Study of Price Adjustment Contract Administration In Nepalese Construction Contracts (Road)

TABLE OF CONTENTS

ABSTRACT

ACKNOWLEDGEMENT

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

LIST OF ACRONYMS AND ABBREVIATIONS

CHAPTER ONE: INTRODUCTION
1.1 Study b ackground
1.2 Problem Statement
1.3 Research Objective
1.4 Scope and Limitation

CHAPTER TWO: LITERATURE REVIEW
1.5 Concept of Project
1.6 Civil Engineering projects
1.7 Construction Industry
1.8 Price fluctuation and Inflation
1.8.1 How does Inflation Happen?
1.9 Effects of Price fluctuation
1.10 Dealing with price escalation
1.10.1 Types of escalation clauses
1.11 Problems of Price Escalation and Adjustment
1.12 Price adjustment formula

CHAPTER THREE: RESEARCH METHODOLOGY
3.1 General
3.2 Research Process
3.3 Sources of Data
3.4 Population and Participants
3.5 Sampling Technique
3.6 Sample Size
3.7 Data Collection Tools and Instruments
3.8 Questionnaire
3.9 Desk Study
3.10 Interview
3.11 Summary

CHAPTER 4: DATA ANALYSIS AND RESULT
4.1 Introduction
4.2 Comparison of Bid price
4.3 Characteristics of Respondent
4.3.1. Grouping of Respondent
4.3.2. Experience of Respondents in Construction Industry
4.3.3. Position of Respondents in Construction Industry
4.4 Statistical Analysis
4.4.1. Reliability of the Sample
4.4.2. Measurement of Normality of data
4.4.3. Kruskal Wallis test for Non-Parametric Data
4.4.4. Relative Importance index (RII)
4.5 Data Presentation
4.6 Desk Study
4.7 Summary

CHAPTER FIVE: FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
5.1. Review of Research Objectives
5.2. Findings
5.2.1. Objective 1
5.2.2. Objective 2
5.2.3. Objective 3
5.2.4. Objective 4
5.3. Conclusions
5.4. Recommendation
5.5. Knowledge Contribution
5.6. Further Works

REFERENCES

APPENDIX I

Questionnaire

APPENDIX II

Examples of price escalation clauses

ABSTRACT

One of the wide ranging problems which construction industry is facing is the fluctuation in prices of Construction inputs which is causing most of the projects to be completed at cost much higher than the original contract prices. In the recent past, we have seen significant price escalation occurring not only with the basic construction materials but also with the labor and fuel which creates uncertainty among the participants involved in a construction project. To overcome the effect of price fluctuations, certain methods or contract clauses are desired to deal with this uncertainty. The main purpose of the price adjustment clauses is to allow the contractors and clients to adjust the increase or decrease in prices. In addition to this, it also encourages competitive bidding. The objective of this research study is to study importance of price adjustment in construction contract and analyzing the response of the different stakeholders in construction contracts regarding FIDIC formula and suggesting for improvement. Similarly, identifying different cost element, weightings and determining contingency is also goal of research so that price adjustment contract administration becomes systematic, equitable and with less ambiguity. Recently, the price fluctuation of construction materials and services in Nepal has become severe and very much unpredictable. Most of the contractors in Construction Industry, especially local contractors, are facing strong challenges during bid process due to the high uncertainty of predicting what would happen during the course of the execution of the project. Based on the above explained fact, the research problem has been addressed in this research by conducting diagnostic survey among ten contracting firms working on ADB project, collecting data with the help of questionnaire, distributed to contractors, consultant, client and conducting desk study on ADB projects, World bank projects, Midhill highway and RIP projects under department of Road whose construction were started after 2014 and construction progress was more than 80%.

MS Excel and SPSS are the software used to analyze the data collected through questionnaire based survey. Findings demonstrate that amount of price adjustment is dependent on type of formula being used for the price adjustment in construction contracts. The study also identifies the ratio of price adjustment to estimated amount and ratio of price adjustment to total payment amount. Finally, based on the analysis of the results, different conclusions have been made and recommendations have been proposed that enables to make price adjustment contract administration systematic, fair and equitable and favors the construction industry for better performance.

