A Key Battleground: Material Price Escalations and Supply Chain Disruptions

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on July 16, 2021.

Material price escalations and supply chain disruptions are hot topics in the industry, with many clients inquiring about their rights and how these risks should be shared. Some have even questioned whether their projects should proceed given the volatility in the market.

For instance, I saw at least one project’s price increase by over $10 million in a matter of months due to the precipitous price increase in lumber. The resulting sticker shock was mitigated somewhat by the recent drop in lumber prices. However, the developer and contractor team were not alone in asking whether the project should proceed and, if so, who carries the risk of future price changes and/or supply chain delays.

Generally speaking, under a standard Guaranteed Maximum Price (GMP) contract, such as the American Institute of Architects’ A102/A201 combination, the contractor is guaranteeing its price against price escalations – i.e., this is a contractor risk. This risk allocation can be adjusted through a variety of methods, including the use of: 1, allowances; 2, contingency; 3, savings bonus; or 4, specifically tailored risk-sharing provisions, addressing both compensation adjustments and/or time adjustments.

How allowances and contingency work in concert, and what those terms mean, differs even among sophisticated contracting parties. For many in the Pacific Northwest, an allowance is merely a placeholder for the expected “Cost of the Work.” If the allowance item costs more than the placeholder, the GMP is increased. If it is less, then the owner should get a deductive change order.

However, industry standard forms like the AIA A201 don’t treat allowances this way and in fact state that “Contractor’s costs for unloading and handling at the site, labor, installation costs, overhead, profit and other expenses contemplated for stated allowance amounts shall be included in the Contract Sum but not in the allowances” – i.e., no increase in the GMP for additional time or labor related to the allowance item.

Under the AIA approach, the contractor would get more, for example, for the price of the door, but wouldn’t be allowed to seek an increase for the time it took to install it. Contingency for some owners and contractors is simply padding to cover additional costs of the work until the GMP ceiling is exhausted. For others, contingency is solely for discrete items, and only to be used upon advance written approval by the owner. Many contractors prefer to list price escalations in materials as an approved use of contingency.

When contract discussions become logjammed over risks that neither party can control, finding an outcome where both the owner’s and contractor’s interests are aligned is sometimes the best way to advance discussions. That often means a sharing of risk to some degree, full transparency by both sides, and even sharing in any savings for effective materials and subcontractor buyouts. Alternatively, if the owner is not willing to share in the risk, which is not uncommon, it should expect the contractor to ask for a higher fee for taking on that risk, or price padding on certain line items.

Supply chain disruptions and resulting delays are treated differently and separately from price escalation risks. Unusual delay in deliveries is generally a basis for a contract time adjustment under most industry-accepted contracts. This is important to contractors because, without the adjustment, they could face liquidated damages or other delay liability.

Who pays for the extended costs resulting from the delays is a more difficult question and not squarely addressed in the AIA A201. Owners feel they are already losing money because of the late delivery (time is money), and contractors question why they should carry the costs.

Historically, given the economic risks to the owner resulting from delay, contractors typically agree to limit their recovery to a time extension and/or expressly negotiate a contingency line item to cover this risk. Also, because contractors are in a better position to control timely subcontractor buyouts and coordination of work among subcontractors, including through the use of float, some argue that contractors should carry this risk. In other words, the party in the best position to control a risk should be the party who bears it.

While not uncommon in other industries, insurance products to cover price escalations in materials are not commonly used in the construction industry. However, sensing the stress in the marketplace due to lumber prices, insurance products are now being offered for those interested in “hedging” risk against future price fluctuations. As we work through the consequential effects of the pandemic on supply chains, it will be interesting to see if the use of these products proliferates through the market. As with bonds, which are rarely used on private projects below $100 million, the cost and ability to timely collect on such products will dictate whether owners and contractors are interested in hedging their bets in this fashion.