Index linked inflation adjustment clauses in contracts

We are receiving an increasing number of queries about index linked inflation adjustment clauses in contracts (Fluctuations or Variation of Price clauses). Particularly on which indices to choose and how to apply them.

Using an inflation adjustment clause removes some or all of the inflation risk from the contractor allowing them to provide a competitive current price at tender stage. It also removes much of the risk of problems occurring during the contract.

There are four approaches to choosing and apply indices:

• To use work category, or resource indices, applied to relevant expenditure in each valuation.
• To prepare a single index from several indices by modelling the work category or resource indices to a project
• To use a standard whole building construction cost index
• To use a non-construction inflation index such as RPI or CPI

Let us dismiss the last one it introduces a double risk to the contractor who has to forecast both the inflation in their own costs and the rate of general inflation.

If opting for a standard whole building cost index you need to be confident that the weightings in the index reasonably reflect the mix of resources in the project.

Apply the individual indices to the work carried out in each valuation will match the impact of inflation on project as closely as possible.

When Index linked inflation adjustment clauses were introduced in the 1970’s, and most calculations were done by hand, the use of weighted indices modelled to sections or the whole of a project was promoted to reduce the cost of administration.

This will work well enough when inflation is affecting all work equally, however in periods of volatile pricing, which affects some materials and trades more or less than others, it may be important to track the changes against specific sections of work.

The first thing is probably to break a project down into its work categories or resources and identify the work that is particularly at risk.

JCT, NEC and other contracts have standard inflation adjustment clauses.

BCIS administers the Price Adjustment Formulae Indices (often erroneously referred to as the NEDO, Baxter and Osborne indices) and publishes general indices for building, civil engineering and maintenance.

There are PAFI Series for:

• Building (65 indices)
• Civil Engineering and specialist engineering (42 indices)
• Highways Maintenance (22 resource cost and 9 work category indices)
• Specialist Engineering (17)

It is important that you always use the latest series of indices, older series are still published to support existing long-term contracts.