Keywords: Standard Bidding Document, Asian Development Bank, Contract Administration, Price Adjustment, World Bank, Procurement

ACKNOWLEDGEMENT

I would like to express my deep sense of gratitude to my thesis supervisor Mr. Krishna Raj Panta (Senior Divisional Engineer, Commission for the Investigation of Abuse of Authority). His proper guidance, suggestions and supports of every type, he has provided to me during my research as well as academic period are very remarkable. He has ignited the initial concept of this research and encouraged me throughout the research period.

I would like to extend my sincere thanks to Assistant Professor Mr. Mahendra Raj Dhital (Programme Coordinator, Master of Science in Construction Management, Pulchowk Campus), who has provided various ideas during initiation and completion of this thesis. I am deeply indebted to the Department of Civil Engineering for support, it has provided for my thesis work. I am deeply thankful to, Assistant. Prof. Santosh Kumar Shrestha, for the consistent help during this research.

I would like to extend my special gratitude to my external examiner Mr. Shashi Bhattarai for his suggestions and advices which have occupied prominent place in this thesis.

Special thanks should also go to Er. Madhav Jung Karki (Senior Divisional Engineer at CIAA) and Er Jyoti Tamang (Engineer at CIAA) for their kind support on various aspects of this thesis.

My friend's Er. Umesh Sharma (Section Officer at Department of labor) and Mr. Yogesh Aryal (Engineer at Ministry of Tourism and Civil Aviation) deserve special thanks for their sincere encouragement and support from beginning to completion of this research.

Last but not the least, I am very grateful to my family, the source of my moral support, encouragement and motivation in order to bring me at this level of education.

LIST OF TABLES

Table 3.1 Methodology Objective wise

Table 3.2 Details of Respondent

Table 4.1 Increase in bid price in overall contract

Table 4.2 Average increase in bid price in different item of road contract

Table 4.3 Grouping of Respondent

Table 4.4 Experience of Respondents in Construction Industry

Table 4.5 Position in Construction Industry of Respondent

Table 4.6 Reliability Statistics

Table 4.7 Shapiro Wilk test for Normality

Table 4.8 Kruskal Wallis test

Table 4.9 Relative Importance Index

Table 4.10 Sources of Index for different construction inputs

Table 4.11 Projects which are considered for study

Table 4.12 Contracts using FIDIC Harmonized (large work) formula for price adjustment

Table 4.13 Contracts using PPMO (NCB) formula for price adjustment

Table 4.14 Contracts using MDB formula (Small work) for price adjustment

LIST OF FIGURES

Figure 0.1 Comparison of inflation rate between different countries

Figure 0.2 Inflation rate of Nepal in different years

Figure 3.1 Research Methodology

Figure 4.1 Percentage premium added by contractor in different item

Figure 4.2 Percentage premium added by contractor in overall contract

Figure 4.3 Grouping of Respondent

Figure 4.4 Experience of Respondents in Construction Industry

Figure 4.5 Position of Respondent in construction Industry

Figure 4.6 Familiarity with price escalation and price adjustment process

Figure 4.7 Knowledge about dealing with price adjustment process

Figure 4.8 Frequently working with price adjustment formula

Figure 4.9 Construction material, labor and equipment as a cause of cost overrun

Figure 4.10 Price adjustment providing fair environment to all parties

Figure 4.11 Efforts to anticipate the effect of price escalation of any kind

Figure 4.12 Inclusion of price adjustment clause in reducing conflict

Figure 4.13 Price adjustment as effective method of reducing risk of price fluctuation

Figure 4.14 Subject formula according to FIDIC has limitation in use

Figure 4.15 Weightage of construction inputs be proposed by bidders

Figure 4.16 Weightage of Construction inputs be revised periodically

Figure 4.17 Following price escalation trend of different materials

Figure 4.18 Price adjustment should always be part of contract

Figure 4.19 Price adjustment formula represents cost variation of any kind

Figure 4.20 Price adjustment formula having flexibility to change in scope of work

