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Managing Inflation in Commercial Contracts – What You Need to Know

With UK inflation rates at a 40 year high, cost containment is high on the CFO’s agenda. As a result, when approaching new contracts for the supply of goods or services, especially where the supply is on a long-term basis, customers’ procurement and sourcing teams must focus on ensuring that agreed prices are honoured, budgets are not exceeded and that there are no surprises on contract renewal. They may also require suppliers to keep their costs of manufacture and supply under regular review, to investigate alternative vendors or sources of materials, and to deploy cost reduction and productivity enhancing techniques such as automation and robotics. Conversely, suppliers will want to ensure that contracts are not loss-making and profit margins are maintained, with protection against the effect of inflation on input costs such as labour, raw materials, power, plant, machinery and consumables.

Focus on price variation clauses

In this environment, contract negotiations will see more time and emphasis placed on price variation clauses. The following tips may be helpful when drafting these clauses:

  • When should a price increase take place? Depending on the circumstances, a price increase might take place before delivery due to increased cost of raw materials; at any time on supplier’s notice (with or without requirement to show an underlying rise in costs); or annually, linked to changes in the rate of inflation.
  • Automatic or further discussion needed? The clause should state whether a price increase takes place automatically and when it takes effect from. The supplier might have to follow a particular process as a condition of claiming a price increase.
  • Should limits and caps apply? Time limits will be relevant in some cases, e.g. a two or three-year fixed price deal or a locked-in period during which no price rises are permitted. In other cases, a percentage or other cap (or floor) and/or an upper (or lower) limit might be used.
  • Define the index carefully. Where using an index, define the index (usually by reference to the publisher) and state over what period percentage change is to be measured (usually annually but maybe more frequently in volatile economic situations). Also provide for what happens if the index stops being published (or if the basis on which the index is calculated changes).
  • Upwards only? Provide for what happens (if anything) in a negative inflation environment (i.e. can the price be decreased?)
  • Be precise. Statements to the effect that variations to the price will be agreed from time to time (and even an obligation on the parties to renegotiate the price) might be found to be unenforceable agreements to agree. Consider whether to use a greater/lesser formulation e.g. the price shall increase by the lesser/greater of X% and the percentage change in [CPI] over the prior [Y] months.
  • Is there another remedy? Provide for suitable remedies e.g. a right for a customer to terminate in the event that a price increase is not acceptable to it or if the increase exceeds a certain amount or percentage.
  • Anything else? Where fees are paid in a volatile currency, inflation may have a significant effect even over short periods of time. There may also be other parts of the contract which should also be indexed, such as service credits or liability caps. Finally, note that a provision allowing a supplier to increase prices after the contract has been executed may be subject to a reasonableness test (see section 3 of the Unfair Contract Terms Act 1977 (legislation.gov.uk) which provides that an attempt to render a contractual performance substantially different from that which was reasonably expected must satisfy the requirement of reasonableness).

Use an appropriate index

Price variation clauses often use an index which measures changes in average price levels, such as the Consumer Prices Index (CPI). Compared with other price indices such as the Retail Prices Index, CPI is considered mathematically more precise and more easily adjusted to reflect changing trends. In an international environment, an index such as the Harmonised Index of Consumer Prices (HICP) which is published by Eurostat may be better. Where personnel are a major cost component, an index such as UK Average Weekly Earnings, which measures wage cost inflation, may be preferred. On occasion, a basket of different indices will make sense.

Review existing arrangements

It will also be important to ascertain the situation under existing commercial contracts e.g. to determine if a supplier can unilaterally increase its prices or to identify minimum purchase commitments, price review mechanisms, rights to trigger pricing renegotiations, or even rights to terminate and exit. As many inflation adjustment clauses in current commercial agreements will have been negotiated when inflation rates held steady around 2% compared to current highs above 10%, suppliers may be left out of pocket, unable to pass through 100% of inflated costs and thus faced with loss-making contracts.

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