Appendix 4: Financial Risk Management:
(Inflation)
Overview:
To develop an understanding of the ways in which
financial risk from inflation can be minimized.
Summary:
A4.1
A4.2
A4.3
A4.4
A4.6
Inflation
Risk Management Under Inflation
Contingency
Escalation Clauses
Example of the Index Formula Methods
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A4.1 Inflation
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• Inflation can have a significant impact on an
international contractor’s profits:
– erode value of financial assets (cash in bank, bonds);
– pay more for goods than anticipated (estimate x, pay 1.1x);
– make financial liabilities more attractive (although often
counteracted by high interest rates accompanying high inflation);
– example inflation rates between 1980 and 1985:
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Argentina: 342.8% per year;
Brazil 147.7% per year;
Bolivia 569.1% per year;
Israel 196.3% per year.
• What causes inflation?:
– too much money chasing too few goods, that is, demand
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exceeds supply so prices increase to compensate.
• Problems caused for international contractor by
inflation:
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depreciation/devaluation of local currency;
import restrictions;
higher borrowing costs;
political chaos and labor unrest.
• Some approaches to mitigating inflation:
– receivables must be collected as soon as possible;
– keep idle cash to a minimum;
– import materials from countries where prices are
stable (although add in additional costs of packaging,
shipping, insurance, customs duties..).
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• Inflation
occurs in different areas:
– general (throughout the economy);
– specific to an industry, for example, a very large
project can create a shortage in resources and thus
inflation in construction costs and prices:
• Taipei 55 mile MRT,
• London Docklands Redevelopment.
– specific to resources:
• high fuel prices due to shortage in oil;
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• Three basic types of contract pricing (with implications
for international contracts operating in an inflationary environment):
– fixed-price:
• lump-sum: a single sum is agreed in advance;
• unit-price: paid a rate agreed in advance (multiply by quantity);
– cost-plus contract:
• paid for costs incurred plus a fee (usually stipulated limits).
• owners, worldwide, prefer the fixed price approach:
– if inflation is high, then good to include a a provision
for cost escalation (to share inflation risks between parties);
– otherwise contractor will include a large contingency to
cover inflation;
– however, if inflation is high, the cost-plus fee is
preferable for a contractor;
– even when the risk is passed to the owner, inflation will
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still impact the contractor elsewhere (overhead, profit).
A4.2 Risk Management Under
Inflation
• Three basic approaches to managing inflation risk in
international contracts:
– contracting approaches, for example:
• cost-plus fee? (as discussed above);
• advanced payment arrangements;
• add contingency to bid (as discussed above).
– construction management approaches, for example:
• execute work using inflation prone items as early as possible;
• careful purchasing;
– countertrade approaches:
• payments received in goods or materials (for example: oil).
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Reducing Impacts
of Inflation
Construction
Management
Contracting:
risk sharing?
YES
Countertrade
NO
Contract on hard
currency
Cost-plus
contract
(cost/unit
and quantity)
Escalation
provisions
Inflation
contingency
Advance payment
arrangement
Documentary
proof method
(cost/unit not quantity)
Index formula
method
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• Reducing risk through construction management:
– Planning:
• review of cash flows as a defense against surprise;
• use an appropriate currency;
– Maintaining current information:
• update control information with prices, indices and trends;
– Payments:
• Scrutinize payment schedules (receive early);
– Design time (where you offer design as well as
construction, or management of both):
• expedite engineering to reduce project time;
– Innovative contracting:
• for example, design-build and fast-tracking allows
construction to start before design completed;
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Design then build (traditional approach):
DESIGN
CONSTRUCT
TIME
saving
Design-build (eg; turn-key projects):
DESIGN
CONSTRUCT
TIME
Fast-track (where project can be phased):
DESIGN CONSTRUCT 1
DESIGN
DESIGN
saving
CONSTRUCT 2
CONSTRUCT 3
TIME
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– Procure certain long-lead times:
• identify and purchase items likely to delay the schedule or be
in short supply;
– Subdivide contracts:
• subdividing a large risky contract into several small ones
spreads the risk;
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A4.3 Contingency
• Contingency is specific provision for variable
elements of cost.
• Variable components can be either:
– unforeseeable, for example:
• ground obstructions in piling operations;
– foreseeable, for example:
• a prescribed increase in interest rates on a loan;
– partially foreseeable:
• future inflation rates (note, the further into the future, the more
difficult it is to predict).
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• Factors determining the amount of contingency
added:
– Magnitude of the Firm:
• where there is uncertainty, a bid near the expected cost could
result in either a loss or profit;
• in such cases, the greater the uncertainty, then the greater the
possible loss or profit;
• over many projects, the uncertainties will balance out;
• large companies, operating many projects, can afford the risk
since they can carry losses and survive for the projects where
they will make a large profit;
• small companies cannot carry a large loss on a project, and so
must include a LARGER contingency to minimize this risk;
• so small companies will either be taking on a larger risk than
large companies, or will have to bid higher;
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– Estimate Accuracy:
• a contractor will add a larger contingency when they are less
sure about the accuracy of their bid;
• a major determinant of the level of confidence in the accuracy
of a bid is the amount of information available for producing
the estimate:
• overseas contracts can be subject to high levels of
uncertainty due to lack of prior experience of prices,
delivery efficiency, etc..;
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– Form of Financing:
• Government financed projects are sensitive to cost overruns
• reimbursement requires a lot of red tape;
• the incentive for a contractor, therefore, is to avoid this problem by
including a large contingency;
• Joint-ventures (a good approach for international projects) often
include lengthy contractual procedures for evaluating cost
overruns:
• the incentive for a contractor, therefore, is to include a large contingency;
• If a project is financed exclusively by internal sources, there is less
pressure to make large short term returns, and so contingency tends
to be smaller (one-off financiers want a profit this time);
– Previous Experience with Inflation:
• A contractor working overseas may be working in a high inflation
environment:
• if this is their first contract in that country, it is possible that they will have
little experience of working in a high inflation environment;
• in this case, it is likely that they will include a large contingency to cover
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the uncertainty.