Figure 4.21 Contractor having monetary advantage due to price adjustment

Figure 4.22 Employers having monetary advantage due to price adjustment

Figure 4.23 limits for weightings to be provided by employer

Figure 4.24 Portion of nonadjustable portion in FIDIC formula to be always fixed

Figure 4.25 10% of contract amount being sufficient for price adjustment contingen

Figure 4.26 Maximum price adjustment to be limited to 25%

Figure 4.27 Construction inputs in which price escalation occurs

Figure 4.28 Construction inputs in which price adjustment is made

Figure 4.29 Index for other material if sources of index is Nepal Rastra Bank

Figure 4.30 Overall view of respondent if source of index is NRB

Figure 4.31 Weightage for which construction input needs to be subjected to price adjustment

Figure 4.32 Overall view of Respondent for weightage of construction inputs

Figure 4.33 Shall mobilization amount be deducted while giving Price Adjustment

Figure 4.34 Overall view of Respondent for deduction of mobilization amount

LIST OF ACRONYMS AND ABBREVIATIONS

Abbildung in dieser Leseprobe nicht enthalten

CHAPTER ONE: INTRODUCTION

2.1 Study background

Construction Industry (CI) and Construction activities are regarded as the backbone of economic and social growth as 70 % of the gross capital formation is contributed by this sector. In Nepal, this industry contributes over 8% of GDP and has the growth rate of more than that of the nation average (Pandey, 2069). It can be considered as a source of generating the employment for thousands and millions of unskilled, semi­skilled and skilled persons. It also plays a very important role in generating revenues in both formal and informal sector of economy.

Nepal is a developing country and it requires lots of development activities yet to be undertaken for its economic growth. One of the main important factors to attain a required level of economic in a developing country like Nepal is the Construction Industry which is always a front line role player. Nepalese construction industry has taken a leap since 1990’s with significant growth in the number of construction and consulting firms. However, we need to actively work on the building of all stakeholders in the industry especially at the dawn of nation building efforts that could evolve the end of current political transition period (Pandey, 2069).

Construction is always considered as one of the high risk business for stakeholders in the business (yigezu, 2008). The Project owner, contractor, consultant, financers, suppliers and even the service providers, everyone has their own perception of facing risk. Risk management is a vital element of the decision making in construction (Castillo, Al-jibouri, & Halman, 2009).One of the many major risks and challenges construction industries facing, is the fact that the cost at completion of the projects are much higher than original contract prices. In the recent past, we have seen significant price escalation occurring not only with the basic construction materials but also the labor and fuel. This creates uncertainty among all parties involved in construction project. It is therefore very critical for owners and contractors to find ways to quantify and manage cost escalation on their projects. In order to ensure the availability of sufficient funds to achieve the final goals within allocated cost and schedules to overcome the effect of fluctuation certain methods or contract clauses are devised to deal with uncertainty. The main purpose of the price adjustment clauses is to allow the contractors and clients to get the benefit of increases or decrease in prices. In addition to this, it also encourages competitive bidding. Price adjustment clauses in construction contracts are intended to reduce the financial risk to project owners and contractors if the input costs rise or fall sharply during construction when the contract period is long. If a contractor knows at the bidding stage that payments for his work will be periodically indexed, he will not have to add a premium to the bid price for possible cost increases during construction. This reduces his risk of losing the contract by adding the premium. Adjustment provision in a contract also lowers the risk of contractors underestimating cost increases, and later experiencing financial difficulties and defaulting on their obligations.

The Provisions of price adjustment on account of increase or decrease in cost of goods and services in construction contracts are practiced world over to have more realistic competitive bids and execution of contracts on equitable and just manner. Price of goods and labor are highly variable due to fluctuations in the currency market. Public procurement act 2063 and public procurement regulation 2064 provides legal framework for procurement. Based upon act and regulation, Public procurement monitoring office prepares standard bidding document for different works, prepare guidelines and monitors the procurement activity. Public procurement regulation 2064 has a provision for price adjustment in rule 119. Most of the projects in Nepal either funded by Government of Nepal or donor funded projects longer than twelve month has a provision of price adjustment.

