Strategies for addressing cost overruns with transparency
Dramatic price increases in construction materials over the past few years have created enormous tension for construction contractors and their customers.
When a contract is signed but material prices double by the time they are purchased, the contractor may be left with an uncomfortable truth. They can’t accept a no-margin or negative margin job, but also understand that the owner won’t be enthusiastic about paying for additional (and potentially unbudgeted) costs.
There are best practices for these situations that will lead to an equitable outcome for both sides. These strategies are even more pronounced now due to the historical volatility of raw material prices stemming from, among others, the COVID-19 pandemic, supply chain challenges, energy prices, the war in Ukraine and increased freight costs.
For example, on March 18, 2020, the NYSE reported that steel sold for $539.40 a ton. Barely two years later, on April 12, 2022, it was $2,039.58. Similarly, the NASDAQ priced copper at $2.3155 per pound on March 17, 2020. It soared to $4.738 per pound on April 6, 2022. The following chart summarizes the percentage increase for steel, lumber, and copper from June 2020 until June 2022.
Of course, in an ideal world, these contingencies would be addressed in the construction contract and provide a playbook for both contractor and owner. But it’s doubtful that even the most robust contracts include escalation “rules” tied to specific price indices or escalation trigger scenarios, outline strict disclosure requirements, and define requirements for negotiating the unforeseen price escalation that we have witnessed recently.
As a result, many contractors struggle to justify and isolate the real material escalation costs they have experienced. Conversely, owners may be suspicious that a contractor’s claims could be opportunistic and lead to an unearned windfall to the contractor. These realities need to be managed so that escalation claims can be addressed comprehensively, while avoiding project delays and reducing the likelihood of lengthy and costly litigation.
What to do? A plan of action.
The first action is to speak up.
Ironically, the most experienced and conscientious contractors may be in the deepest trouble when they face escalating materials prices. “It’s common for contractors to think, ‘I have some cost spikes, but I can make up for them somewhere else — I’ve been able to in the past,’” says Grant Thornton Construction Advisory Services Manager Tim Lynch. “This mindset can be dangerous in today’s economic environment, as the movement of future raw materials prices is unknown and could delay an important conversation with the owner on additional, unforeseen costs.”
Instead, move as quickly as possible and communicate fully. Even with limited information, develop an estimate of the material cost escalation impact and start the conversation with relevant stakeholders. This creates a runway for creative solutions and builds a collaborative environment.
Transparency leads to equitable resolution
Theoretically, neither contractor nor owner benefits from cost escalation: contractors’ cost escalation premiums are passed through to their suppliers and owners still receive the same scope and specifications. To increase the likelihood of an equitable resolution, the development — and subsequent review — of material escalation claims should address qualitative and quantitative factors.
The qualitative factors outlined below describe why escalation is required, specify what was done to limit escalation, and identify other relevant extenuating circumstances. The presentation of the claim should be easy to follow, provide a timeline that summarizes the changing macroeconomic environment against key project milestones, and be supported with detailed calculations, available meeting notes, and relevant external data sources.
- Operationalize contract terms. Look closely at the contract language. Is there a clearly defined escalation clause that addresses the situation at hand? If not, proactively discuss gray areas to come to an agreed-upon understanding.
- Describe mitigation efforts. Set out the actions taken to minimize the impact of rising material costs. Common steps include expanding the supplier pool, pre-purchasing material at volume, and developing an offsite storage plan.
- Support the claim with data. Claims should include detailed and accurate data regarding the specific product items included in the claim, the estimated costs, and the cost at the time of purchase. Support each with vendor invoices and relevant pricing data.
- Define other costs not included in claim. Document the contribution and commitment to the overall partnership due to the absorption of additional costs. For example, quantify costs linked to additional internal management and coordination of new suppliers that are excluded from the claim.
Cost escalation is the difference between two basic numbers: actual costs minus estimated costs. However, both inputs are subject to different interpretations that could delay settlement and lead to lengthy and costly litigation.
Once the dialogue has begun, both parties should look hard at the numbers. According to Grant Thornton Forensics Managing Director Alex Koltsov, it’s crucial to keep the end goal in mind. “The goal here is to show how much the owner’s price increased due to the unforeseen material escalation throughout the project,” he said. “That means contractors should use a conservative and defensible methodology that relies on supportable, accurate pricing data and includes reasonable explanations for any adjustments or assumptions used in the calculation.”
No matter the timing, contractors should follow — and owners should support — these best practices in a cost escalation claim. The claim should also provide a general overview of the methodology, note any limitations or assumptions in the calculation, and explain how the claim properly accounts for the limitations.
- Define estimated costs. Estimated costs should be based on the owner-approved contractor’s bid and, if possible, separated out on a per-product, unit, and price basis. The estimated cost is the starting point for any potential escalation.
- Map actual costs to estimated costs. Actual costs should generally only address actual price increases against the initial estimates. If additional units are claimed, the contractor should justify this by highlighting the amount of change order work, or by showing that the owner required a significant change to the means and methods.
- Consider typical escalation factors. A contractor’s estimated costs typically incorporate an assumed escalation for long-term projects (e.g., over 6 months). These escalation assumptions should be accounted for in the calculation and supported by historical submissions and/or external price indices (e.g., Federal Reserve Economic Data).
- Avoid broad generalization. Poor data or the inability to calculate direct escalation costs should be avoided if possible. Any indirect escalation claim should be vetted thoroughly due to the uncertainty and increased risk of inflated costs being passed through to the owner.
A balanced and supported claim that considers the above qualitative and quantitative recommendations should provide the necessary transparency to efficiently understand the overruns and proceed to an equitable resolution.
Reach out for a deeper conversation
Grant Thornton works with owners, contractors and outside counsel across the construction lifecycle. Our experienced professionals of construction auditors, CPAs, and former law enforcement officials provide services related to managing and assessing construction claims, reactive fraud and corruption investigations, proactive integrity monitoring compliance services, and operational enhancements intended to manage financial and regulatory risks.
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