Edward Federico and Kimberly Reome | HKA
Case example: A 20-story apartment building is under construction in a major USA city’s downtown. The owner and general contractor established a contract with a guaranteed maximum price of $50 million and planned for a two-year construction schedule. The contractor lined up the subcontractors and started the foundation work with no issues. However, cost increases and supply chain issues impacted the project, including major price increases in structural steel and delays to steel delivery for the building construction. The cost increases and delays did not stop at the steel. Once the contractor moved into the interior construction, they faced major cost increases and supply chain delays related to lumber for framing. Further delays occurred through the completion of the job, due to long lead times on the appliances needed to finish up the apartments before the residents could move in. The costs grew 50% over the original budget, and the project took one year longer. Determining which party is responsible for these delays and cost increases in this case requires an in-depth analysis of supply chain and material price issues, as well as related risk allocation mechanisms in the contract. This article explores some of these topics.
Introduction
Since the covid-19 pandemic started in Q1 2020, the construction world has been faced with major challenges due to material price increases and supply chain delays. These issues are still prevalent today, more than two years since the pandemic started, and continue to grow, due to other world issues such as the Russian invasion of Ukraine, environmental challenges, wildfires and economic issues related to increased tariffs from the United States. Contractors and project teams have worked to mitigate the impacts during the past few years, but it has become increasingly challenging due to the unpredictability of the issues with no foreseeable end in sight.
In November 2021, President Biden signed a US$1 trillion infrastructure plan to help fund road, bridges, airports and other transportation and utility projects. While this provides increased funding for infrastructure across the USA, it is not enough to offset skyrocketing construction costs. These continuing cost increases are causing some parties on sizeable capital projects to reevaluate scope, extend schedules or even cancel projects, and while the federal funding will likely still be spent, the amount of work it stimulates may be far less than originally anticipated.
Material Price and Supply Chain Issues
In Michigan, the Michigan Department of Transportation (MDOT) is being forced to cut back on road construction due to the steep increase in construction costs. The Waverly Road project in Lansing, for example, has experienced costs overruns of more than 50% to rebuild a one-mile section. MDOT typically plans for 4% inflation year-on-year but is currently dealing with an inflation rate of 2-3% higher. The steep increase in such project material costs, such as concrete, asphalt, fuel and steel is causing MDOT to reevaluate the number of road repairs that will fit in the budget. In some cases, projects are being delayed or even cancelled (www.wilx.com/2022/04/11/some-michigan-road-projects-scaled-back-because-inflation/, April 11, 2022.).
The Des Moines International Airport was planning on a four-year renovation with a budget of $434 million and a completion date by 2026. Costs have increased to $733 million, or approximately 70% higher than budget, and the airport is unable to afford the new cost. The project scope has changed, and is now broken up into five phases, with only a few gates to be completed by 2026. Despite reducing the number of gates to five, or 36% of the original plan, the cost is still budgeted at more than $400 million (www.ironmountaindailynews.com/news/local-news/2022/06/inflation-taking-a-bite-out-of-new-infrastructure-projects/, June 21, 2022).
Figure 1 from the recent April 2022 Construction Inflation Alert from the Associated General Contractors of America shows the two-year increases in key construction project materials per the producer price indexes (PPIs) provided by the United States Bureau of Labor Statistics. As shown in the chart, major construction materials that cover all phases of a construction project, from foundations through finishes, are being severely impacted. Some of materials most impacted include fuel, steel, lumber, and other metals:
Source: Bureau of Labor Statistics, producer price indexes, www.bls.gov/ppi
Diesel fuel prices were increasing before the Russian invasion of Ukraine, but have recently skyrocketed. This impacts the costs of both heavy equipment and the transporation needed to deliver materials, and the unexpected increases in these costs is causing many construction teams to exceed project budgets. Figure 2 shows national United States gas prices as reported by American Automobile Association (AAA) (as of June 27, 2022), and shows the national average of diesel fuel at $5.794 per gallon and the highest recorded average per-gallon price as $5.816.
Lumber, which also was impacted during COVID, started to see prices level off in late 2021, but are now increasing again, due to California wildfires and the United States’ tariffs on the Canadian lumber industry. In November 2021, the tariff rate increased from 8.99% to 17.9%, but is in the process of being reduced significantly (AGC Canadian Softwood Lumber Tariffs to Be Lowered | Associated General Contractors of America (agc.org), February 17, 20/22). While lumber costs have come down slightly, the fluctuating prices are making it more expensive to build homes (CNBC, Soaring lumber price adds nearly $19,000 to the cost of a new home (cnbc.com), February 15, 2022).
Due to the ongoing material issues over the past few years, many contractors have increased bid prices in an attempt to address the impacts of rising material costs. As shown in Figure 3, the Bureau of Labor Statistics reported a large variance between bids and actual costs through the first half of 2021. Starting in Q4 2021, however, bid prices for new projects have risen significantly, but the actual PPIs are still higher.
