Regardless of industry, rapidly rising or wildly fluctuating material costs can have a negative impact on a business. The same is true for material shortages, but those are usually managed via substitution or a simple delay. When shortages lead to a spike in prices, however, the result can be disastrous for business owners who may already be operating on thin margins. The goal of this article is to provide some strategies to prevent or mitigate the risk as well as protect from other, potentially unforeseen, expenses due to the rising price/shortfall situation.
Consider Adding a Price Escalation Clause to Your Contracts
The simplest way to protect from a sudden spike in costs is to include price escalation language in all contracts. Simply put, a price escalation clause provides that the contractor reserves the right to increase the price if there is a market-wide increase in the cost of a certain material over a certain amount or percentage, so that the contractor will be able to pass along that price increase.
Typically, price lock language is used for commodity type materials: steel, PVC, asphalt, concrete, etc. These terms are more common in longer term (multi-year) agreements but, given the current pricing and scarcity, have become more and more common in shorter term agreements.
It’s a good idea to meet with a business attorney who specializes in contracts and can give you the most protection in documents such as contracts, quotes, proposals, estimates, etc. It is also important for customers to pay attention to this language and ensure that a 10% increase in steel does not trigger a price increase of the entire job by 10% (since a job most likely consists of more inputs than steel alone!).
Many of these clauses are triggered only if the contractor cannot obtain the same or similar material for the index price (as stated in the agreement).
Make sure to explain the terms in agreements to your customer. Instead of burying language in the fine print, make sure the customer knows what they are signing. The conversation will go much better if the customer doesn’t feel blindsided and is made aware of the language up front. Providing a link to a short explanatory video or requiring acknowledgement as part of a digital agreement are some examples.
Price Escalation Clause Timing Considerations
Even with the inclusion of this language, timing is an important factor to consider. For example, many contracts are written months or years before work begins. The longer the time from contract signing to the price lock date, the more risk is carried by the contractor. For example, two parties may agree that any price escalation language only applies after the contractor breaks ground. Any material cost fluctuation from signing to groundbreaking is not part of the price escalation calculation.
Other business owners choose to provide a limited duration price lock. This is common in the trades or technology industry where adolescence, scarcity, and thin margins are a major factor. A paving contractor may issue a quote with pricing valid for only 30 days to protect themselves from any wild fluctuations in the price of asphalt caused by changes in the price of oil. We’ve also seen IT consultants provide quotes for as little as 14 days with a contingency for availability of the quoted item within X% of the quoted price. A price spike or the need to substitute a higher priced product due to a lack of supply would severely impact what is already a low margin industry.
Factor In Other Costs Related to Sudden Material Price Increases
Another aspect to consider is repeated trips. If scarcity or lack of staffing will require multiple trips (mobilizations to some industries), a smart business owner needs to factor that cost into the price. A plumber might typically block off one week for the rough-in work, and another for the finish work. But, if shortages of appliances and other items are going to require multiple trips or require the installation of temporary appliances, a business owner must consider this additional cost and include it in the pricing.
Change Your Materials Purchasing Model
Another strategy to handle rapidly changing prices is to change the purchasing model. A business owner who foresees a scarcity of an essential material and expects rising prices may want to lock in a fixed price/quantity contract for a period of time. The same applies for a business owner who expects a dramatic decrease in the price of materials in the future; this owner would only buy the quantity needed at that time to take advantage of the anticipated lower price in the future. Caution is needed with this strategy, however, as gambling on the market opens a business owner up to additional risk if the bet doesn’t go his/her way.
Build Up Reserves
While not specifically related to increased pricing, one way to minimize or prevent rapidly increasing prices from having a significant impact on the finances of the business is to increase reserves. Building up reserves (after paying down revolving debt) to can provide more cushion to weather the storm. A company with deep reserves can buy in bulk to delay the impact of rising prices. Or they can use those reserves to cover the sudden rise in prices and wait until favorable conditions in the market return.
It is important to have in place a plan and strategies for a sudden increase in material cost and to stay in tune with the marketplace when planning new projects. I hope that the above tips are helpful in mitigating risk due to fluctuating material costs in the future.