Put It In Writing! The Contractual Approach To Price Changes
Patrick S. Woods, C.P.M., CPIM, A.P.P.
Patrick S. Woods, C.P.M., CPIM, A.P.P., Commodity Manager, Emerson Electric/Fisher Controls, Sherman, TX 75091, 903-868-8160
83rd Annual International Conference Proceedings - 1998
Overview. In today's dynamic environment and with the unsettling market conditions affecting the cost of raw material, contract services, labor and overhead, the purchasing professional is constantly faced with that ugly beast called the "price increase." Even in so-called "sophisticated purchasing departments," these beasts can completely take the buyer by surprise and even though many companies have contracts and/or purchase orders to address quality, delivery and technology, very few contain specific and concise language to address price change. This presentation will show how contract language can be incorporated into a customer/supplier agreement to address the important and challenging area of price changes including both increases as well as decreases due to a softening in the marketplace. Cost savings through value analysis and its resulting effect on price decrease is also discussed.
Note: This presentation assumes that an agreement is already in place with the supplier and that the more leveraged dollars with a given supplier, the more aggressive you can be in negotiating a price change clause. The overall mechanics of the agreement or its importance to the customer is beyond the scope of this presentation.
Background. A common scenario familiar to many a purchasing professional is the slick sales rep. who waltzes into their office with an official notice for a ___% across the board price increase. Although the rep. convinces purchasing that the notice is official, is printed on their company's letterhead (so-called credibility) and may even be a "pass-thru" increase that was forced on them by their supplier, it can still take purchasing completely by surprise, overrun the forecasted materials budget and diminish profits. Another issue on a more personal note, since management looks upon purchasing as the manager of the supply base, unexpected and "out of hand" price increases may lead to a career limiting result.
Serious questions to consider: Are all price increases unjustified? Do price increases have to take us completely by surprise? How can I avoid the constant battle with my management every time I receive a "take it or leave it" price increase request? How can I convince my supplier, where warranted, to give me a decrease in price?
Price Change Factors. One important question that you should pose to your supplier, if not in initial discussions along with your quality and delivery expectations, then as soon thereafter as possible (prior to production) is: Are you willing to provide my company with a detailed cost breakdown for each quoted price? There is one caveat prior to asking this question. Emphasize to your supplier that your desire is not to reduce their profit but to help them reduce their costs so that they can continue to be profitable and you can resultantly be profitable so that you can continue to give them additional orders (etc. you get the general drift?). This philosophy is part of the "open book" theory and should go "hand in hand" in the spirit of customer/supplier partnering.
A typical cost breakdown should consist of the following:
- Unit Price = % Material Costs
- % Labor
- % Outside (subcontracted) services
- % Overhead (can also include profit)
Material costs are all costs associated with your supplier procuring the outside material(s) that will be converted to your products. Labor costs, also referred to as "conversion costs," are the human resource costs associated with converting the raw material into your product. Outside services costs are the costs associated with additional operations that the supplier cannot perform in-house, (i.g. plating, painting, heat treating, etc.) Overhead or burden costs are the portion of the supplier's fixed costs (i.g. rent/mortgage, utilities, administrative salaries, etc.) allocated to your product. Notice that overheads can also include the cost of profit particularly if the supplier is not willing to provide this as a separate percentage.
Of the breakdown above, the portion that is least within the control of the supplier is material costs. You should at least negotiate within the agreement that with exception to material costs, the supplier is to fix or hold firm the other cost drivers throughout the term of the agreement. At agreement expiration (1, 2 or 5 years), all cost factors can then be renegotiated. As mentioned above, the more leveraged dollars you have with a given supplier, the more aggressive you can be in negotiating such factors as fixed pricing on non-material components.
Price Change Rationale Based On Fluctuation In Material Only. The first step in creating a price change clause for material is to determine if there is an applicable index to base the changes on. In the event of more than one base material making up the total part material, try to negotiate for the leading material (ex. in brass, the leading material is copper, in plastic, it can be petroleum.) If you are not familiar with the makeup of the raw material that comprises your product then you may have to do research. Talking with your direct supplier, their supplier and even the raw material producer should give you a good indication of the makeup of the material. They can possibly even recommend an index that both you and they can agree on as an indicator of price change.
