsibility through contractual provisions; and (ii) take proactive measures to avoid or mitigate any impact on the project.
While extreme fluctuations in building material prices are a relatively new phenomenon, managing contract fluctuations is not a new concept. For decades, parties doing business across borders have included provisions on exchange rate fluctuations in their contracts. These large, varied provisions, backed by a well-developed legal system, are excellent examples of how contracting parties can consider the distribution of risk for fluctuations in the price of building materials. Using these examples, you will find a list of approaches that contracting parties in a construction contract can use to spread the risk of fluctuations in material costs. This mapping can be applied either to material costs in general or to certain types of materials with particularly high risk (e.g. steel, wood or copper).
- Contractor at risk. In the event of material cost increases and / or delays due to a lack of material, the contract will not be changed.
- Risk owner. The contractor is entitled to take into account increases in material costs and / or delays due to a lack of material by means of a change order.
- Risk sharing. The parties mutually agree to share the cost of material cost increases on the basis of a pre-determined apportionment (e.g. 50:50).
- Threshold approach. The owner or contractor undertakes to bear the risk of increases in material costs up to a predetermined threshold (e.g. 5% of the costs assumed), from which the risk is transferred to the other party.
- Trigger provision (allowance). The contractor bears the material costs at a value assumed in the contract. If the actual costs are higher than the assumed value, the contractor is entitled to increase the contract amount in accordance with these costs. If the actual cost is lower than the assumed value, 100% of the savings will accrue to the owner. This is comparable to an allowance in the construction industry.
- Indexing rule. The parties mutually agree to tie the cost of a particular material to an index such as the NYSE American Steel Index, rather than the cost billed by a single supplier.
- Freeze deployment. The parties mutually agree on a predetermined price for the material (s) in question, which is paid for and cannot change regardless of further market fluctuations.
- Guard rail approach. The parties mutually agree on a pre-determined material price or a fixed material price as well as a maximum and minimum amount by which the material costs can fluctuate. The contractor bears the risk of increases above the maximum amount, while the owner bears the risk of decreases below the minimum amount.
- Combination. The parties may combine various elements of the above provisions to suit their particular circumstances. For example, the parties could agree on a threshold of 5% above which they share the risk in a 50:50 ratio.
In addition to risk allocation, contracting parties should also take into account material price fluctuations within the framework of the suspension and termination provisions of the contract. In particular, building owners are well advised to state such fluctuations as an express basis for suspending the start of construction or the progress of construction. This option can be useful if the unavailability of materials affects the planned construction process, resulting in a longer delay and extended framework conditions. In extreme circumstances, the severity of the effects may warrant a complete termination of the contract. In that event, the owner would likely have to invoke a convenience termination provision unless a reasonable argument can be put forward that the contractor is committing a material breach of contract due to the material cost overruns or delays it causes.
Unfortunately, many builders and construction professionals signed contracts before the extent of the fluctuations in the price of materials was well known. As a result, many parties to existing contracts did not contain provisions on how to deal with such fluctuations. To make matters worse, many contractors guaranteed their prices – either through lump sums or GMP / GMAX contracts – without anticipating the imminent price increase. In these cases, contractors are well advised to review their contracts for force majeure or hardship clauses. Even without such clauses in the contract, the contractor can assert the usual objections such as lack of purpose or impossibility, in particular if the unavailability of materials makes the contractor’s performance impossible or impracticable.
Whether or not the contract takes into account significant price fluctuations, both project owners and construction professionals should consider proactive steps they can take to reduce the impact of such fluctuations on their projects. The starting point for reducing this impact is communication. It is critical that the material suppliers promptly notify the general contractor of price effects and the unavailability of products, and equally crucial that the general contractor immediately communicate this information to the owner. Failure to provide this information in a timely manner will significantly limit or eliminate the options available to you to correct the problem.
After identifying the problem, stakeholders should consider all available options, including unusual or creative. It is just as important for those involved in the project to be flexible and not too rigid when implementing these solutions. For example, planned processes need to change, contingencies need to be exhausted, design features may need to be changed, and additional funding may need to be allocated, as needed, to promote the success of the project. Below are some specific solutions that the parties may consider:
- Offering “sweeteners” to the supplier to ensure performance (e.g. payment of a substantial down payment, approval of cancellation fees and / or commitment to additional work for other orders);
- Identify alternative or complementary providers, including those in neighboring cities or states;
- Direct purchase between owner and supplier to reduce the markup;
- Purchase of all materials needed at the beginning of the construction project;
- Securing space in warehouses or parking spaces for the storage of excess material until the planned installation; and
- Propose substitutions or alternatives to the materials indicated in the design.
Due to the uncertainty about fluctuations in raw material prices in the construction industry, some developers may decide to suspend or postpone planned construction projects. Anyone who drives projects in the current economic environment runs the risk that further fluctuations lead to increases in construction costs, construction delays and / or disputes with contractors and material suppliers. However, these risks can be reduced or avoided by including provisions in the contract that distribute responsibility fairly in a manner that the parties can mutually agree on. Finally, in projects that are already in progress, it is imperative that the parties enter into a dialogue to explore ways in which the effects of raw material price fluctuations or material failures on the project can be proactively mitigated.