BCIS basics: managing inflationary risk in construction with BCIS PAFI

Input cost inflation is an important consideration in construction projects. Labour, plant and materials costs change over time and shifts in economic conditions or project delays can affect the financial risk carried by contractors and clients.

BCIS Price Adjustment Formulae Indices (PAFI) provide a structured way to track movements in construction input costs. They are widely used to support inflation adjustment clauses in contracts and help stakeholders apply consistent evidence when managing inflationary risk.

This article explores the basics of managing inflationary risk in construction, from defining index-linked adjustment inflation clauses to practical considerations when using BCIS PAFI.

The evolution of inflationary risk management

Inflation refers to a general increase in prices over time, while deflation describes a fall in prices.

It is widely accepted that construction costs are increasing in the long term, but the timing and scale of these changes can be difficult to predict.

This uncertainty creates financial risk for project stakeholders.

Before the 1970s, this risk was managed on contracts by using invoices, wage sheets and other documentation showing actual costs to calculate movement in each resource cost.

Contractors would typically list the prices of relevant resources in their tender, which were then used as the basis for future adjustments.

Although detailed, this approach was often administratively demanding and could lead to inconsistent calculations of cost movements and imprecise reimbursements for contractors.

In 1973, a formulae method of price adjustment was introduced based on resource cost indices (now BCIS PAFI) to save time and increase the reliability of inflation calculations.

These indices represented individual resources or work categories and enabled the impact of inflation to be modelled at pace.

Why use BCIS PAFI?

BCIS PAFI are commonly employed to manage inflationary risk.

In these arrangements, indices that correspond to the works specified in a contract are used to measure changes in input costs over time. These movements inform price adjustments during the project.

Where appropriate, clients and contractors should agree which indices will be used.

Selecting the right mix of indices that reflect the nature of the works helps to ensure inflation risk is recognised and managed transparently.

The aim is to represent the relevant cost movements as closely as possible.

Using broad, economy-wide indices such as the Consumer Prices Index (CPI) or Retail Prices Index (RPI), are unlikely to reflect granular changes in construction input costs. Their use can increase the risk of price adjustments misaligning with the actual underlying pressures influencing a project’s costs.

Contractors adjusting prices for inflation in subcontracts should also consider whether the indices used reflect the subcontracted works. Indices applied in the main contract may represent a broader mix of activities and may not correspond directly to individual subcontract packages.

Understanding inflation adjustment clauses

Inflation adjustment clauses (also known as fluctuations, variation of price and price adjustment for inflation) are provisions in a contract that address changes in input costs during a project.

Where such clauses apply, increases in the costs of materials, plant or labour may result in adjustments to payments made under the contract, depending on the terms agreed.

Inflation adjustment clauses are designed to deal with both inflation and deflation. Where input costs fall, it’s usually the client who benefits from savings made.

When should inflation adjustment clauses be used?

Inflation adjustment clauses are commonly considered in the following situations:

• During periods of high or uncertain inflation
• In big projects
• For long contracts
• For complex projects

Decisions about whether to include these clauses typically depend on several factors, including expected inflation trends, the potential financial impact on the parties involved, how easy it will be to predict inflation throughout the project and how many stakeholders are involved.

Risk allocation will vary between projects. It is often considered appropriate for risks to be managed by the party best placed to respond to them. In practice, contractors may be better positioned to manage short-term or local market price movements, while broader inflationary pressures may be more difficult for individual firms to control.

What are index-linked inflation adjustment clauses?

To be able to adjust prices for inflation in a construction contract, it’s common practice to index-link inflation adjustment clauses.

This is where a mix of indices (for example, a mix of BCIS PAFI) that reflect the specified works in a project are used to calculate a single index, based on predetermined resource weightings.

The composite index is applied to every staged payment made to the contractor so they do not need to price in inflation separately.

The composition of the index never changes; the indices and weightings used to calculate it are fixed in the inflation adjustment clause.

Index-linked inflation adjustment clauses can be applied in different ways depending on the procurement route.

For example, in design and build lump sum contracts, the agreed tender price will be adjusted for inflation when calculating staged payments. On target cost contracts, the target cost is adjusted for inflation and in framework or term contracts, the value of the individual contracts is adjusted.

BCIS PAFI are widely employed in construction contracts. They are used as standard in contract conditions set by numerous organisations including the Institution of Civil Engineers (New Engineering Contract), the Joint Contracts Tribunal and Association for Consultancy and Engineering (Infrastructure Conditions of Contract) to name a few.

Considerations for managing inflationary risk

Selecting indices that reflect the specified works is an important step in managing inflationary risk and contracts should clearly set out how indexation will be applied.

Other key considerations and actions include:

• Clearly stating the indices used in clauses, including their title, index number and any identifying codes.
• Checking the availability and frequency of the index and stating the base date used.
• Stating the frequency of price adjustments in the indexation clause (i.e. monthly, quarterly, biannually).
• Specifying the date when price adjustment calculations are to be made and the index to be used (reference the latest version of the index).
• Clarifying how the changing status of indices (i.e. provisional or firm) will be handled.
• Specifying how to implement revisions to the index, the index base date and so forth.
• Outlining the method for calculating inflation adjustment and the number of decimal places to be used in this.

Improve your management of inflationary risk by booking a demonstration of BCIS CapX with our team.

More BCIS Basics

Are you using the right BCIS index?

Taking the labour out of labour calculations

Understanding project preliminaries

Six principles of benchmarking in construction

Six reasons to benchmark in construction

Using location factors in construction