Monday, September 3, 2012

Escalation versus Equitable Adjustment

In another forum someone asked the difference between escalation and equitable adjustment in contracts so I though it would be good thing to do a blog post about.

Escalation provisions are used when you know that the costs over the term of the contract are going to change and you don't want the contractor including a significant contingency in their price to cover those changes. In doing that you are taking the cost risk if their are any changes in the costs that are subject to the escalation provision. If the contractor took the risk and the costs wind up to be less than the contingency they built in, the difference becomes more profit for the contractor. Escalation provisions can be written to cover changes to individual costs such as labor. For example if a contract was being performed by union labor and the labor contract was set to expire during the term, escalation could address only the exact change in the labor contract rate. They can be written for changes to specific materials in a highly price volatile market. They may also be used to address inflation over the term of the contract. Well-drafted escalation provisions will always establish the basis against which cost escalation will be measured and a method to adjust the price based upon those changes occurring over time. For example if you outsourced the manufacture of an item where there was frequent changes in the cost of the inventory being used to manufacture the product, you could manage the escalation on a monthly basis. You would look at the changes to the inventory value which could either go up (escalate) or down (deflate) and have a methodology for either credits/payments or adjustments to the price of the product for that coming month.

Equitable adjustment denotes that a party will unilaterally make an adjustment that is fair or equitable. The frequent problem is both parties may have different opinions of exactly what would be equitable. I don’t like equitable adjustment to be used in anything that ties cost or cost related items simply because of that fact.
Equitable adjustment tends to be proposed when there is a change or a delay. They will make an equitable adjustment to the price for a change or deletion. They will make an equitable adjustment to the schedule or date for completion. Neither of those tell you what those adjustments will be. My preference has always been to use unit rates or formulas whenever possible rather than use equitable adjustment. For example in a changes provision that allows changes to the scope of work for the cost of the change I might have something that allows for the cost to be either an amount mutually agreed by the parties or the actual cost plus specific percentages for overhead and profit. I would also include language that deductions to the scope of work would be calculated in the same manner as additions. I do that drive the supplier’s initial proposed cost for the change to be reasonable as they know that if I don’t agree with what they propose I can make them prove their actual cost and pay them that plus the agreed percentages. The time impact for delays can be managed with language where you provide a
“day for day” extension. The time impact for changes to the scope is more difficult to establish a formula. I believe that rather than leave it open to an equitable adjustment its better to negotiate any time impact at the same time you negotiate the cost. If I was representing a buyer I would want that to be either a time period mutually agreed by the parties or an equitable adjustment. I want that so the supplier or contractor will propose something that is truly reasonable rather than being subject to an equitable adjustment which they may not view as being equitable. I also don’t want the supplier or contractor to use that to try to drive a higher price.

If you are a supplier or contractor and you agree to equitable adjustment language, it's very important to have strong record keeping and be documenting the cost or time impact. That way when it comes time to get the equitable adjustment you can prove what that adjustment should be. You also have the necessary documentation should the other party not want to give you an equitable adjustment where the matter may need to be resolved in by escalating the issue to their management, arbitration or litigation.

If you are going to use either word in a contract it's best to create a definition for them so it’s clear exactly what it means when you use them.

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