Road Construction sector is one of the largest sectors of construction in Nepal. Nepal has total road network of 85,037 Km comprised of 29,639 Km road constructed and being maintained by Department of Road (DOR) and 58,398 Km road constructed by Department of Local Infrastructure Development and Agricultural Road ( DOLIDAR) and Local bodies (MOF, 2018).DOR has a vision of Managing roads for National Integration and Socio-Economic development of roads in Nepal. The overall goal is to contribute in achieving sustainable development by providing safe affordable public road infrastructure services through building of cost effective, efficient and reliable road network system. Under DOR, there are 33 Division offices and 61 project offices. The major physical activities and scope of DOR are maintenance, rehabilitation, upgrading and new construction of Strategic road network (DOR, 2012).

2.2 Problem Statement

Price fluctuation has become a very obvious trend in current economic scenario, all over the world. It particularly gets very important in the developing countries due to the dependency of the country on external factors (MCCartney, 2011). As the economic and political instability and the security conditions of the county during the last decade or so remained very poor, unpredicted and abnormal price fluctuation of construction material, labor and equipment has increased the importance of dealing with issue. This leaves the construction industry with a wide range of challenges and consequences (such as higher bids by the contractors by including a cover that can make the bids uncompetitive). Therefore it is necessary to understand how price adjustment affects the bid price in construction contracts.

All the parties involved in construction contract, should get fair compensation which will keep motivating them, at the same time no one should get undue favor. Different types of price adjustment clauses are being used to deal with the issue of price fluctuation and FIDIC price adjustment formula is being most commonly used.

Department of Road is involved in maintenance, rehabilitation, upgrading and new construction of road mostly in unit rate contract. However, progress of individual project in their annual report shows that most of the time, projects are not completed within planned time, budget and also sometimes within specified quality. Price escalation is also considered as a big problem, which hinders project progress, since it decreases the contractor's profit leading to huge losses leaving project in a big trouble. This problem is a result of weak economy, lack of management skills, bad planning, increase in price of materials and others. Project cost overrun is also one of the most chronic problems in Road construction sector. Insufficient amount of price adjustment contingency also causes cost overrun. It is important to determine if 10% price adjustment contingency in construction contract is adequate budget or not.

Use of appropriate cost elements in price adjustment can be beneficial to both project owners and bidders. Bidders can increase their competitiveness by not adding inflation risk premium while the owner can expect more realistic bid prices and benefit from price drops during construction. Thus, it is necessary to understand problems prevalent in price adjustment contract administration so that the problems could be solved which makes construction contracts systematic, equitable and with minimum ambiguities. Proper contract administration helps in managing inflation risk to employer and bidder in appropriate manner which further improves project performance in respect of cost, time and quality.

2.3 Research Objective

This research aims to study importance of price adjustment in construction contract and analyzing the response of the different stakeholders in construction contracts regarding contract document issued by FIDIC and PPMO and suggesting for improvement. It also aims at identifying different cost elements need to be used and determining amount of price adjustment contingency so that contract administration could be systematic, equitable and with less ambiguity. The main purposes are:-

1. To study how provision of price adjustment affect bid price in Road Construction contracts.
2. To collect and analyze the responses of the construction project participants regarding the FIDIC and PPMO price adjustment formula in construction contracts and suggesting improvements.
3. To identify appropriate cost elements and their weightings required for price adjustment in Road Projects.
4. To determine if provision of 10% of the estimate amount specified by public procurement regulation 2064 is an adequate contingency for price adjustment to be provided in project budget or not.

2.4 Scope and Limitation

This study is limited to the Road construction industry of Nepal mainly covering views of major stakeholder i.e. client, consultants and contractors about price adjustment .Data will be collected from government funded projects or Donor funded projects on Road sector under Department of Road. As the data will be collected from the stakeholders of Road construction industry of Nepal, So the results, conclusion and recommendations mainly address and applicable to the Road sector only.

