A Fixed-Price Construction Contract is Usually Just That

Bruce Jervis, Editor
Construction Claims Advisor

A fixed-price construction contract is usually just that. Sometimes, however, prices for materials or commodities such as asphalt or fuel are stipulated in the bid documents, with payment to the contractor adjusted to reflect the actual costs indicated in periodic published indexes.

From a project owner’s point of view, a price adjustment clause promotes accurate bidding. Bidders are not forced, or allowed, to speculate on future costs. There is no need for bidders to carry large contingencies as protection against volatile swings in cost. And of course for the successful bidder these features reduce the risk and uncertainty of contract performance.

In order for price adjustment clauses to work fairly and effectively, however, they must tie adjustments to the contractor’s real costs. The Mississippi Supreme Court recently struck a provision from a state highway contract because it froze “actual” costs at the contract completion deadline. By failing to account for subsequent contractor costs, the clause violated the statute authorizing the use of price adjustment clauses.

I invite comments on this topic from both the project owner and contractor point of view. Are price adjustment clauses a good way to go? In actual practice, are they applied fairly and consistently?

Bruce Jervis, Editor
Construction Claims Advisor

Comments

[mark essert]

I don't see where this type of bidding helps anyone but the contractor. The risk and uncertainty just shifts to the owner. The owner would have to factor in the potential for a price increase into his contingency while not having the contractor's expertice or recent market experience to base their estimate on. I would not recommend this to a client. If there is great market volitility it is probably better to allow advanced material purchase and storage to lock in the price.

[Jeevan Kasthuri]

This is a globally recognized contract pricing strategy suitable under any construction contract procurement. The bid should be hugely depending on the 100% completed design with minimum opportunities for change orders. This is good for short term contracts, and most of the commercial risk born by the contractor. Therefore, the client get disadvantage as the contractor transfers most of his commercial risk into bid price, however this might be minimal in a competitive bidding nature. In other hand this is not good if client wishes to change the design during construction stage as it will end up with huge cost if client disagree with the unit rates for all expected items before signing the contract.

[quercus]

Mark
many manufacturers and material suppliers won't lock in a price even with advance purchase and a deposit. Full payment might help, but what kind of large project has the money to buy materials 12 mos. or more in advance? On large projects lead times can easily be over year and price swings can be huge.
The risk of construction should fall on the owner too. Why should a contractor have to take all the risk, the owner is the one who started the project? If they don't know enough about the process to estimate contingency factors, maybe they shouldn't be developing?
I realize that risk needs to be shared, but as a contractor I seem to be taking more than my share.

[Jeevan Kasthuri]

Most of the Standard Construction Contracts (JCT, FIDIC, NEC) are drafted to share the risk between parties. Eg. In a force major event Owner grant the EOT without prolongation cost. In a fixed price contract, commercial risk will take by the contractor and that risk factor then put in his bid and paid by the owner. Commercial risk the contractor expected in that design could be transferred. The smart contractor wins the job with suitably allocating his anticipated risk and loaded into the bid to win the job. Owner wants the job, also contractor will get the profit if he properly managed the job. This system will provide better understanding to the Owner how much he has to spend on the project. Most of the civil engineering projects awarding under 'measure and pay' system, which will end up with huge cost over run, and will end up with over budget.

[Craig Masnoukian]

In the utility industry a price adjustment mechanism is used for volatile fuel prices, An estimate is made and then an adjustment, plus or minus to the actual fuel cost for the specified period is made. This could be easily adopted in a contract and a plus/minus change order written to adjust to actual. Mirrors a T&M approach for these volatile items.

[Elwin Dobson]

It is understandable that material pricing volatility can create a hardship when it occurs after contract execution. It doesn't seem fair for the contractor to have to absorb these additional costs alone. However, an equitable contract equates risk with control. The fact is that it is the contractor who has the most control over the situation at bid time. He must depend on his knowledge of the market which is much greater than the owner or designer. The contractor also controls the choice of vendor and the timing of the purchase of materials. Given that the contractor has the most control, he must also bear the risk at bidding. Clearly if the contractor placed a contingency on every material he would not submit a competitive bid. The overall contingencies allowed in a contractor's bid must be a business decision based on experience and risk management. Adjustment clauses are contrary to the owner's primary objective of budget control. Owner's contingencies would normally be reserved to address changes in contract scope. That being said, owners may be short-sighted when taking the hard line on significant cost changes related to conditions that would not normally be anticipated. The cost and time associated with bankrupting the contractor, collecting the bond and/or re-contracting the work must be weighed against the additional costs.