If the above strategy does not work for you nor the supplier then you may want to consider the Producer Price Index (PPI). The PPI is published monthly by the U.S. Department of Labor's Bureau of Labor Statistics and measures the average changes in prices received by domestic producers of commodities in all stages of manufacturing or processing. The PPI measures approximately 3,200 commodities and is compiled from approximately 80,000 price quotations each month. If your specific material can be found within the 3,200 commodities (ex. steel) then its change from one period to the next could be an indicator for justified price change.
For example, within your agreement, if you allow price change for packaging and you have selected corrugated containers per the PPI category, and the PPI shows a 5% increase in corrugated containers from 1996 to 1997, then should the supplier be allowed to do the following?
- Unit Price Of Widget A= $10.00
- PPI Increase From 1996 to 1997= 5%
- New Price = $10.50
- Represents A Overall Price Increase Of 5%
This supplier should not be allowed to use this logic since the price increase above reflects an increase in all cost factors and not just the packaging. The price increase would be overstated. As mentioned above, prior to the price increase notice, you should have been familiar with all cost factors.
For example, in the 5% increase scenario, the price breakdown on the $10.00 price could be as follows:
- Unit Price Of $10.00 = 25% Packaging = $2.50
- 25% Other Materials = $2.50
- 25%Labor = $2.50
- 25% Overhead(Profit) = $2.50
Therefore the true increase is on the packaging portion = $2.50 = 5% of $2.50 = $0.13*
The new price should be increased to $10.13 as opposed to $10.50.
- With Rounding.
Accordingly, if the PPI had shown a 5% drop in corrugated packaging, then the unit price above should have been reduced by $0.13. That is why, as you develop the price change language, the section title should be PRICE CHANGE as opposed to PRICE INCREASE to also allow a reduction in price based on a softening in the marketplace.
Timing For Price Changes. As indicated in the definition, the PPI index can change monthly; other indexes can change more frequently. One of the problems with volatile material is constantly battling price changes even if justified in your agreement language. Even a monthly adjustment can prove to be a nightmare for your accounts payable department who have been instructed to pay purchase order price as opposed to the readjusted invoice. Another problem is that if purchasing (along with most companies) are required to set standard prices (usually once a year) then constantly changing prices, particularly price increases, can look very disconcerting and suspicious to upper management, resulting in yourself or your management called on the carpet more than you care to visit the ivory tower.
There are two schools of thought for handling the timing of the price changes (hopefully some decreases will come through as well).
Method number one: You may wish to negotiate with the supplier that prices will be reviewed and changed in set intervals: quarterly, semi-annually or annually are common time frames. At the high end of the market where you suspect that prices will fall, then it could be to your advantage to adjust prices down quarterly rather than paying the higher price for a longer period. Annual price adjustments could be to your advantage if the pricing is rising or stable (benefit to supplier) and standards would remain fixed until next year's adjustment period (timing of price changes with the supplier should match the resetting of standards date). A compromise between the two is semi-annual where in the event of rising prices, the supplier is afforded some protection and vise-versa to you in the event of price drop. Within the agreed to interval however, pricing can still greatly fluctuate (ex. semi-annual interval, pricing could change monthly or 6 times). With frequently changing pricing, what should the new price be based on? The early part of the interval or the later part? A common method to compensate for the changes is to take the average price.
Example, pricing changes 6 times from the initial price in the 6 month interval:
- Month 1+ 3%
- Month 2+ 4%
- Month 3+ 0%
- Month 4- 2%
- Month 5+ 5%
- Month 6+ 3%
Average Price Change From The Starting Point Price = 13%/6 months = 2% (rounded down). Therefore, the new interval pricing would be adjusted up by 2% (remember only the material portion would be adjusted up and not the entire unit price!).
