Construction project owners and contractors now anticipate unpredictable prices and time frames resulting from the economic effects of the COVID-19 pandemic.
Projects must proceed, but price volatility and supply chain issues place everyone at risk and no one wants to suffer the financial consequences alone. At this point, force majeure claims arising under new contracts are unconvincing. There are different approaches for dealing with price escalation and delay. Owners and contractors must be aware of strategies being employed to shift these risks. This summary provides a brief overview of the dynamics between an owner and a contractor.
Fixed Price Contracts
In the absence of other contractual provisions on point, a fixed price contract places the risk of material and labor price increases on the contractor. The contractor agrees to provide a scope of work for a stipulated price. The owner takes solace in the general understanding that the price of the project will not increase unless the scope of work increases or the contractor is delayed by something outside of its control. Fixed price contracts require the design documents to be sufficiently complete for a contractor to formulate its proposal with sufficient confidence at the time the contract is entered. When possible, owners should seek out competitively bid fixed price contracts.
Conversely, in the absence of other contractual provisions on point, a cost-plus contract places the risk of price increases on the owner. In the typical scenario, the owner agrees to pay the contractor the direct costs incurred by the contractor for labor and materials plus either a set fee or a percentage markup. The contractor is entitled to payment in full for all costs incurred, as well as its budgeted overhead and profit. Thus, the contractor is protected if price increases occur. Under this type of contract the owner is unable to predict the cost of the project when labor and material costs are volatile. Many owners view this type of contract as writing the contractor a “blank check.” Contractors clearly prefer this type of contract. Typically, only high-end and highly coveted contractors are able to dictate this approach.
GMP or Guaranteed Maximum Price Contracts constitute an attempt to blend the best aspects of fixed price and cost-plus contracts. The contractor bills its costs and fee/markup subject to a “not-to-exceed” amount, which is determined by adding a contingency to the budgeted cost to account for uncertainty. The contractor can generally look to the contingency to cover increased labor and material costs, but is limited by the GMP. The contractor assumes the risk for all costs exceeding the GMP, unless the scope of work is increased. The owner rests a little easier trusting that the GMP will not be exceeded. However, not all GMP contracts are created equal. The details regarding how the contingency may be spent and whether the GMP can be adjusted can shift the risk in unanticipated ways.
Timing of Purchase/Storage
A contractor with the ability to pre-purchase and store materials for longer periods of time may use this flexibility to guard against increased pricing. If done effectively and efficiently, this approach can result in a net savings of avoided price escalation against storage costs and prevent project delays. It does, however, require the Owner to pay more on the front end or the Contractor to finance the materials and increases the risks associated with material storage.
Responsibility for Materials
A contractor may entice an owner to provide certain materials to the project or deal directly with a subcontractor by emphasizing cost savings resulting from the lack of a markup. Such an arrangement also reallocates the risk of price escalation and supply chain delays. The contractor assumes no responsibility for price increases or delays for materials outside of its scope of work. Any delay experienced would as a result of owner-provided materials would entitle the contractor to additional time and, possibly, additional payment.
Price Escalation/Acceleration Clauses
A contractor concerned with the possibility of increased material prices may seek to include language in the contract that allows the contractor to increase the contract price in response to substantiated escalation of labor and material prices without a change order. Under such language the price increase could be triggered by a passage of time or a percentage increase in cost. This type of clause protects the contractor against crippling price increases under a fixed price contract by shifting such risk onto the owner.
Material Delay or Substitution Clauses
A contractor concerned by the risk of material delays may seek to characterize such delays as “excusable” under the contract. This would entitle the contractor to additional time to complete the project in the event materials are not delivered on time. The contractor may also seek to include language in the contract that allows it to make a reasonable substitution for the material that is not readily available. This mitigates the risk of project delay resulting from supply chain issues, but may frustrate the intent of the owner’s design choices.
Termination/Suspension for Convenience
Depending on the severity of the price escalation or delay experienced, either the owner or the contractor may find it advantageous to terminate or suspend the project rather than incur the increased costs. Allowing a party to terminate the contract or suspend performance for convenience provides the parties a means to amicably avoid the expense of idle projects or financial ruin. Termination and suspension clauses must be carefully drafted to avoid situations where a party would opportunistically act in bad faith.
While these contractual approaches and other strategies are available to shift the risk of price escalation and delay, owners and contractors must accept that fair allocation of such risks is necessary for a project to be successful. It is important to protect oneself from taking on more than a fair share of the risk, but putting too much risk on others increases the potential for project failure.
This post was written by Timothy Berkebile