Fall 11 - Risk Management
Protect Yourself Against Volatile Material Costs
Although prices for commodities such as raw copper and aluminum have climbed steadily from their lows of 2009, the prices of many other building materials have been relatively constant, held back by continuing low demand.
On the other hand, fuel prices have generally soared over the past two years, and raw lumber prices have been on a rollercoaster. The National Association of Home Builders’ index of framing lumber prices soared from a low of $190 per 1,000 board feet in January 2009 to well over $350 in 2010, then bounced down and back up again before falling back to the $250-$300 range for much of 2011.
In spite of all these conflicting signals, economists from across the political spectrum warn that a period of rapid and substantial inflation is possible — even likely — as soon as demand for materials starts showing signs of a permanent uptick. That could mean serious problems if you have committed to a long-term project, since the work you are negotiating or bidding on today could be performed under a very different cost structure.
Fortunately, there are ways for contractors and subcontractors to protect themselves from rapidly rising material costs.
Cost-Plus Contracts
The ideal contracting arrangement from a risk management perspective is a cost-plus contract, which shifts all the risk of price increases from the contractor to the property owner. Of course, many owners are understandably reluctant to enter such contracts. You may find a more receptive reaction to a cost-plus contract if it’s coupled with a guaranteed maximum price. This enables the contractor and owner to share in any cost savings that are achieved, while still providing both parties some protection against the unexpected.
Cost-plus contracts are not without their drawbacks. For one thing, the accounting requirements are demanding, since pay requests must generally include supporting documents for every cost incurred. In addition to having adequate administrative resources, you will also need a robust job cost accounting system to provide the required level of detail.
Cost Escalation Clauses
If a cost-plus contract is not acceptable, you may be able to negotiate escalation clauses that help spread the risk. For a subcontractor, such a clause would specify a trigger price for key commodities — copper pipe for a plumbing contractor, for instance. If prices escalate beyond that trigger, the general contractor (and, ultimately, the owner) agree to absorb a portion of the increase.
It is important that the owner, contractor and subcontractors all communicate clearly when negotiating such clauses, so no party ends up bearing an inordinate share of the risk. In addition, no matter which type of contract you negotiate, make sure you understand all contract terms in detail.
Strong Supplier Relations
A savvy contractor or subcontractor will talk regularly with suppliers and manufacturers about where they anticipate prices will be going. In the best-case scenario, you may be able to negotiate a price guarantee during the period covered by the contract. But even if this is not possible, maintaining a good relationship with suppliers can alert you to possible trouble ahead.
Under certain circumstances, you might consider purchasing critical materials in advance, even though this can cause new problems like cash flow issues, storage costs and the risk of loss or theft. In addition, you could find yourself in a difficult situation if the project is halted for any reason. In the case of a cost-plus contract, you may be able to convince the project owner to underwrite the upfront cost of such a purchase in exchange for the potential saving opportunity it presents.
Sudden price hikes can put even well-managed contractors and subcontractors at significant risk. Patient negotiating, clear communication and careful attention to detail can help you limit your exposure.
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For more information, contact:
Dale A. Ruther, partner
Practice Leader
330.255.2427
Email