Cost Fluctuations in Build Contracts – Guest Blog

Date Published: 10 June 2022

Just a couple of years ago, the use of the words “cost fluctuation” in the residential building industry was about as common as the use of the word “liquefaction” prior to September 2010!

What do cost fluctuation clauses in residential building contracts actually mean?  Are they fair?  Is there a better alternative?

Below we look at what a fixed price building contract means today, how cost fluctuation clauses work and an alternative to these blanket cost fluctuation clauses that is fairer to both the builder and the owner.

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Tom Evatt & Co have written this article solely for information purposes and it is not a substitution for specific legal advice. All building contracts are unique and interpretation of them will also depend on the relevant facts. Please contact Prue Miller for further assistance.

The original version of this post can be found here.

prue.miller@tomevatt.co.nz : 021 023 80405

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Fixed Price Vs Cost Reimbursement Building Contracts

Like ‘cost fluctuation’ and ‘liquefaction’, the words “fixed price building contract” are gaining a lot more attention lately due to current issues in the construction sector such as shipping delays, labour and material shortages, and high inflation.  This attention has highlighted how uncertain and subject to change these fixed prices actually are.  Residential building contracts are typically priced on a fixed price basis, but on occasion will be priced on a cost-reimbursement basis.

A fixed price in a residential building contract is a specified total contract price, which is subject to change by variation or adjustment.  A variation or adjustment can result in an increase or decrease in the original costs of trades, labour and materials used to establish the fixed price.  These can occur in a range of circumstances including:

• delays for which the owner takes the contractual risk of any cost increase;
• changes to the scope of what is being built (i.e. changes to the plans and/or specifications);
• provisional or prime cost sums (estimates)which form part of the fixed price; and
• cost fluctuation of labour, materials, trades, and builder overheads.

Fixed-price contracts are intended to give the owner certainty of price (subject to variations or adjustments) as the builder takes on the risk of price change. Inherent in fixed pricing is that the builder does not disclose its margin across the different parts of the building works.

Cost reimbursement contracts, also known as charge-up contracts, don’t provide a total price at the outset (although they may provide an estimate), but instead allow the builder to charge on a regular basis as the works progress.  Cost reimbursement contracts usually include fixed labour rates and all-time and other material, trade and overhead costs incurred by the builder are invoiced once they are incurred, with an additional agreed percentage added for margin.  From the owner’s perspective, at the outset, there is no certainty of the final price, but there is continued visibility of all costs incurred by the builder and the builder’s margin.

Provisional or Prime Cost Provisions (PC Sums)

Provisional Sums are an estimated amount for a specific part of the building works which are not yet established or defined in enough detail to be able to accurately price at the outset.  They are included as part of the overall fixed price.

Prime Cost Sums are similar to Provisional Sums.  They relate to an item of specified materials that can be clearly defined, except that the cost cannot yet be fixed because the owner has not yet confirmed the specific item/material the owner wants.  Sometimes Prime Cost Sums have also been used where even though the owner has confirmed the item/materials, the builder is unwilling to agree to fix the pricing.

Provisional and Prime Cost Sums (we will call them both PC Sums) are ‘placeholders’ for the final amount that the owner will pay for specified parts of the work or specified materials.  If the final amount increases, the owner pays the additional cost, plus the builder’s margin.  If the final amount decreases, the owner is credited the decrease (although the margin is usually retained by the builder).  Essentially, they allow for an agreed combination of fixed pricing and cost reimbursement.  Both the builder and the owner are clear from the outset which parts of the building works are fixed and which parts may be subject to price increases and valued on a cost-reimbursement basis.  PC Sums still need to be managed carefully.  Owners should do their due diligence and ensure that the placeholder amounts are realistic estimates for the parts of the building works to which they relate.

Cost Fluctuation Provisions

Cost fluctuation provisions in fixed price residential building contracts are not new and all standard residential building contracts in New Zealand contain these clauses (unless the parties have specifically removed them).  Since the 1980s, these clauses have remained relatively redundant, however, in the current climate of shortages of materials and inflation, their fine print is getting a dust-off.   The result – no part of the pricing in a fixed price contract is fixed.

These clauses allow the builder to increase the fixed price if the builder has suffered an increase in its own costs, often without a requirement to provide any evidence of the increase.  The crux of this is that (even though the builder’s margin may not be charged), a cost fluctuation clause works either like a big PC Sum that is the placeholder for the overall contract price, or morphs a fixed price contract into a cost reimbursement contract, either way without the visibility to the owner of all of the builder’s costs.

Even if the builder produces evidence of an increase in costs in reliance on a cost fluctuation clause, unless the part of the works or the materials to which the increase relates is clearly specified, priced and communicated to the owner at the outset (like a PC Sum) then there is potential for a builder to unilaterally change the contract to a combination of fixed pricing and cost reimbursement, over whichever items of work and materials the builder chooses.  This erodes the very concept of price certainty inherent in a fixed price contract and has the potential for the total building cost to exceed what it would have been under a cost reimbursement contract.

Cost fluctuation clauses are intended to be used for genuine cost increases to protect builders.  Our construction sector is crucial to the future of New Zealand and it is not in anyone’s interests for building companies to fold.  Owners also need to remember that they receive the end result of the cost increases – their home and its potentially increased value. However, these blanket cost fluctuation clauses and the way they can be manipulated by some unscrupulous builders should be seriously questioned. The clauses themselves and some practices that are developing from reliance on them in these current times potentially breach builders’ obligations under the Fair Trading Act 1986.

Are PC Sums an alternative?

PC Sums are, and rightly so, viewed as uncertainty of cost in those parts of the fixed price building works to which they relate.  The benefit of PC Sums though is that the owner and the builder are clear at the outset which parts of the building works have price uncertainty and which parts are fixed.

Prior to the current residential building boom, builders used PC Sums more frequently than they do now.  Unfortunately, PC Sums started getting a bit of a bad rap, particularly from the banks, who often required the removal of any PC Sums as a condition of finance being approved.  This was an unfortunate direction taken by the banks, as it has resulted in builders having their hands tied, removing genuine PC Sums and now resorting to the use of blanket cost fluctuation clauses to recover their additional costs, without the benefit of cost visibility that PC Sums allow an owner.

An alternative to these blanket cost fluctuation clauses is to be clear from the outset which parts of the building work will be subject to cost fluctuation and those parts be given a placeholder amount, in exactly the same way that PC Sums work.  Such clauses should also include a cost-reimbursement process that requires the builder to provide evidence of the increases.

Just say No!

Removing blanket cost fluctuation clauses, which often omit detail around what pricing needs to be disclosed to the owner, and instead, dealing with price uncertainties in the same way as PC Sums, is fairer.  In other words, it allows the builder to fix the pricing that the builder can fix, but still recover increases for specific parts of the works on a cost-reimbursement basis where the builder cannot fix the price.  This approach means the builder does not have to disclose its margins on the fixed priced aspects, but still gives the owner clarity of actual increases on the non-fixed parts.  Not only is this a fairer approach, but it will no doubt reduce the risk of disputes arising.