When businesses are facing price increases for materials and spiraling recruitment and wage costs, you cannot remain the ‘squeezed middle’. Future proof your contracts with the inclusion of a price escalation clause so you can pass on your increased overheads to your customers.
In this article our commercial solicitors look at increasing contractual prices and how best to go about future proofing your terms of business whilst maintaining your client base.
Contents:
Mechanisms for increasing prices
Whatever the economic circumstances your business is operating in, or anticipates in the future, it pays to plan ahead. That is especially true of industries and sectors where it is usual to enter into long term contractual agreements because of set up costs or other factors, such as lead times or the specialist nature of the services provided.
Whilst everyone should try to keep their commercial contracts short and to the point, including mechanisms for price increases in your commercial and consumer contracts is good business planning. Price escalation clauses can
- Reduce the risk of contract disputes and litigation as you have a future proofed agreement
- Enhance contracting relationships as both parties know where you stand on price increases so there’s no need to have awkward mid-contract price negotiations
- Minimise the risk of one party trying to terminate the contract to negotiate a better deal with you or move to a new supplier
When instructing your commercial solicitor to sort out the contract they are likely to flag up price escalation clause options with a menu to choose from. That’s because you know best what future proofed price contract structure works for you as a manufacturer, supplier or purchaser of goods or services.
Once you have finalised what price escalation clause works for you in your key contracts you then need to get your lawyer to look at your other contracts to check any mechanism for price rises fits with any existing long-term contracts or with any planned contract reviews.
Pricing is like a jigsaw puzzle; the pieces need to fit together in the contract and as supply chain and other contracts are entered into at different times it’s equally important that there is a planned and coordinated approach to contracting, business terms and pricing. For information on contract reviews and the contract life cycle take a look at: Contract lifecycle management: what you should be doing.
There are a number of different price mechanism increase considerations and options:
Limits and thresholds
The first consideration for contracting parties is whether price structure should be based on limits and thresholds. For example, the price of a gadget is £x for orders of 1,000 units or less but the unit price reduces to £y if the order is for over 1,000 units and so on. Limits and threshold pricing only works for a business if you gain from economies of scale, such as reduced manufacturing or transport costs or improved pricing from your supplier. If you don’t gain from pricing based on limits and thresholds there may be a wider picture to consider, such as the importance to your business of gaining market share through volume orders.
Changes subject to indexation (CPI, RPI)
Businesses will frequently be offered the option of including price escalation clauses that rise in line with indexation. The advantage of this type of price clause is that:
- It is not considered controversial, often because the other party does not fully consider the cost of the rise over the term of the contract or whether their sub-contracts or associated contracts also include indexation prise escalation clauses
- It avoids negotiation on a price rise as there is a pre-agreed formula and reduces the risk of commercial litigation over commercial contract disputes
If you decide to negotiate a contract that includes an index-linked price increase clause, so the price of goods or services rises on an annual basis in accordance with a nominated index, the next question is what index should be selected? It is essential that you select an index that suits your company and your industry and sector rather than choose the obvious options of either the retail price index or consumer price index. For example, if you are a professional services firm the use of the average weekly earnings index (AWEI) may be more advantageous to you than use of RPI or CPI. The AWEI includes salaries and they may be a significant proportion of your increased overhead.
Automatic price increases
Some contracting parties prefer to negotiate fixed price increases. A fixed price increase can be stated as a percentage rise in unit price, a fixed increased unit price or a hybrid index rise. The hybrid option is usually expressed as a percentage rise of say 5% of the contract price plus RPI or CPI increase. Not every buyer is savvy enough to consider how these price rises will affect them over the life of a contract or their affordability.
