Now that the Trump tariffs are in play, as well as other inflation causing events, a lot of people are trying to wrap their hands around what that means for their businesses. Particularly at risk are construction contractors and subcontractors who contract for projects months before they expect to do the work although other industries face the same risks. The game has changed for those who traditionally bid their projects on a lump sum or a guaranteed maximum price basis. The result is to put off contracting until there is more certainty in the industry, take risks that the market for construction materials will remain unstable, or mitigate those risks through negotiated price escalation clauses in contracts.
Price escalation clauses allow the parties to agree on how price increases will be managed before the contract is signed and the price increases are realized. That is typically better than relying on the change order process since that process generally gives one party more leverage over the other in a situation where disputes are common. By agreeing up front, the parties are negotiating on a level playing field and with a sense of fairness.
Price escalation clauses can take several forms with some being rather straightforward with others being quite complex. The most simple provision requires the parties above the contractor to agree to pay an increased price for the work if the cost of materials goes up. That, however, will often be met with resistance from higher tier contractors and owners because it removes all of the risk from the subcontractor. Other clauses have the risks more balanced, and spread the risk among the parties. For example, if a subcontractor’s material costs increase due to tariffs by $1,000, the absorption of that cost could be spread among the parties, for example, the subcontractor absorbs thirty percent, the general contractor absorbs thirty percent, and the owner absorbs forty percent. In addition to agreeing upon how the increased costs will be spread, the parties will need to agree on how and when the escalation is triggered.
In return, the party benefiting from the escalation clause should be prepared to open their books to an audit of the relevant documents so the party paying the higher prices can be comfortable that they are not being improperly charged. Along those lines, the benefiting party should also be prepared to show that it did everything possible to keep their costs as low as possible.
Escalation clauses are not a panacea for one party to a contract. Rather, they are based on fairness and maintaining good customer relations. Because of that, the parties should expect some give and take in the negotiating process, and be prepared to give something to get something in return.