INFLATION IS HERE. IS TYING PRICING TO AN INDEX THE ANSWER?

Inflation is here and probably to stay for a while. Long-term contracts often contain clauses by which pricing is adjusted over the course of the contract in order to anticipate the effects of inflation or other factors affecting cost.?Often, this is done by tying price to some index.?

???????????Since such clauses can have unintended consequences, care needs to be taken in how they are structured.?If the goods or services can be purchased on a fixed or cost-plus basis, the risk of using indexes to adjust pricing can be avoided.?Assuming that fixed, cost-plus, or other type of pricing is not the best approach, the following points should be considered before agreeing to use an index to adjust pricing:

1)????Review all possible indexes which could be used.

2)?????Make a determination as to the best index to be used.

3)????Specify the exact index or part (and base year).

4)????Clearly identify the applicable base price.

5)????Specify when price adjustments will be made.

6)????Specify how price adjustments will be made.

7)????Clearly state any caps or limits on adjustments.

8)????Anticipate that an index may change or be discontinued.

9)????Anticipate that market prices may decrease.

10)??????Secure the right to terminate the agreement.?

If a decision is made to use an index it is important to specify the specific index and its effective date. It is also important to specify in the agreement, the schedule of activities, with defined start and completion dates, and to clearly state when and how the index will apply. Indices should be selected based on the type of costs being escalated since indices typically represent a group of items.?

Cost indices have their limitations since they are based on average data. Accordingly, some level of judgment and experience is required in order to determine whether and index is appropriate for the costs to be adjusted. By carefully selecting and crafting pricing clauses tied to an index so as to accurately reflect the cost increases against which the seller should be protected, the risk of a “runaway” price escalation and overpayment by the purchaser, can be reduced.?

???????????Strong termination rights with the option to end the agreement on acceptable terms is another way a purchaser can protect itself against unanticipated consequences of escalation clauses.?Termination rights are especially important when there is no cap on the escalation.?

???????????Often, only some component(s) of a purchase drive the need for an escalation clause.?Ideally the index used reflects only those components.?However, large indexes are often composites which may not have any real correlation to the particular component(s) that are driving the desire for an escalation clause.?Moreover, just because an index has in the past, whether by coincidence or circumstance, had a correlation with price changes associated with a particular component, there is no guarantee that the correlation will continue.?Where the price of one component has a disproportionate effect on total cost, an escalation clause predicated on a broadly based index will not reflect actual costs.?

???????????Since such clauses are designed to protect against long-term price changes, it may not make sense to have them apply immediately.?Nor should such clauses protect the supplier against avoidable costs or costs already incurred.?Consider placing limits on the escalation clause.?The escalation could be made to apply only after a certain time or after costs have risen by a certain amount.?It may not make sense to apply the escalation clause or the same index to all components of procurement.?Purchases involving a combination of both goods and services may warrant that different (or no) adjustments be made to certain components.?

???????????Note that if the contract contains a Force Majeure clause excusing performance under certain circumstances, it may be appropriate to reflect that the escalation provisions are tolled for the period of any Force Majeure.?If you are going to use an index as part of your inflation stategy be careful. Learn more at: https://www.amazon.com/Contract-Management-Supply-Chain-Professionals/dp/0615956718