Managing material price risk in construction contracts
Between the day a tender is priced and the day the last delivery arrives, the price of steel, cement or copper can move by more than the contractor's margin. Somebody carries that risk. This article explains who, how a fluctuation formula works, and what both sides can do about it.
By the Caprix AI team · · 8 min read
Key takeaways
- On a fixed price contract the contractor carries material price risk and prices it into the tender.
- A fluctuation clause moves the risk to the employer, who pays the actual movement instead of a premium for it.
- Formula methods adjust payment by index movement, which is simpler to administer than proving actual costs.
- Exposure depends on timing: the materials bought latest in the programme carry the most risk.
- Tracking the few materials that dominate a project's cost is worth more than watching everything.
Who carries the risk
There are two basic arrangements, and each has a price.
| Fixed price | With fluctuations | |
|---|---|---|
| Risk carried by | Contractor | Employer, wholly or in part |
| Tender price | Includes an allowance for expected movement and its uncertainty | Priced at current levels |
| Cost certainty for the employer | High | Lower |
| If prices rise sharply | Contractor's margin is eroded, which can lead to claims or distress | Employer pays the increase |
| If prices fall | Contractor keeps the gain | Employer benefits |
Neither is free. On a fixed price the employer pays for the risk whether or not it materialises, because every tenderer has added an allowance. With fluctuations the employer pays only what actually happens, but loses certainty.
As a rule, risk is cheapest when carried by the party best able to manage it. A contractor can manage a few months of price movement through its supply arrangements. Few can manage several years of it, which is why long contracts and volatile markets are where fluctuation provisions tend to appear.
How a formula adjustment works
The older way to deal with fluctuations is to reimburse the contractor's actual increases against a list of basic prices, which means checking invoices. The formula method replaces that with published indices.
In its simplest form, for one material:
Adjustment = value of work in the period × weighting of the material × (current index − base index) ÷ base index
For example, take RM2,000,000 of work certified in a period, with steel weighted at 25% of that work. If the steel index was 120 at the base date and is 132 now, the movement is 10%, and the adjustment is RM2,000,000 × 0.25 × 0.10 = RM50,000. These figures are illustrative.
Real provisions add detail: several materials each with its own weighting, a non-adjustable portion, thresholds below which no adjustment is made, and rules on what happens during a period of delay. Public works contracts in Malaysia have used variation of price provisions of this kind for selected materials. The terms differ between contracts and over time, so read the provision in front of you.
Where the exposure really is
Not all of the contract sum is exposed, and not equally. Three questions narrow it down.
- Which materials dominate? On most buildings a short list, such as reinforcement, concrete, structural steel, copper cabling and facade materials, accounts for most of the material value.
- When is each bought? Substructure materials are purchased early. Finishes and services equipment are purchased late and have the longest exposure.
- How volatile is each? Traded metals move far more than locally produced aggregates.
Value multiplied by volatility multiplied by time gives a rough ranking of where to spend your attention.
Ways to reduce the risk
Buy early
Place orders, or fix prices with suppliers, for the dominant materials soon after award. This trades price risk for storage, cash flow and the risk of design change.
Fix supplier prices
Agree a price held for a stated period or quantity. The supplier will charge for this, and their ability to honour it matters.
Shorten the exposure
A shorter gap between tender and award, and realistic programmes, reduce the time over which prices can move.
Specify with alternatives
Allowing equivalent materials or sources gives room to respond when one product spikes.
Share the risk
A fluctuation clause limited to named materials, or with a threshold, can cost less than pricing all of the risk either way.
Hold a reasoned allowance
Where the risk stays, quantify it for the exposed materials instead of adding a general percentage.
Watching the market
Whatever the contract says, both sides are better placed if they know what is happening to prices before it reaches a valuation. That means a short watch list for the project, reviewed regularly, with a record of prices at the tender date to measure against.
For the contractor this informs when to buy. For the consultant it supports advice on tender validity, on whether returned tenders reflect the current market, and on claims that cite price increases.
Doing this in Caprix AI
Track pins up to 10 material, labour or machinery rates to a watchlist that updates itself when a newer period is published, with a price alert on any item and an optional email when a tracked rate has a new price. A rate forecast gives low, base and high scenarios for a single item, and Trends charts the cost index for a category and state. For the contractual side, such as what your fluctuation clause entitles you to, Advise gives guidance from Malaysian case law and the documents you attach.