By Marty McCarthy, CPA, CCIFP, of McCarthy & Company, PC

Construction contractors are regularly challenged to deliver projects on time and within budget. Of particular concern are supply chain interruptions and price fluctuations that make it challenging to start or complete projects. However, there are steps that can improve the situation, by ensuring that contracts contain certain provisions to protect contractors. Without these provisions, contractors could suffer significant losses, adversely affecting their ability to meet their financial obligations and materially affecting their ability to obtain bonds.

It is helpful to understand construction contracts, what contractors must deal with, and what they can do. Again, the goal is to provide contractors with the insight to operate without materially affecting their financial situation. Contractors should discuss contract provisions with their legal counsel. Sureties can also help by discussing options with their contractors. Here are topics to address:

Excusable Delay Clause. A justifiable delay clause may apply if a construction contract’s performance is delayed due to a supply chain issue. An excusable delay clause allows the contractor to extend the project timeline due to a “cause beyond its control.”

Cost-adjustment clauses. If a construction project is delayed due to supply chain issues, a cost-adjustment clause in the contract can provide relief. This clause can be found in most construction contracts. It addresses the commitments of the contractor and owner.

Delay provisions in a construction contract should be written carefully. They are meant to provide equitable adjustments in the event of an increase in the cost of materials or labor. Since delays are unpredictable, a fair argument needs to accompany this clause.

Price Escalation Clause. This type of clause is essential to mitigate and manage inflation. A price escalation clause should account for the risk of price increases due to supply shortages, high demand, or several other legitimate reasons. Many contracts don’t include escalation clauses, which can lead to reduced profits. Contractors could use this clause as a way to mitigate risks and improve productivity through technology and better job management.

Force Majeure Provision. Generally, a force majeure provision provides relief if a specific unexpected condition occurs. Either party may be relieved of having to perform under the terms of the contract. Depending on the circumstance(s), a contractor or subcontractor may be entitled to an extension due to supply chain disruptions.

A force majeure clause allows the contractor to recover damages for delays due to a broader range of circumstances. For example, a global pandemic that impacts the supply chain can trigger a force majeure clause. However, if the clause does not explicitly address the type of delay in the project, the contractor may be unable to pursue recovery.

Transfer of risk. Another option for dealing with construction contract delays is to transfer risk. This option can eliminate the need for separate insurance policies for contractors and subcontractors. This is known as a wrap-up insurance program that reduces the overall insurance cost and ensures consistent coverage.

While this option may reduce costs, it also increases risk, as a disruption to the supply chain can prevent materials from being delivered on time or at all. Supply chain issues are particularly problematic for construction projects because they can directly affect construction progress. Generally, liability or builders’ risk insurance does not cover these risks.

Whether to transfer risk or not is a crucial decision. Ultimately, the choice will depend on the nature of the construction project and its risks. For example, many risk-based construction contracts include incentive clauses that reward the contractor if he or she completes the task ahead of schedule or penalizes the contractor for finishing late. On the other hand, if the project is delayed, the contractor is exposed to direct and indirect liability for delays and damages. In addition to liability coverage for the contractor, insurance companies can also provide coverage for business interruption, worker’s compensation, and other issues.

Contractors should look at all insurance policies to check coverage and ascertain if it is feasible to opt to self-insure their risks. In this case, the company pays for the financial consequences of a failure rather than an insurance company.

During the contract formation process, a contractor must understand the damages that may be awarded. The most common and easily understood type is liquidated damages. These agreements predetermine the damages that an owner can recover from a contractor and allocate a fixed amount of damages for each day a contractor fails to meet a significant milestone.

Acceleration Damages. If the contractor can’t deliver the project on time, the owner will likely be entitled to acceleration damages and compensation for the additional expenses. An example of such payment would include any overtime or payroll costs incurred by the owner due to the delay. Further, if the delays have caused the project to miss its designated completion date, the contractor could be contractually required to fast-track construction on the job. This could increase the costs associated with the project, including overtime and equipment costs.

Other Considerations

The economic climate is forcing construction companies to look for ways to protect themselves. Adding termination and compensation provisions to the contract has been an effective tool. In addition, an indemnification clause allows the parties to adjust the price or payment for materials when costs increase

With jobs being canceled due to higher interest rates, increasing costs, project delays, and changing market conditions, it is beneficial for contractors to check backlog, review overhead costs, and reduce operating expenses where possible. Of course, overhead costs are always a challenge, but awareness of those costs and where opportunities exist for cuts can yield significant benefits in this environment.

Contractors could also purchase materials early in the construction process to avoid price increases and guarantee that enough inventory is available for future jobs. It is important to stay updated on market conditions, trade agreements, tariffs, politics, and other factors that impact supply chains and prices. Contractors should also talk with their bankers to ensure their line of credit is adequate to meet the new normal.

Now is a good time for sureties to be proactive. Encourage contractors to openly discuss what is going on with their contract obligations, job progress, and completed projects. Recommend tracking key metrics, comparing prior years, and projecting future results based on historical data and “what-if” scenarios. While there is no way to predict what will happen with certainty, contractors will be better prepared to face challenges with strong contracts to back them up.

Disclaimer: This article is for informational purposes only and doesn’t constitute professional advice.

Marty McCarthy, CPA, CCIFP, is the managing partner of McCarthy & Company, PC, a leader in construction accounting. The firm is committed to helping clients strengthen their financial position, grow their businesses, and become more profitable. McCarthy can be contacted at 610.828.1900 or marty.mccarthy@mccarthy.cpa.