A4.4 Escalation Clauses
• Many long term contracts contain escalation
(fluctuation) clauses to counter the effects of
inflation.
• It is a clause in a contract which automatically
revises the contract price, note:
– not applicable to changes in the type and quantity of
work (this can be handled in other ways);
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– is applicable to significant changes in the cost of
construction (or significant changes in relevant exchange rates):
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equipment;
material;
labor;
construction services;
taxes;
import tariffs;
– can be used in fixed price contracts (lump-sum and unit
price) (no need for this in cost-plus contracts);
– The contract should specify whether prices can adjust
DOWN as well as UP (if, say, oil prices fell);
– usually only included for contracts that are at least 12 to
18 months in duration, though may be less in countries
where inflation is very high.
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• Advantages (from owners perspective):
– significantly removes the need for contingency sums;
– savings to owner if prices turn-down;
– at least savings to owner if prices do not go up
(compared to contingency approach);
• Disadvantages (from owners perspective):
– price to owner increases with inflation;
– little incentive to contractor to keep costs down;
– general inflation indices may not reflect increased costs
to the contractor;
– more owner participation is required to ensure that
escalation clauses are appropriate (determination) and to
ensure that they properly implemented (verification).
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• Types of escalation clause:
– Day-One-Dollar-One Clauses:
• owner pays the difference in increase in cost between the date
of the contract and the time of installation;
– Significant Increase Clauses:
• owner reimburses the difference in cost as before, but only for
large increases often expressed as a percentage (risk is shared);
– Delay Clauses:
• owner reimburses the difference in cost (through inflation), but
only increases incurred during a period of delay (the types of
delay need to be stipulated, and often the contractor is
responsible for the earlier part of any delay).
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• Two types of method are used for determining Price
Escalation:
– Index Formula Method:
• where refer to some index of inflation:
• most governments produce a consumer price index (measure of
general inflation);
• however, governments may purposefully understate the true rate;
• remember, general inflation may not reflect inflation in the type of
work you are involved in;
– Documentary Proof method:
• here the actual costs to the owner are used in the calculation:
• this can be more time consuming to compute since it requires a
compilation of evidence of both:
• the original expected costs of all relevant materials, equipment,
labor, etc;
• and the actual costs of all relevant materials, equipment, labor, etc.
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• Index Formula Method in detail:
– The method requires agreement on both:
• an index to use as a measure of inflation; and
• a formula for applying the index to costs:
– Indices:
• A price index is a statistical measure of changes in price of
goods and services;
• it is calculated as the ratio of prices at any point in time to
prices at a base point in time (and is thus dimensionless);
• for example, if the base price of a commodity in the following
example is time 1, then:
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time 1 = $532
time 2 = $530
time 3 = $541
time 4 = $547
time 5 = $546
index = 532/532 = 1.00000
index = 530/532 = 0.99624
index = 541/532 = 1.01692
index = 547/532 = 1.02820
index = 546/532 = 1.02632
(deflation)
(inflation)
(inflation)
(deflation)
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– Two broad types of indices used in escalation clauses are:
• price indices (used to revise material costs); and
• earnings series (used to revise labor costs).
– The US Department of Labor’s Bureau of Labor Statistics
publishes several indices used in escalation clauses:
• Consumer Price Index;
• Producer Price Index; and
• Gross Average Hourly Earnings Series.
– However, these are only relevant to the USA.
– Use appropriate indices from the country in which the
product/service etc.. is being purchased:
– For example, in the UK, indices applied to escalation
include:
• RPI ( general inflation);
• Building Cost Indices, Tender Price Indices (industry measures);
• NED02 (specific work categories).
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– Note, some countries may produce limited set of indices.
– The second factor is the formula in which the indices are
applied to costs:
• a typical example:
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P1 = (P0 / 100) · (a + b·M1/M0 + c ·N1/N0 + d ·W1/W0)
P1 = price payable;
P0 = initial price stipulated in the contract;
note, a, b, c, and d specify the proportions of different components;
a is the proportion of the price excluded from adjustment;
b is the proportion of an index related to one category of materials;
c is the proportion of an index related to another category of materials;
d is the proportion of an index related to wages;
note: a + b + c + d = 100;
M1 = current price of comparable materials to category b;
M0 = base price (at contract start) of materials in category b;
N1 = current price of comparable materials to category c;
N0 = base price (at contract start) of materials in category c;
W1 = current price of wages;
W0 = base price (at contract start) of wages;
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• Calculate P1 for the following example:
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P0 = $50,000;
a = 10%;
b = 30%;
c = 30%;
d = 30%;
M1 = $10,600;
M0 = $10,000;
N1 = $10,800;
N0 = 11,000;
W1 = 15,000;
W0 = 14,000;
• Note, if the work is delayed, the contract may stipulate that the
indices be calculated before the delay if the delay is the fault of
the contractor.
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