CHAPTER TWO: LITERATURE REVIEW

2.1 Concept of Project

Project is defined as a means of achieving an organizations strategic plan (project management institute, 2004). Projects are unique, temporary and project may be a component of a certain program. Almost all the civil engineering construction is executed in project form having a predefined cost, completion time and specification for quality.

2.2 Civil Engineering projects

All the civil engineering projects are completed through different stages: Initiation, planning, execution, monitoring, control and project closure and every stage is accomplished through a number of activities. The project participants are owners/clients, financer, consultant, designers, contractors, suppliers and users of the project. With the minor variation, all the civil engineering works are accomplished through these parties. These stakeholders can have direct or indirect interaction among them, depending upon the requirements of the project. (Dinku, 2003).

2.3 Construction Industry

The construction industry is a business sector with a huge amount of investment and turnover. The amount of construction activities being carried out in a country directly reflects the economic condition of the country. In developing countries, construction industry is being used as a tool for poverty alleviation by generating revenue and by creating employments. Out of all the parties involved in civil engineering projects, contractors and consultant are purely of business organizations which are in the field to earn profits for the service and the others may or may not be of business organizations. The contractors are mainly involved in activities of diverse natures and have direct effect of the prevailing market situation.

Price fluctuations in the market affect the contractors mostly as they are the ones who are at the front line in the construction business and are responsible for the procurements and timely delivery of labor, material and equipment, depending on the type of contract, required for the completion of works. For that they are directly linked with suppliers, sub-contractor and the labor. However contractors need not sustain and suffer permanently from price fluctuations in the market. Such fluctuations shall be sustained by the project owners or clients as they have the ownership of the proj ect.

2.4 Price fluctuation and Inflation

Price fluctuation is generally defined as the rise or fall of price or goods, materials and services. A survey of construction industry showed that the building material and labor component comprise 85% of construction costs (Tripathi, 2015). These two major components are highly sensitive against the price changes and slight changes in the prices of material and labor affect the construction contract considerably.

A contractor who tenders at a fixed price runs the risk that he may later have to pay more for materials and labor than the price and wages current at the time of his tender. Conversely he may get benefit if those price and wages go down. There are many causes of the recent material price fluctuation in the construction industry. They involve both domestic and international market forces, as well as aspects of the construction industry, that make it particularly vulnerable to average cost fluctuation and Bank economic report (Riggs, 2006). The reasons for fluctuation are several, the major one being:

1. Supply and demand imbalances
2. Exchange rate changes
3. Imported inflation
4. High energy and transportation costs
5. External shocks
6. Exhaustion of natural resources
7. Taxes

Inflation is a very important phenomenon especially in the context of construction industry because the purchasing power of money rarely stays constant in most world economies. Overtime the amount of materials and services that can be purchased with a fixed amount of money changes. Inflation causes the currency to lose the purchasing power. That is, with the inflation in price we can purchase less with the same amount of money. Inflation makes future currency less valuable than present value (Newnon, Lavelle, & Eschenbach, 2002).

When the purchasing power of goods and services increases instead of decreasing with the passage of time, the result is deflation. Deflation is rare in modern world but nonetheless, potentially exists. As such, deflation makes future currency more valuable than current value of the currency (Newnon, Lavelle, & Eschenbach, 2002). Higher inflation rate is always associated with increased price variation, which can affect the future of investment project. It will ultimately, lead to the reduced interest of Investors and economic growth. Moreover, Inflation can play its part with the tax system of country to disturb borrowing and lending decisions. Single digit inflation rate is always preferred for the better growth. The figure below shows the comparison of inflation rate in different years between different countries. Similarly figure 2 shows the inflation rate of Nepal in different years.

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Figure 0.1 Comparison of inflation rate between different countries

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Source: Statista 2018

1.4.1 How does Inflation Happen?

Economists don not agree on all of the sources of inflation but generally agree that the following factor influence the inflation; either in isolation or in combination.

1. Money supply

Amount of money in our national economy is thought to have an effect on its purchasing power. If there is too much money in system versus goods and services to purchase with that money, it tends to decrease the value of money. When there is fewer dollars in system, it becomes valuable. The federal reserves, through its influence on the money supply, seek to increase the volume of money in the system at the same rate that the economy is growing (Newnon, Lavelle, & Eschenbach, 2002).

