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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 Inflation

A4.2 Risk Management Under Inflation

A4.3 Contingency

A4.4 Escalation Clauses

A4.6 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:• 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 exceeds supply so prices

increase to compensate.

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• Problems caused for international contractor by inflation:– 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 still impact the contractor elsewhere (overhead, profit).

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• 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).

A4.2 Risk Management Under Inflation

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NOYES

Contracting:risk sharing?

Contract on hardcurrency

Cost-pluscontract(cost/unit

and quantity)

Advance paymentarrangement

Escalationprovisions

Documentaryproof method

(cost/unit not quantity)

Index formulamethod

Inflationcontingency

ConstructionManagement

Countertrade

Reducing Impactsof Inflation

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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 TIMECONSTRUCT

DESIGN

TIMECONSTRUCT

Design then build (traditional approach):

Design-build (eg; turn-key projects):saving

TIME

Fast-track (where project can be phased):

DESIGN CONSTRUCT 2DESIGN CONSTRUCT 3

DESIGN CONSTRUCT 1

saving

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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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• 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).

A4.3 Contingency

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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

the uncertainty.

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• 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);

A4.4 Escalation Clauses

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– is applicable to significant changes in the cost of construction (or significant changes in relevant exchange rates):• 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:• time 1 = $532 index = 532/532 = 1.00000• time 2 = $530 index = 530/532 = 0.99624 (deflation)• time 3 = $541 index = 541/532 = 1.01692 (inflation)• time 4 = $547 index = 547/532 = 1.02820 (inflation)• time 5 = $546 index = 546/532 = 1.02632 (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).

– Note, some countries may produce limited set of indices.

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– The second factor is the formula in which the indices are applied to costs:• a typical example:

• 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:• 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.