Effects of Inflation on Construction and Government Contracts
As of June 2022, the annual inflation rate in the United States hit 9.1%, the highest it has been since November 1981.1 Inflationary effects and risks are not always uniform and can be different across industries, materials, and even equipment.2 Year-over-year price comparisons for typical construction costs are provided below.3
Potential drivers of inflation include labor shortages and supply chain impacts (e.g., COVID-19 pandemic). While the initial shutdown and lasting effects of the COVID-19 pandemic continue to impact the construction industry, other global events have also likely contributed to the market inflation, including:4
- 2021 Texas power crisis
- Blockage of Suez Canal
- Hurricane Ida and impacts to Louisiana’s electrical grid
- Mudslides in British Columbia
- Invasion of Ukraine
Impacts on the Construction Industry
Inflation volatility directly impacts the construction industry. For example, it can impact a contractor’s ability to predict future costs and profit margins. This may result in bids coming in higher than expected, to account for worse-case pricing scenarios or a final contract that carries cost overrun risks with aggressive pricing.
Additionally, inflation volatility may put more emphasis on contract structure and front-end project negotiations. For example, contractors might avoid certain contract types such as fixed price contracts when there is such cost uncertainty. Contractors might also consider adding contract clauses specifically to account for inflation volatility.6 Contractors with more stable and dependable pricing metrics may be in a better position to win and successfully manage projects. This may include contractors that own their own equipment7 or contractors that have superior relationships with their vendors and suppliers.8
Inflation can also increase construction project insurance costs and may impact insurance coverage. For example, generally, direct risk and liability insurance premium costs increase with increasing contract value, including cost increases caused by inflation.9 Second, inflation increases direct costs required for rebuilding or repair work that may or may not be covered by existing insurance policies.10 While existing insurance policies may contain certain insurance inflation policy protections, or “escalation clauses,” these protections or clauses need to be carefully considered as they are generally capped at a certain price or percentage point.11 Contractors and owners should ensure their insurance coverage is adequately updated with inflation volatility.
Impacts on Government Contracts
Inflation can also have unique impacts on government contracts. The government awards contracts through various contract vehicles, including firm fixed-price (“FFP”) contracts. FFPs may not account for inflation and are designed to “provid[e] maximum incentive for the contractor to control costs and perform effectively” by making the contract “not subject to any adjustment on the basis of the contractor’s cost experience in performing the contract.”12 Accordingly, some government contractors may face challenges recovering increased costs due to inflation.
May 25, 2022, the Department of Defense released its “Guidance on Inflation and Economic Price Adjustments” memorandum to provide guidance to contracting officers on how to proceed with government contracts in a high-inflation environment.13 This memorandum states the inclusion of economic price adjustment (“EPA”) clauses “may be appropriate” in newly written government contracts to “equitably balance the risk of inflation between the Government and contractor.”14 However, for existing FFP contracts, the memorandum states that the Government should not consider or “accept [Requests for Equitable Adjustments] (“REAs”) in response to changed economic conditions.”15 Therefore, existing FFP government contracts may have limited recourse for inflation impacts alone.
Economic price adjustment clauses establish “a mechanism to mitigate specifically covered cost risks to both parties as a result of industry-wide contingencies beyond any individual contractor’s control” which “enable[s] a contractor to accept a fixed-price contract without having to develop pricing based on worst case projections to cover the cost risk attributable to unstable market conditions.”16 Economic price adjustment clauses depend on various indices to measure inflation, so contractors and contracting officers alike should be wary when selecting an appropriate index.17
Compliance with contract requirements is vital when proposing adjustments under economic price adjustment or REA clauses, which can include properly tracking estimated and incurred costs and providing timely notice of any impacts.18 A contractor should understand its contracts, including any limitations that may affect its project performance in a high-inflation market.
Many of Breakwater’s clients feel the impacts of market inflation and its downstream effects. Breakwater has skilled professionals who are experienced in analyzing and developing bid schedules and schedules of values, analyzing disputes related to cost escalation and inflation, and assisting government contractors through contractual procedures like REAs.
1: It is important to note that inflationary effects and risks are not always uniform and can be different across markets, materials, and even equipment.Trading Economics United States Inflation Rate.
2: Economics From the Top Down, par. 50: The Truth About Inflation.
3: Associated General Contractors of America Feb 2022 Construction Inflation Alert.
4: Associated General Contractors of America April 2022 Construction Inflation Alert.
5: Associated General Contractors of America April 2022 Construction Inflation Alert.
6: Rogers Joseph O’Donnell: Legal Strategies for Contractors to Survive the Surging Price Increases and Delays in the Later Stages of the Pandemic.
7: Equipment World, par. 11: How Contractors Can Continue to Navigate 2022 (Ben Johnston, COO of Kapitus).
8: For Construction Pros: Construction Companies Shifting Pricing Models to Reflect Inflation (Study).
9: Insurance Journal: Commercial Rate Hikes Not Enough to Offset Construction Costs (Moody’s).
10: Insurance Journal: Inflation Is Inevitable. Why Are Property Insurers Unprepared?
11: Husch Blackwell: Protection Against Escalating Material Costs in the Construction Industry.
12: Acquisition Regulation: Subpart 16.2 Fixed-Price Contracts.
13: U.S. Department of Defense: Guidance on Inflation and Economic Price Adjustments Memorandum.
14: U.S. Department of Defense: Guidance on Inflation and Economic Price Adjustments Memorandum.
15: U.S. Department of Defense: Guidance on Inflation and Economic Price Adjustments Memorandum.
16: U.S. Department of Defense: Guidance on Inflation and Economic Price Adjustments Memorandum.
17: U.S. Department of Defense: Guidance on Inflation and Economic Price Adjustments Memorandum.
18: Government Executive: How Can Defense Contractors Battle Rising Costs? Here Are Some Tips.
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