by Dr. Chandana Jayalath*
The provisions of price adjustment on account of increase or decrease in costs of goods and services in construction contracts are practiced World over to have more realistic competitive bids and execution of contracts on just and equitable manner. Prices of materials, plant and labour are highly variable due to fluctuations in the currency market. Construction experts, therefore, thought it prudent to compute the cost of contracts on present price, keeping provisions of price adjustment for probable fluctuations. The Institute for Construction Training and Development (ICTAD) of Sri Lanka has undertaken among others, the standardization of “country specific” documents to regulate and streamline the administration of contracts. The Formula Method for Reimbursement of Price Fluctuation is one such initiative to offer a reasonable basis for calculating price adjustment for construction contracts.
It provides a mechanism for contract price adjustment due to open market escalation in specified construction inputs such as major building materials, hire charges of plants, and wages for the labor. The choice of those inputs largely depends on the principle of cost significance in the overall share for the quoted tender price. Therefore, the adjustments to the contract price shall be made in respect of not only in rise but also in fall in the cost of materials and other inputs affecting the cost of the execution of the works. In bidding documents having provisions for price adjustment, the Employer is expected to receive more competitive offers from reputable parties and will have to meet the net variations in cost as may actually occur. It is therefore intended to make reasonable price adjustment in the claimed amount, which by virtue of its being restricted to listed adjustable elements, is an approximation. The objectives of this mechanism are to make price adjustment (as a reasonable compensation against variation in prices of the selected inputs) as close as possible to the actual, set out a simple procedure, minimize ambiguities and make the contract more equitable.
It must be noted at the outset that ICTAD price fluctuation mechanism is a compensation method and not an actual loss recovery method. The formula method it prescribes is for compensating escalated components of prices of construction materials, labour, and plant, using indices. Indices are a general reflection based on price movements of a particular input relative to a base point of time. The fluctuated component is ascertained on the difference between the indices of costs of construction labour and materials at the time of bidding and the current values of those indices during the construction stage in accordance with a predetermined relative proportion for each cost index. Under circumstances, there could be apparent deviations from the traditional calculations on actual records. However the totality at the end of the contract would amount to a less significant deviation though there may be few proven research to justify this proposition.
Also, one would see as a glaring anomaly when the payment for fluctuation caused by increase or decrease in the prices of certain materials may be made at a time when such materials were not used at all. For instance, in a project where substantial demolition works form part of the escalation payment resulting for increase in price of roof cladding for example may be made on the value of demotion work. In such instances, the next resultant impact due to escalation is made reconciled only at the practical completion.
ICTAD initially recommends that their price fluctuation formula should be used for those contracts where duration is more than three months on the presumption that: (i) the changes of price during a shorter period like three months is not significant: and (ii) an experienced contractor can foresee the likely price variance in the first four months. However this does not restrict the reimbursement if any on price escalation even for projects having a lesser duration.
Also, it is assumed that the payments to the contractor shall be made on monthly cumulative basis and the adjustment to price variation may form part of the interim progress claim. Accordingly, the cumulative work done (Vc) up to the time of valuation will be computed based on the rates of the claim of quantities, the total cost of material at site (Mc) is added to the cumulative work done and the valuation of work for the period concerned is then computed by deducting the cumulative work done and cost of materials at site (Vp + Mp) of the previous valuation. Amongst those not considered for price adjustment are non adjustable items; basically preliminary items, provisional sums, prime costs sums, fixed sums where the employer has allocated for any specific purpose, work done with the employer supplied materials and work valued at day work rates.
It is also presumed that the employer shall list out the percentage cost contribution of materials, plant and labour. The selection of materials is based on the principle of cost significance and these input proportions must represent the percentage shared by the construction inputs in the total cost of the project. The contribution of the minor items is built into the formula by assuming that the combined contribution of such items is ten percent of the contract.
Formula applications are dependent upon the availability of reliable indices that should reflect price movements of basic inputs at regular intervals. Indices used in the formula are those regularly published by ICTAD in the Bulletin of Construction Statistics. Basic prices are generally those established one month and current prices are those prevailing at the time construction. In other words, it will be the index for the month applicable for the purpose of interim application and if the contractor fails to forward an interim claim but has a claim subsequently, the current indices for that valuation shall be taken as those prevailed at the calendar month after the previous valuation was done. If no claim is forwarded by the contractor for the work done on month 1, but has forwarded a claim subsequently, the current indices applicable are those indices prevailed during the month 1. Prices could be ex-factory, imported, or open market and no account shall be taken on profit, off site and general overheads including costs on delivery to site.
