How construction firms can guard against inflation

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Peter Hibberd of the Joint Contracts Tribunal examines the prospects for inflation and how construction firms can guard against a rise

Recently, the Bank of England governor claimed that his ex-chief economist’s view that inflation may reach 4% was alarmist and that we should not overreact to rising prices. Overacting is one thing but making sensible provision is another.

Fluctuations in labour and material prices in relation to construction projects can, and do, quickly erode a contractor’s margin. Over recent years, price inflation has been benign, which has led to those entering building contracts giving less consideration to its impact and to the need to incorporate fluctuation provisions in their contracts.

Inflation since 1992 has only exceeded 5% on one occasion, so perhaps that is not surprising. However, during the previous 20 years (1971-1991) it was seldom below 5% and reached a peak of over 24%. Maybe that is history never to be repeated, maybe not. The problem is we do not know.

Shortages leading to delay

What we do know is that over the past few months there has been increasing concern about inflation because of monetary policy both here and abroad. Furthermore, inflation can be exacerbated because of shortages, both of materials and labour, and which could also lead to project delay.

I would not wish to make any prediction about future inflation rates, except to say that the risk of inflation has increased and it would be prudent to make provision for it in building contracts. Not just simply by increasing the tender price by some arbitrary figure. There is now also an increased risk of changes to the types and rates of contractor’s contributions, levy and taxes payable as an employer, which arises because of the need to redress government finances following the cost of support provided during the coronavirus pandemic.

The other factor that urges consideration of the incorporation of fluctuation provisions is that even in a low inflationary climate there can be significant volatility in the cost of materials. Construction material’s inflation frequently diverges from the general inflation level, which is around 2%. For example, the World Construction Industry Steel Purchasing Price Indices show a 40% increase between April 2020 and February 2021, or the oil price that has risen by close to 400% since April 2020. Consequently, where there is a high content of certain items in a building project, profit margins can be quickly eroded, unless there is protection under the contract.

JCT provides for three approaches to fluctuations, namely Option A (which deals only with contribution, levy and tax payable as an employer), Option B (which additionally covers labour and materials costs) and Option C (formula adjustment using the Formula Rules).

The principal 2016 editions of JCT contracts that refer to all three Options are: Design & Build Contract (including subcontracts), Standard Building Contract (including subcontracts), Intermediate Named Subcontract, Construction Management Trade Contract and the Management Works Contract. Option A is in the printed text and digital versions; Options B or C is available from the JCT website here.

Option A is the default position and provides only for changes to contribution, levy and tax fluctuations, which occur after the Base Date. The other Options only become operative by completing the Contract Particulars.

The Minor Works, and the Intermediate Building Contract only contain what is Option A in the principal contracts, with no reference to other options. The logic is that those forms of contract are for small scale, short-duration work and, consequently, the risk is deemed to be small. In certain circumstances, which currently prevail, it may be appropriate to consider whether this provision alone is sufficient.

Identifying fluctuations

By contrast to other JCT principal contracts for large-scale works, neither the Major Project Contract nor the Constructing Excellence Contract expressly contain fluctuation provisions. However, that does not mean they cannot provide for them. That can be done through the Pricing Document under the Major Project Contract and by identifying fluctuations as a risk under the Constructing Excellence Contract. In either case, one must include or specifically identify details of how fluctuations will be determined. Such requirements may be modelled on one of the JCT Options.

Last September, I advised that “in such circumstances those entering contracts for projects of more than a few months should consider the desirability of using a suitable fluctuation provision”.

It seems that it was timely and what has followed makes it is equally relevant today. It is essential prior to entering a contract to carry out a risk assessment, which must include fluctuations and the timely availability of materials and labour. Such an assessment will guide the user to the most appropriate means of dealing with the risks. Current circumstances suggest that wide cover is secured in respect of fluctuations unless one is entering into cost plus type arrangements. That means the use of either Option B (Labour and materials cost and tax fluctuations) or Option C (Formula adjustment).

The time involved in preparing calculations, especially for materials, under Option B has put some off using it, but it should not, because for materials it need only apply to a small number of high content items. The use of a prescribed list, like the basic price list, which was in common usage in earlier times, meets such an objective.

Where Formula adjustment is adopted, it is prudent to consider the Work Category method (identify in Contract particulars) in preference to Work Group method because of hugely variable price changes related to some materials and trades. In such circumstances, it is more likely to accurately reflect the differences that arise. To operate the formula, either annotated bills of quantities or schedules determining the work category for the items of work must be prepared.

In current circumstances, do not overlook fluctuations and be sure to incorporate the relevant provisions following a risk assessment. General inflation is one thing, construction inflation is another.

 

JCT Ltd

stanform@jctltd.co.uk

www.jctltd.co.uk

 

Please note: this is a commercial profile.

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