If you want to include an automatic price rise in a contract it is essential to look at how:
- Your price increase proposals fit with your other contractual relationships
- Whether your contracts are auto renewable or not
- The circumstances in which the contract can be terminated
Flexible price escalation clauses
In some industries and sectors flexible price escalation clauses, not linked to an index or specified percentage increase, are the preferred option to future proof your contracts. For example, if you are in the construction industry, the price of building material has ‘gone through the roof’ and a CPI price rise clause in a commercial contract with a local builders merchants, or with by a company commissioning a building, may not reflect the real price rise of the cost of plaster or the salaries of your employees with skilled trades. With a poorly thought out, or too rigid price escalation clause, your company could in effect be subsidising those it contracts with as your price escalation clause isn’t flexible enough to meet and adapt to trading conditions.
With flexible price rise clauses, the seller provides a price list but includes provision for the prices to be increased on either a set annual or bi-annual basis or through giving reasonable notice of a planned price rise. The notification of the planned price rise could result in the other contracting party electing to terminate the contract rather than pay the increased price. Whilst flexibility allows you to accurately increase your prices to reflect market conditions, this type of clause does not give you the same degree of control as a price escalation clause with automatic or index linked price rises.
Advice for suppliers
Whether you choose to include no provision for price rises, auto renewing contracts, or automatic or indexed price escalation clauses, there are three key interlinked points to consider:
- The length of the contract term
- The termination triggers in the contract
- How the contract fits with your other contractual relationships
Short term contract or price increase provision
If a contract is of short duration there is less pressure to ensure it is future proofed with a price escalation clause. A short term contract may suit in uncertain economic times but if you want to:
- Build a long term loyal customer base
- Negotiate better discounts with your own suppliers
- Enhance the value of your business for the purpose of financing or selling or merger
Then long term contracts with price escalation clauses may be the best option to meet your goals.
Termination clauses working with price escalation clauses
There is no point in carefully assessing and analysing price structures in a contract if the termination clause allows the other party to terminate the contract on notice without the party having to give you a valid reason, such as poor contractual performance.
The wording of the termination clause needs to work with and be commercially compatible with your selected price escalation provisions. Likewise, if your buyer can terminate because they don’t like a price increase, have you negotiated a similar flexible contract with your supplier? Are your workers engaged on a freelance basis so you do not have staff commitments if your buyer terminates a contract because of a price escalation and you cannot quickly secure an alternative buyer?
When negotiating a termination clause, you need to ensure the termination notice period gives you sufficient time to contract with another party so you are not left without supplies. However, it is important that the notice period is not over long so you end up paying a premium price for goods or services during the notice period, when you could have easily and quickly sourced an alternative supplier.
Future proofing your terms of business through price escalation can't be looked at in insolation – it involves the entire contract and the contract chain.
For more information take a look at our article on contract termination provisions.
The timing of contract price increases
If you have included a price escalation clause in your contract, you do not need to wait until the end of the contract to increase the price of your goods or services. When negotiating a price escalation clause, it is best to be strategic and assess your suite of contracts. Does your supplier increase their prices every April ? Do you need to include similar timings rather than include provision for a price review every December, when you will have shouldered the price rise from your own supplier for over seven months?
Advice for customers on the use of price escalation clauses
Whether you are entering into a commercial contract or consumer contract it is easy to miss a price escalation clause through focussing on the headline clauses, such as the current price or contract term. That mistake can cost you if a combination of a long contract term, limited termination provisions, and a price escalation clause combine to work against you.
None of us have a crystal ball to work out what would be a fair and reasonable price increase to accurately reflect market conditions or know how your circumstances will affect your ability to pay a higher price for goods or services. On the other hand, locked in price escalation price clauses can really work to your advantage if you have agreed a fixed fee contract or price limited to CPI rises when industry specific conditions have seen massive price rises in goods because of transport difficulties or reduced crops.
The best advice for customers is to be on your guard for price escalation clauses. If you are hoping to pass on price rises to your own customers, ensure that your sales contracts enable you to do so . Alternatively, change your terms to require your customers to pay a substantial deposit to cover the cost of materials so you can in turn fix the price paid for the materials by buying in advance and before you are notified of a further price rise by your supplier.
For further reading and information try our handy guide on how to successfully negotiate a commercial contact.
