1. KEY CAUSES OF MATERIAL SHORTAGES AND PRICE INCREASES
Australia is currently experiencing a profound and ongoing construction boom. This, compounded with a multitude of factors as set out below, has resulted in widespread labour and material shortages – and subsequent rises in prices of building-related commodities. The aforementioned compounding factors are:
(a) an increase in building activity due to the Federal Government’s HomeBuilder Scheme and other causes;
(b) COVID-19 pandemic associated delays, increased logistical costs and the impact of the pandemic on local spending priorities;
(c) a decrease in timber production, attributed to the ‘Black Summer’ bushfires of early 2020, which destroyed a large proportion of local hardwood and softwood, and consolidation and contraction in the local timber industry; and
(d) a decrease in building material imports (in particular steel, timber and electrical products) from offshore suppliers as a result of constraints on international freight costs and production shortages.
The extent of impact is accurately represented by the Australian Bureau of Statistics, Producer Price Index for the period of June 2021, where it was recorded that house construction prices have risen by 5.6% in the past 12 months.
The construction boom is fraught with complexities and numerous issues: this article seeks to summarise some of the key considerations for owners and builders entering into domestic building contracts.
2. CONTRACTUAL CONSIDERATIONS FOR OWNERS AND BUILDERS
The ability to account for and respond to such material and labour price increases depends upon the form of contract entered into by the parties.
There are two basic forms of residential building contracts, being:
(a) lump sum (or fixed price) contracts; and
(b) cost plus contracts.
The terms of both types of construction contracts are regulated by relevant legislation which, in the case of Victoria, includes the Domestic Building Contracts Act 1995 (Vic) and Building Act 1993 (Vic). For this reason, care should be exercised by builders in seeking to pass on costs to owners because this conduct may be prohibited by domestic building legislation. Whether a builder can pass on costs for material price increases will essentially turn on the provisions of the relevant construction contract.
2.2 Lump Sum (Fixed Price) Contracts
A fixed price contract is a contract for a fixed dollar amount which covers the labour and materials necessary to complete the scope of works. In general terms, the specified contract cannot be varied to take into account the fluctuating costs in materials or labour, of which the builder may incur or save, up until completion of the scope of works. Fixed price or lump sum contracts are commonly used for most high volume and low to medium priced domestic building contracts in Australia.
Under a fixed price contract, unless there is a variation or other narrow and specified grounds for a price increase, the builder must bear any costs incurred above the fixed price. This is a consumer protection mechanism and it is reasoned that, when the contract was first entered into, a builder should have taken into account any increased costs of labour and materials caused as a result of market fluctuations. An exception to this is in the case of costs incurred due to variations requested by an owner, or sometimes as a result of unforeseen, force majeure events.
Importantly, commonplace residential building contracts such as the standard Housing Industry Association (HIA) and Master Builders Association (MBA) residential building contracts are fixed price contracts.
2.3 Cost Plus Contracts
For cost plus contracts, the risk lies with the owner to bear any increased costs incurred by the builder. The owner is charged for the actual cost incurred, plus profit, at the time it is incurred.
In Victoria, the threshold amount above which cost plus contracts are permitted is $1million or more for contracts entered into on or after 1 August 2017. (Financiers and banks may not be prepared to advance funds for domestic building works under cost plus contracts.)
3. CONTRACTUAL PROTECTION AGAINST MATERIAL SHORTAGES AND COST INCREASES
Because of the construction boom, material and labour shortages are exacerbating supply delays and impeding builders from reaching completion of the scope of works. As such, builders are at risk of being required to pay liquidated damages for each day a house is delayed after the contractual end date.
In order to mitigate or remove such risk, certain changes or amendments to a contract can be incorporated, which in some circumstances, will offer some protection to the builder.
3.1 Rise and Fall Clauses
A rise and fall clause (commonly referred to as a cost escalation clause) enables the price specified for building work to be adjusted to reflect changes or shifts in the costs of labour and materials incurred by a builder. These clauses are potentially onerous to owners, because it may be difficult for an owner to determine whether a builder’s claim that it has been impacted by price increases for materials is valid or not.
