How Contractors Can Control Margins with Escalation Clauses

Author March 17, 2024

5 min read

Construction material prices can be unknown when planning a project.

That’s why contractors should know how to use material price escalation clauses to control their margins. By using an escalation clause, you can account for various material price variances in a contract.

What is an Escalation Clause

Typically, escalation clauses are used in larger construction projects for materials such as lumber or concrete. Escalation clauses have gained traction recently given the United States’ ongoing trade war with China.

Escalation clauses help protect against a number of different factors that can derail a construction project. Some of which include:

Tariffs
Supply chain concerns
Volatile raw materials markets

These disruptions can cause fluctuations that can impact the bottom line for both homeowners and contractors.

Types of Escalation Clauses Contractors Can Use

There are three basic types of escalation clauses that represent different levels of compromise between the homeowner and contractor:

Day One Provision

This gives contractors the right to capture costs associated with material price increases immediately. This type of material price escalation clause typically occurs in smaller projects with less expensive materials than larger construction projects.

Set Period of Time Provision

This allows contractors to be compensated after a set period of time. For example, if a contractor cannot recover the material cost, it increases for the first 100 days.

Sharing of Risk Provision

This entitles the contractor to reimbursement for higher material prices, but only after the rate of increase reaches a certain percentage. Anything up to that threshold would be the contractor’s risk to bear. This provision extends to public work projects as well under the Federal Acquisition Regulation (FAR).

There are specific instances where a contingency fund could be set up to pay for material price increases. Usually, this is reserved for stand-alone clauses.

The homeowner can require the contractor to take material price increases from that pool of money first and then cover additional costs via an escalation clause.

Real-World Examples of Escalation Clauses

We mentioned earlier that escalation clauses typically impact materials such as concrete or lumber. But what exactly would that look like?

Last year the price of precast concrete products increased by 4.4% from September 2018 to September 2019. The price of cement went up 2.2% and the price of construction equipment and machinery also increased by 2.2%, according to Bureau of Labor Statistics data compiled by Ken Simonson, chief economist of the Associated General Contractors of America.

An interesting byproduct was that the price for lumber and plywood decreased by 10.1% during that same time period. Also, the price of fabricated structural metal bar joists and rebar fell by 3.1% and the price of prefabricated metal buildings dropped by 4.6%.

Uncertainty plays a large role in how homeowners price out jobs over a long period of time.

A trade war between major world powers like the United States and China brings another level of uncertainty. This leaves many contractors wondering how projects will be paid for in the future.

Where Are Escalation Clauses Typically Applied?

What some contractors might not realize is that there are circumstances where they can mitigate or even eliminate the pain of significant and unexpected material price increases through the inclusion of escalation clauses in their contracts.

In general, if material prices rise higher than what was included in the original bid, the contractor will be reimbursed for all or part of the difference.

Typically, many public and private owners are willing to negotiate escalation clauses. These clauses are usually reserved for large, private construction projects as the stakes are so much higher.

How parties decide to allocate their risk during construction largely influences whether escalation clauses are implemented. Contracts for lengthy projects are also more likely to include escalation provisions as it is more difficult for contractors to predict how material prices will change over the long term.

The Price of Not Using Escalation Clauses

Any small bump in price can make a huge difference to both contractors’ and homeowners’ budgets. For instance, if a project uses a lot of steel, just a small bump in the price can make a huge difference to both contractors’ and homeowners’ budgets.

In 2010, some contractors went out of business when there were simultaneous shortages of both steel and concrete. For a variety of reasons, this drove up prices and left many contractors in the position of having to absorb the difference.

Contractors that account for these bumps in price are better able to manage their margins and avoid complete ruin if a project falls through.

How to Ask for Escalation Clauses

As you can imagine, asking homeowners to add in premiums to an already expensive project can be a daunting task for smaller contractors.

One approach to making the idea of an escalation clause more attractive to homeowners is to offer shared savings or some other benefit if material prices go down. These provisions don’t need to cover every material—usually, these clauses are applied to materials that have the greatest cost concerns at the time.

Conclusion

It doesn’t hurt to try and ask project owners for an escalation clause. In fact, it shows that you know more about your craft and have considered the risks of the project itself.

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