Cost Price Adjustment (CPA)
Also known as Economic Price Adjustment, Cost Adjustment, Price Escalation, Price Indexing etc.
What is Cost Price Adjustment?
It consists of providing contractors with protection against materials, manpower and fuel price increases that may occur during the execution of the work through the use of Price Adjustment Clauses (PACs). Under these provisions, the contract accepts the risk for increasing prices by offering a PAC that will compensate the contractor for any increase above the bid price or a trigger amount of a specific material.
Why use Cost Price Adjustment?
This type of provision has the following benefits to the project:
- It lowers bid prices
- It increases the number of bids and fewer bid retractions
- Better market stability
- Increased reliability in the supply chain
- Consistent contractor profit margins
- Maintains time value of money
- Insure risk on price fluctuation
What does CPA do?
PACs help in addressing the issues caused by commodities with volatile prices. The uncertainty about future costs brings large risks to the construction contracting industry. As a result, under regular payment provisions, contractors try to include risk premiums to their bids to ensure profitability through unforeseen circumstances causing overall higher bid prices. In addition, for the case of long term projects, changing prices result in much higher risks as the changes increase with time resulting in unrealistic bid prices. By transferring the risks from the contractor to the Client, the need for these contingency costs is eliminated resulting in better bid prices. In addition, by eliminating the risks, PACs shield construction firms from large losses on single contracts. PACs help reduce the number of firms that exit the market and provide better market stability.
How to use CPA?
The guidelines for the implementation of PAC include the following four sections:
- Criteria for Implementing a PAC Program – In this stage, the Client should perform a risks and benefits analysis to assess the need of a PAC. Among the benefits are improved market stability, better bid prices, increased number of bidders, less bid retractions, and reduced risks for contractors. Among the risks are political barriers, increased power of suppliers in the supply chain, start-up costs and increased administrative costs.
- Criteria for selecting materials to include in a PAC program – Here, the Client should analyze which materials are adequate to combine with PACs. The Price Indexing in Transportation Construction Contracts provides the following material selection framework:
- Availability of price index – Find a material specific price index that can be used to monitor price changes. Materials with readily available price indices are more suitable for PACs.
- Validity of the chosen index – Assess the reliability of the price index chosen. Materials for which the prices are easily accessible at any time have better price indices and are therefore better for PACs.
- Method for measuring material quantities used – Determine the method for measuring and calculating the material quantities. In this case, materials that can be easily measured are preferred.
- Impact of changing prices – The impact of the changing prices on the overall project cost comes from the volatility of the material price and the quantity of material to be employed in the project. Materials that are required in larger quantities and have very volatile prices will have larger impacts on overall project cost and are more suitable for PACs.
- Contractor’s ability to control price – For some materials contractors can secure constant prices from suppliers for the duration of a project, or they can store large material reserves. However, other materials are hard to procure at a constant rate or store for long periods of time. This last type of material is preferred for PACs.
- Program setup and administration – Assess the cost of implementing and maintaining a PAC program for the material.
Client use PACs for a variety of materials such as fuel, liquid asphalt, cement, structural steel, aggregates, and pipes. However, based on this framework the two materials that get the most benefits from PACs are fuel (Gasoline and Diesel), and liquid asphalt as they have very volatile prices, and can have large impacts on overall project costs.
When to use CPA?
PACs are heavily dependent on project duration. In shorter duration projects it is easier to forecast the price of materials until the end of the project as there will be small variations in time. In longer duration projects however, it is harder to forecast these prices as they can vary greatly over time resulting in higher risks.
Limitations of CPA?
Some of the risks of using PACs are:
- Accuracy of indices – Can affect the overall performance and effectiveness of PACs
- Program Start-up costs – Cost of purchasing indexes, setting up resources and procedures, and developing computer programs among others.
- Price adjustment payouts – If prices change considerably it may be forced to pay more through PACs than it would by using non-adjusted prices.
- Increased power of suppliers in the supply chain – Suppliers have increased power as contractors do not have any motivation to negotiate lower prices.