2. Exchange rates

The strength of the U.S dollars in world market affects the profitability of International companies in those markets. Price rates may be adjusted to compensate for the relative strength or weakness of the dollars in the world market. As corporations profits are weakened or eliminated in some markets due to exchange rates, price may be raised in other markets to compensate (Newnon, Lavelle, & Eschenbach, 2002).

3. Cost-Push Inflation

It is the supply side inflation, in which producers of goods and services push their increasing operating cost along to the customer through higher price. These operation cost includes fabrication/manufacturing, marketing and sales among others (Newnon, Lavelle, & Eschenbach, 2002).

4. Demand pull inflation

This is demand side inflation, when customers spend freely on goods and services. Often "free spending" is at expense of customer saving (Newnon, Lavelle, & Eschenbach, 2002). As more and more people demand certain goods and services, the price of those goods and services will rise (demand exceeding supply).

2.5 Effects of Price fluctuation

The market price hike of construction materials and labor are a big hindrance towards the growth of construction industry. The lack of availability and affordability, both in quantity and quality can lead the stakeholders of the construction project into failure to complete their projects within acceptable limits of quality and time. In the absence of any compensation strategy, the major effects of price fluctuation can be (Abatemam, 2006).

i. Delays or cancellation of projects
ii. Reduced no of bidders
iii. Poor quality
iv. Problems of the cash flow
v. Loss of interest of stake holders in the project

2.6 Dealing with price escalation

Much can happen to the economy and to the prices in general in the time it takes a project from start to become fruitful to its users. Under such circumstances the victorious bidder who has overlooked likelihood of price increase will not apt to show much of the profit in his work. There will be incessant bickering, claim and perhaps even litigation before accounts are settled to say nothing of delays, shoddy, work and other evidences to save last penny in contractors cost. It is for this reason most contracts entered into for more than one year long duration to carry escalation/ price adjustment clause. An escalation clause can be defined as" An escalation clause is a clause in a contract that guarantees a change in the contract price once a particular factor beyond the control of either party results in an increase or decrease in the contractor's cost (Kinala & Roukema, 2011). A price escalation clause allows the parties to have an opportunity to plan for uncertainty and allocate how, who and to what extent the additional costs will be absorbed. Thus future increase in prices for major cost item is thus made employers risk whereas the owner not only to get the benefit of saving themselves from getting a "reluctant to perform contractor" under the circumstances, but also get competitive and more reliable bid. In the absence of an adjustment clause the bidders will estimate and bid possible future cost increase differently which may result in unrealistic prices. Moreover it will make sure to estimate the future cost increases being estimated not too high, which would otherwise results in higher bids.

1.6.1 Types of escalation clauses

Keeping in view the consistent and unpredictable trend of fluctuation in the prices of construction material and labor, price adjustment clauses are being the part of construction contracts to overcome the unpredictability of prices at the start of project and allow a certain degree of flexibility. These clauses must be tailored with care and should be thoughtfully drafted specifically identifying the various building materials most at risk for price variation. This procedure also should recognize the price guide to be used to measure changes in price, and it should describe how often a price adjustment clause may be used during the project. Three type of price adjustment methods remained in use for the calculation of adjusted prices (Barthet & Wasserstein, 2010).

1. Invoice method

In this method, contractor provides documentation in the form of invoice, purchase bill or certification from its supplier to confirm the change in price of any purchased material. It must reflect the change in material price from time of signing contract to time when actual purchase was made. On the basis of this document, the contractor is paid the difference between rates of material on the two dates. This was not popular because of inflow of different information of increased/decreased rates from both sides.

2. Index method

When applying the index method, increase in contract price is fixed to a price index guide for a particular product and documented as such. This method allows the contract to adjust the index price to regional and local fluctuations and conditions for major commodities such as steel, diesel, fuel, cement and asphalt. The index method can often be a good choice when a supplier is not able to provide a fixed bid until the actual purchase is made. The client has advantage as the rates are monitored by an independent body.