The contract must specify whether local and/or foreign components are subject to adjustment due to price escalation. According to the NPA guidelines, in any contract for works, exceeding a period of three months, the price variation formulae for the local currency component shall be included in the bidding document and the contract agreement. For foreign funded projects, if it may be a requirement of the foreign funding Agency, the price adjustments shall be made for foreign currency component, such recommended formulae may be used for the foreign currency component. However, in such case the ICTAD formulae shall be used for local currency component.
Computing average inputs derived from weighted average of each separate section of the Works, is also possible particularly in projects such as housing, factory complexes etc where there can be many composite items.
The use of simplified formula requires some clarification. Firstly, the simplified formula shall be used for contracts, where the estimated price is less than Rs. 10 m. In the Standard Formula, indices are based on the material, labour, and plant/ equipment issued monthly by ICTAD. However, in the simplified formula indices are based on the type of contracts and issued quarterly by ICTAD. The monthly indices for this formula should be calculated by interpolation.
What will happen in a situation where the contract has extended beyond the agreed completion date? If the Contractor fails to complete the Works within the agreed time for completion the price adjustment for the work done after the due date of completion shall be made using the current indices prevailed at due date for completion. Accordingly, the use of indices will freeze at the point of agreed completion date.
There can be over or under recovery in some extreme cases. One instance is where the contractor will have to expend more money for the whole quantity of input with the fluctuated amount earlier than what was envisaged in the original sequence. This ‘early input early rise’ situation is when a particular item is executed at an early stage and at the same time the price fluctuates but the contractor will have to await up until the project completion in order for reimbursement of the total fluctuated component. The second scenario is ‘early input late rise’ where the price fluctuates after the input has been used in the Works. In these circumstances, the contractor is going to receive an extra amount of money for late fluctuation though the contractor has incurred the cost of inputs free from any fluctuated amount. ‘Late input early rise’ situation is another eventuality where the input used in the late stage of the project has been already sustained fluctuation well in advance so that the contractor’s paid amount for the inputs invariably include the fluctuated component. The contractor can claim price escalation in the inputs from early stage of the project without use in actual works. A situation of ‘late input late rise’ is when both the input and fluctuation that attached to input occurs at the late stage of the project than envisaged in the original sequence of Works. The contractor simply expends additional money on fluctuation only at the last lap of the project though the fluctuation has been considered in each interim valuation from the beginning of the project. It must be noted that depending on the time of input usage and how it has been planned in the original sequence and the way it sustains fluctuation, the parties may incur either loss or gain that reconciles only at the final accounting stage. What can be derived from foregoing eventualities is that the method of computing price escalation operates on the caveat of project duration instead of a particular point of time of the project. For a full reimbursement without over or under recovery, the application of the formula method must continue on the correctly calculated input percentages, and adjusted inputs from time to time due to varied works and errors if any in theoretical quantities and the right choice of the indices.
ICTAD publishes to-date materials of 57 species each has its own price trends based on seasonal effects, localities, changes in the user perception, changes in tax system, and also the price. PVC products for example are assumed to be linearly fluctuated in equal magnitude. Sand prices go up in shortage of supply. Locally manufactured bricks and blocks virtually remain constant throughout the year. Prices are the open market price payable at the source of purchase generally without transport. This ‘final’ price per one number unit of purchase is taken as appeared in the price lists produced by the sellers. It does not either include discount for bulk purchase. As such, the contractor may get the benefit of large scale bulk purchase delivered to site for future works. The contractor may similarly lose in a subsequent price decrease.
Regarding tax, construction is a taxable activity at different points of value addition and care must be taken as to how different forms of tax apply. For the purpose of the indices, the price of a material is ‘final’ consumer price as declared by or collated from price lists. Care must be taken to see whether the tax components have been considered uniformly in preparation of the indices. However, it can be argued that this formula is a ‘Colombo formula’ as it simply survives on the prices collected from Colombo and Colombo suburbs.
With industrial feedback, both for and against, the ICTAD formula method has been used in contracts and found to be best fit for large contracts having a large number of activities over a period of many years where the administration of price escalation using traditional method is simply tedious and laborious. For contracts having a smaller number of activities, the ICTAD simplified formula is appropriate.
Disclaimer; the contents of this article are opinions of the Author presented for the study purpose. They are not a legal interpretation neither the position stood by the ICTAD as far as the application of this formula method is concerned.
* Chartered Quantity Surveyor
