An escalation clause allows for the escalation of a certain price for labor or materials to be used in a construction project. Specifically, an escalation clause is most commonly used to account for the potential fluctuation of material prices throughout the life of the project.
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Why Use an Escalation Clause?
The bottom line is that escalation clauses protect your bottom line.
The first and most obvious benefit of using an escalation clause is protecting yourself against price surges. Profit margins can be thin in construction, and absorbing a cost increase for materials could really endanger the bottom line.
The customer’s benefits aren’t as clear cut, but escalation clauses can actually be beneficial to everyone involved. When escalation clauses are used, bidders don’t need to bake in as much risk into their bids. When they know that a sudden jump in the cost of fuel or steel won’t derail their entire margin, bidders can more accurately bid the job. Further, escalation clauses can work both ways (upstream and downstream). So, there’s the potential to include de-escalation provisions that will lower the price if the cost of materials drops. Those situations can really create a win-win and a fair allocation of risk.
So, on large projects where lots of materials will be used, or on drawn-out jobs where the project’s life cycle will take an extended amount of time, escalation clauses are pretty much mandatory in order to account for changes in the price of materials.
Escalation Clauses Account for Volatile Prices
Construction is a volatile industry, and it’s made up of volatile parts. No, we’re not talking about your customer’s attitude – we mean that there’s just a lot of uncertainty in this line of work. The best businesses account for that uncertainty and adjust. This uncertainty includes uncertainty in price.
Prices are always on the rise. Typically, they’ll rise at a steady pace so that contractors, subcontractors, and suppliers can account for the increase in their bids. But what about when prices are volatile? What’s the protection when prices jump? That’s what an escalation clause is for.
What Events Do Escalation Clauses Help Protect Against?
So what sort of volatility might create the need for an escalation clause? Basically, any event that could cause a jump in prices. Here are a few examples:
What Items Should Escalation Clauses Apply to?
This really depends on the individual business, to be honest. However, here are some of the more common items escalation clauses will be tied to. Most of them will be obvious.
- Unforeseen administration costs
While those may be the most common bases for escalation clauses, any materials or supplies that will be used in great quantity or that might be subject to price fluctuations could be a good candidate.
How to Use an Escalation Clause to Your Advantage
These clauses can take many different forms.
An escalation clause might act in a really simple manner. For example, the clause could state that any increase in the price of materials will be reflected when billing. That could certainly minimize a contractor or subcontractor’s risk, but it also might annoy the customer. They might feel like they’re being nickel-and-dimed if the clause hasn’t been clearly communicated beforehand.
Another way to use an escalation clause is to save it as a sort of last resort. For example, an escalation clause might state that the price will only be escalated if the related cost rises 10% over the price at the start of the job. This allows contractors and subs to give their customers a solid price at the time of contracting, keeps the customer from feeling nickel-and-dimed, but still protects against unforeseen or untenable rises in price.
What Projects Most Commonly Use Escalation Clauses?
Any project that is particularly exposed to market conditions could be a prime candidate for an escalation clause. First and foremost – escalation clauses make the most sense on large scale projects where increases in material or overhead costs could quickly crush profit margin. Projects that will span several years make a lot of sense because they could be subject to a lot of price volatility – a lot can happen in a single year let along a multi-year span of time.
Projects contracted in times of political unrest might make sense too – who knows how a new administration’s policies or actions might affect prices. Finally, projects heavily dependent on transportation costs or oil byproducts are prime candidates since the cost of oil can fluctuate wildly over a matter of only a few weeks.