Source: Bureau of Labor Statistics, producer price indexes, www.bls.gov/ppi
CRUX
HKA, which provides claims consulting and dispute resolution services to clients worldwide, has developed an integrated research program to evaluate construction projects. HKA’s CRUX Insight 2021 identifies, analyzes, and summarizes the principal causes of claims and disputes. More than 1,400 projects in 94 countries around the world, totaling more than $2 trillion in construction value, were analyzed for the CRUX Insight 2021 report. In it, industry leading HKA consultants have distilled the underlying causes of claims and disputes on these projects, which total approximately $73 billion and involve time extensions totaling more than 750 years. As revealed in this innovative report, the COVID pandemic has shifted the causes of construction disputes. For example, owners and contractors are wrangling over who is liable for disruption and lost productivity on projects, which may or may not be due to COVID. However, the biggest impact – on the supply chain – may also prove the most enduring. Managing the supply chain always was a challenge on construction projects, but the pandemic has complicated things even further.
The effects on project completion dates have yet to emerge in the CRUX Insight data pool. Up to the data capture cut-off in August 2021, just over 1 in 10 projects had been hit by late delivery of materials and/or equipment. Cost overruns, time extensions and budget increases are being reported on projects around the globe, and steep price increases and delivery lags are identified as some of the main causes.
The impacts being caused by supply chain issues, material shortages, rising freight costs and distribution delays will only increase the number of disputes in the pipeline. And, like the case study cited at the start of this article, project teams will experience claims related to unforeseen costs that may not be covered in their contracts, which intensifies the challenges.
For additional information, the full HKA CRUX report can be viewed at crux.hka.com/.
Mitigating Impacts
While the global challenges involving supply chain and material costs are daunting, there are a variety of actionable measures that can help manage some of the market uncertainties, reduce the risk of claims or, at least, help parties be prepared for the claims process.
Project teams can be proactive in reducing risk during all phases of construction, with the overall risk of an unpredictable situation shared between owners, contractors, and subcontractors. During the early stages of a project, this can include incorporating concise and equitable escalation clauses that share risk for material price increases. Contract language can identify specific materials and how pricing adjustments will be applied to revise the contract price. Contract language also can include a credit to the owner if material prices decrease during the contract period.
Additional contractual language may include provisions for purchasing materials.
Because the prices of major materials are fluctuating so much at this time, clauses can be considered to cover material purchasing periods and promote pre-ordering certain materials with shared risk if the material requirements change. Such clauses also could help with overall project schedule management, as they can help to reduce delays that could otherwise be caused by long lead time materials or material shortages.
For ongoing projects, especially those that do not have detailed contract clauses mentioned above, the project teams can work together to identify any pricing adjustments as soon as they are made aware of them. In many contracts, a contractor has a defined time period, for example 30 to 60 days, to submit a request for a material price adjustment. Therefore, parties should identify and address material issues as soon as possible to avoid significant schedule impacts.
Project teams should also work to keep good contemporaneous project records that document supply chain issues and price escalation along with the associated impacts to schedule and budget. An analysis can be performed that compares the contract prices and quantities from the bids to the actual quantities purchased as well as average industry prices and material price indices. Further analysis could include, for example, comparing various vendor costs and delivery dates to support the schedule and cost impacts. Maintaining good project records and ensuring timely communication are key to limiting the impact of supply chain issues.
On some projects, the project teams may not have enough resources to handle the extensive supply chain and price escalation issues. Because of this, some companies are starting to assign supply chain teams that are specifically focused on these issues and work with the project teams to clearly document and address all potential impacts. While project superintendents and project managers are focused on building a project, supply chain teams can actively monitor the material costs, availability, and delivery dates to assess the impacts to the project and propose necessary adjustments. Using supply chain teams allows issues to be proactively addressed to minimize the risk of project delays while the construction moves forward, rather than waiting to resolve things at the end when it can become more expensive and difficult to go back and piece together contemporaneous project information. In some cases, project design is being revised to accommodate the high costs of certain materials. Designs for concrete or steel structures, for example, are being altered to include a hybrid of the two that is based on current or expected steel fabrication schedules, materials costs and availability.
Conclusion
The case study discussed at the start of the article involved an apartment building that experienced cost and schedule delays caused by material price escalation and supply chain issues throughout the project’s duration. To determine who is responsible for delays and cost overruns, it is important to have a clear understanding of the contract and how it defines material escalation, time extensions and other budget increases. Also, key contemporaneous project documentation should be reviewed with these contractual clauses in mind to evaluate the delays and assess damages.
Despite the roller coaster of material prices and supply chains issues throughout the construction industry, most projects continue to progress and project teams are adapting. While there is no timetable for these issues to be resolved, successful project teams are adjusting the way projects are set up, starting with contractual agreements, and ensuring that all project phases are proactively managed to mitigate unforeseen issues.
When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.