Tackling Tariffs: Allowances vs. Contingencies

As trade wars continue to impact the construction industry, many clients are asking the same question:  “How do I address the risk of increased costs resulting from tariffs in my construction contract?”  Two common approaches to address the current market uncertainty involve the use of allowances and contingencies.  However, these two concepts are often misunderstood, which can lead to unintended risk-shifting in your construction contract.

Allowance

An allowance is typically used to address items that are already included in the scope of work, but for which the price cannot be determined at the time of contract execution.  To address this known scope, but undetermined price, the contractor provides the owner with an allowance (basically an estimate) of the cost for this item.  The allowance, however, is meant to cover only those work items that are undetermined and can fluctuate in price, such as construction materials for a certain trade. An allowance typically does not include costs for unloading and handling at the site, labor, installation, overhead, or profit because these costs are known and will not fluctuate following contract execution and, therefore, should already be included in the initial contract price. 

Once the cost of the work item covered by the allowance is determined, the contract price gets adjusted (up or down) to reflect the difference between the allowance and the actual cost.  If the actual cost of the work item covered by the allowance is higher than the allotted amount, then it is the owner’s responsibility to pay for the increased cost.  Likewise, the owner gets a credit if the actual cost is lower than the stated allowance.  Because the owner bears the risk of any price increases, the owner’s goal is to keep allowances to a minimum (or preferably none).  After all, too many allowances can essentially convert a contract priced as a Guaranteed Maximum Price (“GMP”) contract into a Cost-Plus contract without a GMP.  (For a discussion on Cost-Plus contracts, check out one of my earlier posts.) 

Contingency

Like an allowance, a contingency can also be used to cover known or foreseeable, but undetermined, costs at the time of contract execution.  But a contingency can also be used for costs that are unknown.  Regardless of what work items or costs the contingency is used to cover, the main difference with an allowance is that a contingency caps the owner’s exposure for the items covered by the contingency because once the contingency funds are depleted, the owner’s exposure for that item ends.

A contingency can either (i) be included within the contract price (typically within a GMP) or (ii) be held by the owner separately and outside of the contract price.  If the contingency is held by the owner outside of the contract price, then a change order must be executed to authorize the use of the contingency funds. 

A contingency can also be either (i) what is often referred to as a pure “contractor’s contingency” or (ii) a project contingency.  If the parties intend to use a “contractor’s contingency,” then typically this means the contractor gets free reign to use the contingency for any costs that arise during the life of the project.  Of course, there are still some basic exceptions, such as the requirement that the contingency be used to cover approved “cost of the work” items and the prohibition against using the contingency to cover costs resulting from the contractor’s bad acts. If the contingency is intended to be a project contingency (which is the more typical approach), then the parties typically set parameters for use of the contingency, including owner approval, and often require that unused contingency funds be credited to the owner.  If the parties use a pure “contractor’s contingency,” it is unlikely that any contingency funds will remain at the end of the project and, therefore, the owner can essentially consider this contingency part of the contract price to be paid to the contractor. 

General Contract Drafting Considerations

For contracting parties currently using, or contemplating the use of, allowances and/or contingencies in their construction contracts, some of the concepts to consider include:

1. Both allowances and contingencies must be called out specifically in the construction contract; 
2. If using an allowance, the contract must:
   1. state what costs are covered by the allowance (and therefore subject to fluctuation); and
   2. outline what conditions will trigger an increase or decrease in the allowance cost.  (For example, is the final cost dependent on the owner’s selection of materials or finishes, or is the cost tied to final design changes or even to a decision from the authority having jurisdiction?); and
3. If using a contingency, the contract must:
   1. clearly state if the contingency is carried within or outside of the contract price; and
   2. clarify whether the contingency is intended for use at the contractor’s discretion (i.e., a “contractor’s contingency”) or whether it is a project contingency.  If the latter, the contingency provision must clarify any requirements or conditions for use of the contingency funds and how unused contingency funds (if any) get allocated.

As contracting parties decide how to address increased costs resulting from new or increased tariffs (or other price impacts of the trade wars), it is important for the parties to understand how allowances and contingencies allocate risks (and, in the case of contingencies, can cap risks).  A clear understanding of these concepts will help the parties make a decision that is consistent with the parties’ business deal and avoid unintended results.