Could Including an Escalation Clause in Your Contract Help With Your Materials Costs?

print January , 2017

That escalated quickly! This oft-quoted movie line could apply to a number of aspects of construction, one of which is materials costs. If you’ve been struggling in this area recently, there’s a tweak to your contract language called an “escalation clause” that might help.

Clear definitions

Without getting into too much legalese, an escalation clause specifies that, in the event materials costs rise beyond a specified amount, you may pass those costs along to the project owner.

For many years, such clauses were fairly common in larger, long-term jobs. As materials costs have risen, contractors have started adding escalation clauses to virtually any size contract — from single-family homes to commercial high-rises to mixed-use developments.

What’s driving up the price of construction materials? Many blame the global economy and rise in overseas construction. Some point to environmental reasons — loss of forestlands driving up lumber prices, for example. Transporting materials is always an issue, too, because of fluctuating fuel costs. For all those reasons, an escalation clause is especially important.

To make it through contract negotiations — and to increase the likelihood of its being upheld in court should litigation arise — an escalation clause must clearly define the materials in question and specify the “triggering event” that activates the clause. A typical triggering event is a 2% or 3% rise in the originally estimated materials cost.

The U.S. Department of Labor (DOL) Bureau of Labor Statistics notes in its PPI Program Spotlight No. 98-1 that “an escalation clause should specify whether price adjustments are to be made at fixed intervals, such as quarterly, semi-annually or annually, or only at the expiration of the contract.” Perhaps most important, though, is that the clause describe the method used to calculate the escalation.

Common methods

There are several methods commonly used when setting the escalation. The simplest is the “invoice” method, in which you use a supplier invoice or similar document to substantiate a materials price change.

A second option is the index method, under which you use a widely accepted, published price index to support your claim. Such indices are typically available for materials such as lumber, cement and steel. However, the DOL warns that any given index might not be available for a particular time period, because either price information wasn’t supplied by enough survey respondents to meet publication standards, or the index was discontinued due to a decline in the commodity’s importance in the marketplace. It’s also possible that any particular index won’t accurately account for localized cost variations.

A third option is a hybrid approach. Under one such approach, the triggering event is specified as an increase under both the invoice and index methods. Under another hybrid approach, the invoice method is subject to a limit based on a widely accepted index.

In any case, the rationale behind these hybrid approaches is to provide a check and balance on invoices by ensuring that the supplier’s prices aren’t widely different from market prices. Work with your CPA to determine an accurate method of calculating any materials price escalations.

Careful language

Perhaps the biggest risk of an escalation clause is that its inclusion in the contract will stall negotiations or eliminate the project entirely. The right contract language, as well as full disclosure and open discussion of the matter, can go a long way toward assuaging any owner fears about the clause.

Another risk is mishandling a claim should one arise. If you decide to take the plunge and write an escalation clause into a contract, be sure to document your materials acquisitions and costs carefully.

Not a cure-all

We hope you’ve found this article rich and compelling — or at least helpful. An escalation clause may not cure all of your materials costs woes, but it’s a viable option to consider. Along with working with your CPA as mentioned, have your attorney review any language you add to your contracts.

For more information on Smith & Howard’s construction advisory services, contact Paul Atkinson at 404-874-6244 or simply fill out the form below.

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