Inflation is blamed for a lot of modular and offsite construction companies losing money over the past year. Most of their losses occurred from fixed-price contracts that the ultimate customer wouldn’t allow to be changed.
Developers, Investment companies, General Contractors and new home builders refused to sign contracts with escalation clauses. How many modular factories found themselves seeing profits evaporate before projects even hit the production line?
Rising prices of materials aren’t the only things that can change between the time a fixed-price contract is signed and the project is completed. Material shortages and labor shortages are two of the more immediate problems faced by everyone since the beginning of COVID. Transportation costs also began going through the roof with diesel fuel reaching record costs since COVID.
One answer that could replace fixed-priced contracts is shared risk-taking by all involved parties. Is this something that is even possible?
The answer to that varies widely depending on who you talk with. Modular factories would welcome it, especially since most of them have been adding escalation clauses in their contract for the past few years. While it helps the factory stay profitable, others in the chain have no escalation clause options forcing them to live with a contract for their services that end up making them little or no profit.
At the very end of the chain are the developers, investment companies and the new home builders that adamantly fight any changes to a fixed-price contract unless they make the changes.
Shared-Risk Contracts
A “Shared-Risk” contract refers to a non-traditional method of assigning value in a transaction. With shared-risk contracts, outcomes are measured and agreed upon prior to signing the contract, and payment is dependent on meeting the agreed-upon measures.
With all the things that cut profits for contractors, clients are noticing an increase in modular factories having them agreeing to sign “escalation clause” based contracts to mitigate the impact of material price increases… inflation…or shortages.
Since COVID our industry realizes that the fixed-price contract is dying a slow but steady death. Shared-Risk contracts are relatively new to the modular construction industry but a major part of it is already in place, the escalation clause.
When modular factories use escalation clauses with their clients, it allows them to take a “pragmatic approach” with their supply chain. They realize if they’ve got good builders, then it’s in their interest to help them be successful. They need to look after the ones that are good to work with and are surviving.
One of the biggest hurdles in sharing the rising costs (or falling costs) and shortages is that an overall general contract must be signed by all parties involved in the process from cradle to grave. While individual companies and contractors cannot see the overall cost of the contract, they would be allowed to adjust their part of the contract knowing that the risk will be shared with all the other signers.
Developers could find themselves going back to the well more than once for more money to finish a project that used a Shared-Risk contract.
Builders, however, especially those in the private sector, agreeing to the provisions of a Shared-Risk contract may not be an attractive prospect. The trouble with a Shared-Risk contract is they do create some cost uncertainty and from the client’s perspective, that is a risk they are not prepared to bear.
Getting them to buy into a shared-risk contract is not in their best interest, or so they think.
Here’s a real-life scenario from an East Coast Developer.
About two years ago, this developer approached a factory with a rather large commercial project of over 100 modules. They worked out the details but when the factory presented their contract with escalation clauses in it to the developer, they refused to sign. They walked away without getting a refund on their engineering deposit.
The developer went to a competing factory that offered fixed-price contracts. They once again paid an engineering deposit and when presented with the factory contract for signing, realized it was almost 20% higher than the first one.
It turned out the second factory inflated its contract price to reflect anticipated cost increases. The developer went back to the first factory willing to sign their contract and was told the factory booked the line space on the production to another developer and the first open date would be 16 months out.
Bottom line: the developer signed with the second factory. Was that a good move or a bad one? We may never know.
In the future, our industry may use a shared-risk contract because everyone has the incentive to make sure that the project gets done and no one has an interest in contractors going under. This does rely on clients being understanding of the issues rather than just going with the cheapest or second-cheapest bid.
One of the biggest problems facing both the factory and the developer is the slim margins they work on. Their margins just aren’t large enough to absorb the double-digit rates of materials inflation, particularly given strong wage demands in areas where there are shortages of skilled trades.
Look for more posts coming your way on Risk-Shared Contracts and how to write them so that all parties are treated fairly.
Gary Fleisher is the Editor in Chief of Modular Home Source and Offsite Builder magazine. Email at [email protected]