[Bob Smith]

Regarding early purchase and storage of materials. Upon request fromo the contractor, our firm often approves the early purchase and storage of price sensitive materials. The material cost for those materials are then billed to the owner and paid, therefore the contractor is not fronting the money for the purchase. This arrangement is equitable to the owner and contractor. The owner pays for the materials in a timely manner and the contractor eliminates the risk of future price increases and product availability.

[Stourley Kracklite]

I'd love to sell you a car. I'll let you know what the "actual" costs will be after contract signing.

[Naveen Kumar]

In my opinion for a balance bid it is better, if price change risk is retained by the client. Anyway the client need to pay these monies through the risk priced in the bid, so why to pay upfront rather than actual cost. In most of the standard contracts this risk is with the client.

[RUFRAN C. FRAGO]

I agree with Elwin Dobson in most of his perspectives. The hardship brought about by material pricing volatility is a given where ever and what ever time it occurs, but in varying intensity and seriousness. The worst time of course is when it occurs after contract signing and the scope becomes executory.

In my opinion, although harsh and hard it might abe, is that everything is considered fair when an instrument has been signed signed for noone in his right mind will put his name on something destined for heartache. If the contractor agreed to absorb certain additional costs brought about by risks he opted to embrace as part of the contract, he has noone to blame except himself alone.

Generally, I do agree hundred percent that a more equitable contract should provide the one with most risk, more control. The success of the bidder lies heavily on his pool of knowledge. He must strike a good balance between submitting a competitive bid and the associated risk he is willing to absorb, just in case the identified risk did show up later on. As Elwin said, "The overall contingencies allowed in a contractor's bid must be a business decision based on experience and risk management". This is very, very true!

But then again, provisionary clauses (whatever it is) can be the most impartial way of dealing with uncertainties and risks, even in the subject Lump Sum contract we are discussing here.

Cheers.

[Derek J.]

I think this practice, most often helps both the contractor and the owner. As stated in the original piece, when this clause is not part of the contract, a contractor often has to make assumptions based on what the actual cost of material will be at the time of purchase. Often times, it can take several months, if not almost a year from the time of bidding until the time the contract is actually awarded and construction begins. During that time prices of asphalt, pvc pipe, concrete, and such can alter drastically. For example, several years ago I bid a long 16" DIP water main job. About a year later the company bid another very large 12" DIP water main project. The cost of the 12" DIP was more than double the cost that the 16' DIP had been a year earlier. In the early 2000's cost of metal spiked.

However, the owner needs to protect himself in this as well and should set some guidelines for price adjustments. All prices should be locked in within a reasonable time after contract execution, as the contractor should be getting all his purchase orders signed at that time. Additionally, the owner should require the contractor to provide the actual purchase order along with the original bid quote from the supplier in order to document the change in price. Additionally, this clause should be in place for price increases and price decreases. If this clause is in a contract, the contractor should be required to provide this information for all material, regardless if the price went up, stayed the same, or went down so that the owner can assume the risk but also take advantage of price changes.

Risk is born by the owner of a project. To expect the contractor to assume risk for the project, when he gets no further benefiet from the project once it is completed is wrong. It is the project owner who will earn profit from the project years after it is completed, not the contractor. However, risk should also be paired with reward, and if prices decrease the owner should get the advantage of those decreases, since he also is assuming the risk of price increases.

[Stourley Kracklite]

"Risk is born by the owner of a project." Good luck with your sales pitch, guy.

[Frank B.]

Obviously all of you who think the contractor should bear all the cost in material increase, never do any sitework. While some things like disposal fees, pipe prices, hauling etc do not swing wildly, asphalt does. How can you guess or anticipate an asphalt cost 6-12 months from when you bid? In Maryland the price is set each month by the state asphalt price index price for liquid asphalt, and several years ago i bid a job at asphalt cost in the $30-$40 per ton range, and when the job didnt start for 6 months, then the paving portion didnt happen until 1 year after that. Asphalt prices went to $70-$80 per ton because of the hurricane disruption of Oil refineries/supply in the gulf. Asphalt can always swing wildly each month so it is standard practice anymore to have an asphalt price index clause in the contract. So many materials (PVC, plastic, HDPE pipe, off-road fuel, copper etc) are affected by the price of oil/gas, and also how much China is buying at the time, if they buy high volume then prices will go up because supply goes down.

[Stourley Kracklite]

The price of asphalt ought not to be a reason for the entire sum of the contract to be unfixed.