Price escalation
When a project is contracted on unit prices and its execution stretches over several months, input prices usually drift away from the ones used as the basis for the budget. Price escalation recognizes that change: it recalculates the value of the work by applying the price variation of the inputs that actually go into each item, so the contractor does not absorb —nor the client overpay for— inflation that neither party foresaw.
The adjustment is normally determined using official price indices. National statistics agencies and central banks publish producer price indices broken down by construction sector, which are taken as the reference to measure how much each input rose between the contract's base month and the month of execution. The adjustment factor is applied to the direct cost of the work carried out in the period, keeping the input structure of the original unit-price analysis.
On public works, procurement law regulates cost adjustment: it applies when an increase or decrease in input costs, occurring after the bid was submitted, is recognized under the terms of the contract. The adjustment does not change the agreed percentages for overhead, financing or profit; it only updates the direct costs. It is calculated and paid separately, usually tied to each progress payment for the affected period.
Formula
Example
A section of work with a direct cost of $500,000 is executed when the construction price index moved from 100 (base month) to 108 (month of execution). The adjustment factor is 108 ÷ 100 = 1.08, so the price escalation is 500,000 × (1.08 − 1) = $40,000 in additional payment owed to the contractor for that period.
Frequently asked questions
How is price escalation calculated on a project?
You get an adjustment factor by dividing the price index of the month of execution by the index of the contract's base month, and you apply that factor to the direct cost of the work carried out in the period. The difference between the adjusted cost and the original one is the price escalation amount.
What is the difference between price escalation and a cost overrun?
Price escalation is an adjustment recognized in the contract for the change in input prices, paid to the contractor based on official indices; a cost overrun is spending above the budget that usually stems from errors, scope changes or low productivity, and is not always recoverable.
When does cost adjustment apply on public works?
It applies when, after the bid is submitted, input costs rise or fall and the contract provides for the adjustment under public procurement law. It is applied to the direct costs of the work executed, without altering overhead or profit.