Fluctuation Clauses

Our standard contracts are expertly designed to accommodate long-duration projects and frameworks by incorporating such fluctuation provisions. Specific indices are usually referenced, which will be used after a predetermined time to adjust contract prices relative to an agreed base date—typically the commencement date or slightly earlier. Most would sensibly choose a construction-specific index for this purpose, as costs in the industry can behave unpredictably and at different rates to the government’s inflation measure. So why do many clients use the Consumer Price Index (CPI) or the Retail Price Index (RPI) as the basis for price adjustments in their construction contracts?

To clarify, the Consumer Price Index (CPI) tracks the change in the cost of a basket of goods over time. We’re referring to everyday items like air fryers, gluten-free bread, and edible sunflower seeds—not exactly the materials used to construct our buildings and infrastructure. The Retail Price Index (RPI) is calculated similarly. It employs the ‘Laspeyres Formula’ (arithmetic mean), which compares the current cost of the basket to the cost in a base year, with weights fixed from the base year, whereas the CPI uses the ‘Geometric Mean Formula’. In practice, the methodology of calculating the indices means that the RPI usually gives a higher inflation measurement. Regardless of the calculation method, the components of these indices have little relevance to the construction industry.

Advocates for using CPI and RPI often cite them as leading indicators of inflationary trends. That’s an understandable viewpoint, given that CPI forms the foundation of the UK government’s inflation measurement and is used by the Bank of England to guide interest rate decisions. In practice, with relation to time, increases in construction costs tend to lag behind CPI and RPI but eventually move in the same direction. However, that’s where the similarities end. For example, the Real Living Wage is set to increase by 5%* this year (or 5.3%* for London), and the UK Government’s National Living Wage is increasing by 9.8%. However, CPI and RPI reflect increases of only 2.3%* and 3.4%*, respectively, for the same period. Since construction operations can be labour-intensive, pressure from inflation-busting wage increases can weigh heavily on construction companies. 

When looking at construction metrics for work category-based indices, there is more of an alignment to CPI. However, every index identifies an increase in costs over that, which could be rectified by an adjustment based on the CPI. For example:

So, why does this matter? The average net margin of the top 100 construction companies in the UK is a mere 1.7%**, down from 2.7% the previous year. The disparity between increased costs incurred and what can be reclaimed by amendment of the contract rates through a fluctuation provision can spell disaster for a company, especially when margins are so low. This is why clients and their consultants must invest time in modelling fluctuation provisions to reflect the project’s elemental profile rather than depend on a one-stop-shop, non-construction-based index. It’s also crucial for construction companies to comply with clients’ requests for detailed breakdowns of how their rates are determined. Only then can a more accurate uplift be calculated, ensuring that inflationary pressures don’t adversely affect the contractor’s net margin. While a perfect model for calculating fluctuations in contract costs may not exist, we can introduce improvements by discarding the illogical use of CPI and RPI in construction contracts and adopting a more scientific approach to calculating fluctuation uplifts. The goal is to place the contractor back in the same position as they initially enjoyed at the commencement of the contract and not penalise nor enrich the contractor.

A straightforward yet effective method would be to dissect the Contract Sum into its component pricing elements and apply indices explicitly tailored for that element. For instance, shifting to a provision that adjusts contract rates based on elemental costs—labour, materials, plant, and subcontractor expenses. BCIS provides indices for:

By utilising indices tailored to the construction industry, stakeholders can ensure that contract adjustments accurately mirror cost fluctuations. This approach clarifies the actual cost drivers and cultivates a collaborative atmosphere where both parties comprehend the reasoning behind pricing changes.

Moreover, this strategy encourages contractors to refine their pricing tactics. Contractors must substantiate their estimates and identify the elemental breakdown of the same. Clients will also gain confidence in the fairness of pricing adjustments, knowing they are based on relevant, industry-specific data rather than general consumer trends.

In conclusion, embracing more precise fluctuation provisions that utilise construction-specific indices can significantly reduce the risks associated with under-recovery of cost fluctuations in  long-term projects. This transition safeguards the financial stability of construction firms and fosters a more sustainable and transparent construction industry. Moving away from outdated practices and adopting a data-driven approach can create a resilient framework that benefits everyone involved.