3. Hybrid method

This is the combination of previous two methods and is based on a certified bid cost in which contractor certifies its estimate of a specific materials cost based on its current supplier price or an index price listing. When the prices of those items change by a certain percentage such as 5 % or 10% positively or negatively, contract would be adjusted accordingly.

Properly drafted, price adjustment clauses in construction contracts minimize risk to both contractor and owner, reducing conflicts add promoting co-operation. The clauses are created with the full understanding that material, equipment and labor prices are at risk of fluctuation between time of contract signed and completion of the project. Best of all, they provide a way to protect everyone's interest and preserves valuable business relation and make sure that none of parties get undue advantage.

2.7 Problems of Price Escalation and Adjustment

Price escalation in transport projects is one of the most important problems in transport planning. The conventional price escalation study has been carried out by academics at universities and research institutes. The study results, including recommendations and newmethods for better cost estimation are published in scholarly articles, books and journals. In some cases, the transport organizations or authorities employ academics and/or private consultants to study the price escalation of their projects (Priemus, 2008). (Flyrberg, 2005)The independent government auditors are responsible for monitoring the accountability, effectiveness and efficiency of public spending. They give recommendations to the Parliament on how to improve the use of the national budget. In some countries, government auditor provides detailed investigations to explain the causes of price escalation and study the frequency and magnitude of price escalation. Even though, the academics and the independent government auditors have the same main interest which is price escalation in transport projects.

The construction industry has been challenged with the rise of construction delivery costs which in some cases do not tally with the budgeted ones owing to the continuous and unpredictable change of the macroeconomic environment. Given such a situation, contractual clauses have been formulated to cater for optimum recovery of cost escalations. Subsequently, various increased cost adjustment methods have been developed and reviewed from time to time (Finsen, 2005).

Fixed price contracts were no longer suitable for such an economic environment since contractors were at risk with regard to recovery of profit due to cost escalation. Contracts were then subject to a cost-escalation provision in which a contractor was compensated for all increases in costs since the base date of tendering. Since then, several methods for cost recovery have been tried and these include traditional method and CPI based formulae. However each of these methods has shortcomings with regards to optimum cost recovery (Atkenson, 1992).

The contract price adjustment formula is a method of compensation or reimbursing for price fluctuation in labor costs, material prices, plant and equipment and fuel (De Vynck, 2002). CPAP stipulates that the purpose of the formula was to provide for the needs of contractors who required a clear-cut, agreed recovery formula method to avoid dissension and disputes with employers and subcontractors and provide a reasonable reimbursement of unusual price fluctuations.

By relying on an incorrect index could give very misleading result (Trickery, 1983). Since no audit of the amount of cost increase is done for each individual item, one would wonder whether clients pay the real losses incurred. CPAP clearly states that the formula cannot precisely reflect the actual cost fluctuations on any particular piece of work or contract.

The proportions and indices applied are indicative of average price movements and do not represent any particular contract. In low inflation environment, CPI formulae may operate satisfactory (De Vynck, 2002).

The following problems in price escalation and adjustment are identified and summarized as variables:

1. Clients resist honoring the escalation clauses.
2. Escalation clauses do not adequately compensate increase in prices.
3. Uncompensated increase in cost of construction materials.
4. Construction price indices may overestimate or under estimate the market condition as how prices have risen.
5. Selection of the most suitable index in using inflation indices.

2.8 Price adjustment formula

History

Generally construction projects, private or public, are carried out over a quite lengthy span of time that may range from several months to several years. Keeping in view the volatile nature of prices of construction materials and labor, there is a strong possibility that the cost of labor and materials will rise and fall periodically in an unpredictable manner, to a greater or lesser extent, during the life of project.

Different parties involved in project try to deal with this risk in terms of mitigation, incorporation or transfer depending upon their attitude towards the risk and their capability to manage it. Therefore there should be provision for price fluctuation for construction contract and proper, accurate and speedy methods to recover the actual fluctuation which should be acceptable to the all stakeholders of the project and it should not give any kind of undue favor to any party.

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