In Victoria, a rise and fall clause can only be included in a residential or domestic building contract if the works are over $500,000. The builder is required to calculate into the contract price any anticipated rises in costs and then substantiate the actual increases in costs.
Further, if a builder wishes to include a rise and fall clause in a residential or domestic building contract, the Director of Consumer Affairs Victoria must approve it. To date, the Director has not yet approved any such rise and fall clause. For this reason, standard HIA and MBA residential building contracts do not include rise and fall clauses.
3.2 Prime Costs and Provisional Sum Items
Incorporating prime costs or provisional sum items into a contract, depending on the scope of works, may offer a degree of protection for the builder against cost increases of labour and materials.
Prime cost items are often included for fixtures or fittings that have been included in the contract; however the exact item has not yet been selected, or its price is not yet known. The builder is required to give a reasonable allowance for a prime cost item, however noting that the end price may change subject to the item’s final cost.
By contrast, provisional sum items are a reasonable estimate of the cost of carrying out work for which the builder cannot specify a fixed amount upon entering into the contract. This is often used for minor items of works for which the design has not been finalised.
Variations may be incorporated into the contract which:
(a) the builder or the owner seeks to make; or
(b) the building surveyor orders after the contract has been entered into and the scope of works has commenced.
The owner is not obliged to pay for variations claimed by the builder to deal with issues that the builder should have contemplated prior to commencing the scope of works under the contract. To this end, in general terms, labour and material price increases are not variations to the scope of works under a contract – and as such, these costs should be incurred by the builder and not by the owner.
3.4 Delays and Extension of Time Claims
In accordance with the standard HIA residential building contract, a builder may be able to claim an extension of time (EOT) for material delays if they are beyond the reasonable control of the builder.
In respect of a standard MBA residential building contract, a builder may claim an EOT if the cause of delay is for material or labour shortages.
In any case, it is fundamental for builders to review their residential or domestic building contracts to determine whether they are entitled to an EOT for material delays, as well as to ensure compliance with such contractual provisions in respect of notifying and claiming an EOT.
Above all, the most effective time to negotiate and implement allowances for delays in construction periods is prior to executing a contract. Builders should consider including a specific right to an EOT for COVID-19 related delays.
In Victoria, section 41(1) of the Domestic Building Contracts Act 1995 (Vic) may restrict the builder’s ability to claim an EOT for COVID-19 shutdowns and related delays. Under section 41(1), the owner can end a major domestic building contract if:
(a) either the contract price rises by 15% or more after the contract was entered into, or the contract is not completed within 1½ times the period it was due for completion; and
(b) the price or time increase was due to something unforeseeable by the builder when the contract was entered into (this may be debatable and give rise to a dispute as to what was foreseeable during the pandemic).
The Victorian government has voiced concern about construction material shortages and price increases, and has referred these issues to the Commissioner for Better Regulation for investigation. Hopefully this investigation will consider the conflict between the consumer protection mechanism of fixed price contracts and the sometimes justified need for builders to pass on unforeseeable cost increases without taking advantage of owners. It is likely that this issue will remain prevalent throughout Victoria – and Australia at large – for the foreseeable future.
To this end, builders should seek legal advice as to:
(a) whether they are sufficiently protected from issues arising from delays in the supply of construction materials and increased costs incurred. Jobs should be priced with an eye on this reality to avoid builders experiencing cash-flow problems and potential insolvency;
(b) what amendments and special conditions can and should be added to building contracts (so as to operate within the law); and
(c) whether they can validly claim variations or cost increases for material shortages or increased costs. Claims that are not justified under the building contract may amount to a breach or repudiation of the contract.
Owners should also seek legal advice on whether claims for ‘variations’ and price increases due to alleged material shortages or price increases are valid under the terms of the contract or otherwise at law. Owners may also wish take a practical approach to claims made by builders to pass on reasonable price increases with a view to achieving agreement and avoiding dispute and/or the potential insolvency of their builder.
If you have any questions about this article please get in touch with the author or a member of our Building & Construction team.
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.