The price of a contract is the key commercial detail to be agreed between the parties. The last couple of years have taught us all how factors outside anyone’s control can severely impact prices of goods, utilities, supply chains, and the performance of contracts themselves. To mitigate this, contracts should contain mechanisms to deal with price changes. Here we consider the top 10 issues to consider to protect yourself against contractual price increases.
Periodical price lists
Many manufacturers or suppliers want the flexibility of a price list which sits outside the contract which can be updated periodically. This must be clearly referred to in the contract so that it clearly forms part of the agreement. While attractive for suppliers, this creates uncertainty for the customer. Customers should ensure that there are adequate protections in the contract to mitigate this, such as a minimum term during which no price increases will take effect or a right to terminate if the contract become uneconomic for the customer.
Index-linked price review
A common way to mitigate the risk of unsustainable price rises is to include an index-linked price increase clause. This type of clause provides that the price will increase, usually on an annual basis, in line with the change to an agreed index. The index should be published at regular interval by an independent third party, such as the Office for National Statistics.
One advantage of an index-linked price increase clause is that it reduces the need for lengthy price negotiations or disputes, as the increase is clearly linked to a verifiable external source. However, choosing the index can still be a point of negotiation as various indices will be affected in different ways.
Choose the right index
In addition to the obvious indices such as the Consumer Price Index (CPI), consider whether another index would be more appropriate or favourable in relation to your contract. For example, the Average Weekly Earnings index is currently around 4% higher than the CPI. As this index relates to salaries, this may be favourable for suppliers providing personnel-related services, such as consultancy services.
There are also many more industry specific indices, such as the Producer Price Indices. Although these may more closely align with changes to a particular industry, there is a risk that these may not be published long-term. The contract should include a fall-back option in this event, with wording such as “or such other index of equivalent value as may replace it from time to time”.
Price increase cap
A contract may permit price increases up to a cap, usually expressed as a fixed percentage. This provides both parties with a degree of certainty. This is attractive for customers as they have visibility as to the maximum price and can factor this into their forecasts. However, it may not provide suppliers with enough protection if changes to manufacturing costs exceed the cap. Further, if a price increase is capped at say 3%, there is still potential for lengthy negotiations or dispute within this range. Suppliers will want such clauses to be ‘upwards only’.
Cover all bases
As the above options do involve a level of uncertainty, a possible solution is to include a price increase clause which will apply to the higher of an agreed index or indices and a fixed percentage. For example, the UK state pension is indexed against the highest of the increase in average earnings, CPI or 2.5%.
Supply chain volatility may be addressed to an extent by a material increase clause. This provides that if there is an increase of an agreed percentage in production costs, the price can be updated to fairly reflect this.
If the contract contains an index-linked price increase clause or cap (or both), this can sit outside these provisions. This protects suppliers if there is an increase in their actual costs which exceed the rate of inflation, for example if there is a shortage of a specific component. This type of clause can also be linked to certain unpredictable factors which a party may wish to protect against, such as the costs of freight or customs duties.
Agree in advance if possible
If it is commercially viable, the parties may be able to agree prices in advance for the term of the contract. The contract can contain a schedule which sets out the prices for several years. It may then be appropriate for the parties to renegotiate the prices or the terms of the contract after this period. This method is not always possible but may be particularly useful if the contract contains minimum order quantities. This way, the supplier has a minimum level of guaranteed orders and the customer has security as to price.
Check related contracts
Any price review clause that is agreed must be properly reflected in any related contracts. For example, if you are a customer in a contract which allows the supplier to increase prices by up to 5%, you need to be able to pass this on to your onward customers to protect your margins. Similarly, if you are subcontracting any part of a contract you need to be able to recover any increases in prices.
Termination for convenience
A contract can contain all the above provisions, but an unpredictable event can still impact supply chains, prices and contracts. As a last resort, you may wish to be able to terminate a contract that becomes commercially unviable. The notice period should allow sufficient time to make alternative arrangements, but not be so long that if a price increase must be absorbed for the notice period it is detrimental to the business. Also take care that the notice period in key customer contracts aligns with supply contracts so that you are not tied in to one without the other.
Review wider clauses
In addition to the ways to deal with price increases set above, it is also important to consider the wider terms of your commercial contracts and how these can assist you in the event of price rises.
For example, in cross-border contracts it is important to include a currency fluctuation provision which governs how material changes in exchange rates are dealt with. Further, note that other countries have different approaches to price rises in contracts. For example, in France, clauses which allow one party to unilaterally increase prices are often void and unenforceable.
The contract should also make it clear which party is responsible for all related costs, such as VAT, customs, delivery. This way, if one of these elements is significantly impacted the parties are clear as to who bears that cost.
Force majeure clauses can also be useful where circumstances outside of the parties’ control impact the price or the ability of a party to perform the contract. However, if adequate protection is included in the contract in the ways set out above, parties should not have to rely on force majeure to deal with price rises.