When the Price Is Right: Planning for Price Escalation in Contracts

In my 20-plus years in government procurement, one thing has been a constant: market conditions are always in flux. When that happens, prices increase, which can lead to new costs for local government projects.

Price escalation requests are constant in the government procurement universe we live in. Given that, how can local governments plan and prepare for price escalation in contracts? My colleague and I will be tackling this question in a two-part blog series on the topic. Part 1 will share some common approaches to plan for price escalation prior to contracting and Part 2 will focus on how to address price escalation after contracting.

Background

For local governments, price escalation is a pricing increase from a contractor related to market conditions impacting contracts for materials, equipment, supplies, services, or construction (public work). While tariffs are the most recent common market condition for price escalation requests, contractors may request price escalation for inflation related to a multitude of market conditions, such as material costs, supply chain disruptions, and fluctuating fuel costs.

To address this constant in the procurement universe, agencies should develop price escalation language specific to each solicitation and contract, in tandem. By developing this in tandem, a government agency can provide expectations for price escalation during the solicitation period, and the potential contractors can provide pricing in alignment with how your agency may expect price escalation to be addressed in the resulting contract.

Let’s discuss some common price escalation clauses, their advantages and disadvantages, and identify “When the Price is Right” for using the different approaches. With each approach, I highly recommend identifying the specific contract language upfront in the solicitation, and this language should then be incorporated into the contract. This will streamline the process to finalize the contract.

Firm-Fixed Pricing

With firm-fixed pricing, a contractor provides prices in response to a solicitation, these prices are expected to be set as reflected in the solicitation, and language is incorporated into the contract award. Pricing will not adjust/increase due to changes in market conditions or contractor costs.

Advantages

With firm-fixed pricing, the agency knows the total contract costs upfront and those costs cannot change. This reduces the risk of increased costs during the project and solidifies budgeting and financial planning.

Disadvantages

The agency may experience higher initial costs. Contractors may include a contingency in their solicitation to cover increased costs due to market changes, which can make the initial contract price higher, particularly for multi-year contracts.

When the Price is Right

Use firm-fixed pricing for short duration contracts (one year or less) that utilize standard materials and equipment with 'off-the-shelf' inventories available from multiple local suppliers. For contracts spanning multiple years or requiring specialized materials/equipment, fixed pricing with a market indicator price escalation clause may be a more suitable option.

Fixed Pricing with Market Indicator Price Escalation

In this second approach, pricing can be adjusted in relationship to a defined market indicator, such as the Consumer Price Index (CPI) or Producer Price Index (PPI).

When planning your solicitation and contract award using the fixed-price approach, consider the following:

• The frequency of price escalation. A common approach is to allow price escalation adjustments only with the renewal of the annual contract.
• Timing for when requested price escalation can be made. For example, if price escalation adjustments are allowed with annual contract renewal, the public agency may require the contract provider to make the request 60 days prior to renewal.
• Total price escalation the agency will allow. As one example, based on specific funding requirements, is there a “cap” that places a limit on the price increase regardless of the percent change in the market indicator used?

As noted above, specific contract language outlining the market indicator (e.g., CPI, PPI) should be identified in the solicitation and also incorporated into the contract.

Advantages

This approach provides a transparent, objective, formula-based method for adjusting prices in government contracts. For multi-year contracts, adjustments are made with market conditions, reducing the risk of contract defaults.

Disadvantages

While transparent and objective, price indexes are often published with a delay (e.g., monthly, or quarterly), which could create timing issues based on when price escalations are reviewed and adjusted.

When the Price is Right

Using the fixed-price approach with multi-year contracts on an annual basis (in line with contract renewal periods) can keep an agency and its contractor aligned with adjustments to market conditions and reduce the risk of contract defaults since contractors are not required to hold the initial pricing steady for multiple years into a contract.

Other Considerations: Requiring Performance Bonds

Even after implementing one of the strategies described above, an agency may want additional protection against extreme cost escalations that could impact a contractor’s willingness to fulfill an existing contract. In such a situation, an agency should consider a performance bond.

Wait, does this apply to all projects?

While performance bonds are commonly associated with public works projects, an agency could also consider a performance bond for a non-public-works project. When developing the project request for solicitation, an agency should include the bond requirement language in the solicitation to indicate that it would be required as a condition of contract award. The agency would want to include a specific requirement that the contractor must provide a performance bond in the amount of 100% of the awarded contract value.

Advantage

A performance bond reduces financial risk with the surety providing financial backing if the contract provider cannot fulfill the contract.

Disadvantage

Performance bond requirements can add increased project cost as contractors will likely pass the cost to obtain the bond along to the agency.

When the Price is Right

Use this approach for a non-public-works project where non-standard equipment is customized to the agency’s needs and the lead time for delivery is longer than the average agency project.

Closing

Price escalation is a constant reality in government contracts due to the multitude of changing conditions in the marketplace. However, an agency can plan for these uncertainties. First, starting with the solicitation, an agency should clarify its expectations related to price escalation with the terms carried through to contract execution. Whether it’s firm-fixed pricing, escalation tied to market indicators, or requiring performance bonds as part of the contract, the key is selecting the right tools to make sure the price is right for the life of the contract.

In Part 2, my teammate, legal consultant Julie Nicoll, will ensure your agency knows when the prices are right by discussing price escalation issues after contract execution.

Additional Resources

In addition to the MRSC Sample Document Library, where you can find many different examples of price escalation clauses from local governments, my research in writing this blog also uncovered the resources listed below.

On fixed pricing with market indicator price escalation

Check out the resources available from the U.S Bureau of Labor Statistics (BLS). First, here are some guides on both CPI and PPI indexes:

• How to Use the CPI for Escalation
• PPI Guide for Price Adjustment

In addition to reviewing these guides, local governments can contact the BLS directly at 202-691-5200 to obtain recommendations on which CPI or PPI index your agency should consider, including cost escalation when developing a solicitation or specific contract. Never having used this resource myself, I called them just to see how it works and was impressed. When I called, someone immediately answered and confirmed they provided this support.

On performance bonds

While focused towards state agencies, the Washington State Department of Enterprise Services' (DES) Using Goods and Services Procurement Bonds contains general information relevant to any state or local government agency on how a performance bond could be utilized in the non-public-works project space.