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An Escalation Clause Can Help Curtail Materials Cost Woes

The price of construction materials remains high, with little to no sign of falling anytime soon. Many blame a building boom overseas, particularly in China. Others point to environmental reasons—loss of forestland driving up lumber prices, for instance. And don't forget fuel costs: Transporting materials has gotten increasingly expensive.

Whatever the cause, high materials costs put your bottom line at risk. One way to protect yourself is to put an escalation clause in your contracts.

A defensive measure

Essentially, an escalation clause is legal language specifying that, in the event materials costs rise beyond a specified amount, you may under the contract, pass those costs along to the project owner.

For many years, such clauses were fairly common in larger, long-term jobs. Now, however, contractors are adding them to virtually any size contract—from single-family homes to commercial high-rises.

For an escalation clause to have any chance of making it through contract negotiations, not to mention any chance of being upheld in court, it must:

• Define the materials in question,
• Specify the "triggering event" that activates the clause (typically a 2% to 3% rise in the originally estimated materials cost), and
• Describe the method used to calculate the escalation

Regarding that last point, several approaches are commonly used. The simplest is the "invoice" method in which you use a supplier invoice or similar document to substantiate a materials price change.

You might also use a widely accepted, published price index to support your claim. Such indexes are typically available for materials such as lumber, cement and steel.

A third option is a hybrid approach. Under the hybrid approach, the triggering event is specified as an increase under both the invoice method and the index method. Another hybrid approach involves subjecting the invoice method 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.

Risks to consider

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

Another danger is mishandling a claim should one arise. If you decide to take the plunge and write an escalation clause into a contract, be prepared to start documenting your materials acquisitions and costs very carefully.

A matter of law

Above all else, it's critical to bear in mind that an escalation clause is a matter of contract law. Therefore, you should work with your attorney, along with your CPA, to determine an accurate method of calculating any materials price escalations as well as to create effective, defensible language to include in your contracts.

Do you have questions about an escalation clause? 
Contact David Gussis at 312-980-2932.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.