Method number two: As opposed to an interval adjustment, set a fluctuation window with a + or - % fluctuation prior to price changes. The key here is to establish a base material cost with a fluctuation window above or beyond. A positive adjustment in price would result when the base material cost exceeds the window. A negative adjustment (price decrease) would result when the base material cost is less than the window.
- Base Material "X" Cost =$5.00/pound
- Fluctuation Window =+ Or - 10%
- Material "X" Cost=$5.50 Or Higher - Raise Price
- Material "X" Cost =$4.50 Or Lower - Drop Price
If the base price increases but not outside the 10% range, then the customer benefits by not having to pay the higher price, if the base price decreases but not outside the 10% range then the supplier benefits by not having to lower the price. Depending on your negotiability with the supplier, you can even request additional factors such as for ___ percent increase outside the range, the supplier will agree to split the difference 50/50. You can basically request any factor you desire, the catch is in the supplier having to agree and sign the agreement.
Price Change Clauses Based On Fluctuation In Material Only. It is now time to incorporate the rationale above into specific language through price change clauses to be incorporated into the agreement.
Price Change Clause Based On Time Interval (6 month) Adjustment - The sample clause could read as follows:
" PRICING ADJUSTMENTS BASED ON RAW MATERIAL ONLY
The price for each customer product may be adjusted in the event of a change in ______material price. At the end of each six (6) month period after the establishment of this agreement, based on a six month average, defined as a "semi-annual period", the parties to this agreement shall determine the average price for the specific "semi-annual period" which will equal the average price per unit of _______ material as published in the ________ index or PPI during such "semi-annual period". The supplier will subsequently decrease or increase the price of each customer product containing _______ material by an amount of the average price change multiplied by the percentage of that customer product that is comprised of _____ material. Such price change will be effective for the next six month period."
Price Change Clause Based On Adjustment Window (+ or - 20%) - The sample clause could read as follows:
" PRICING ADJUSTMENTS BASED ON RAW MATERIAL ONLY
The price for each customer product may be adjusted in the event of a change in ______material price. If any price of _____ material as published in the ______ index or PPI is 20% greater or less than the preestablished base price then the supplier will subsequently decrease or increase the price of each customer product containing _______ material by the amount of the price change multiplied by the percentage of that customer product that is comprised of _____ material. Such price change will be effective for the next invoice."
Depending on your relationship with your supplier, you may chose to incorporate language that is a combination of the above.
Price Change Clause Based On Both Time Interval (6 month) And Window (+ or - 20%) Adjustment - The sample clause could read as follows:
" PRICING ADJUSTMENTS BASED ON RAW MATERIAL ONLY
The price for each customer product may be adjusted in the event of a change in ______material price. At the end of each six (6) month period after the establishment of this agreement, based on a six month average, defined as a "semi-annual period", the parties to this agreement shall determine the average price for the specific "semi-annual period" which will equal the average price per unit of _______ material as published in the ________ index or PPI during such "semi-annual period". If any average price is 20% greater or less than the average price for the immediately preceding "semi-annual period," the supplier will subsequently decrease or increase the price of each customer product containing _______ material by an amount of the average price change multiplied by the percentage of that customer product that is comprised of _____ material. Such price change will be effective for the next six month period."
Price Change Clause Based On Other Factors. The above rationale assumed that the customer purchased a manufactured item. What if you purchase services or the supplier of the manufactured item insists on allowing fluctuations for other factors, primarily labor? Normally, labor rate changes along with overhead increases (such as utilities and rent) generally follow inflation rate changes. The best overall indicator to capture such changes is the Consumer Price Index (CPI). The CPI is a common measure of inflation and is referred to as the "cost of living index". Like the PPI, the Bureau of Labor Statistics is involved in measuring this time the price data associated with 57,000 households and 19,000 establishments across the U.S.
The sample clauses above could then again be employed, this time substituting ______ material for labor costs and the CPI in place of the PPI or other indexes. As was the case above, you can negotiate the price change based on a time interval, fluctuation window or combination of both.
Price Change Based On Cost Reduction Through Value Analysis. A proactive way to encourage the supplier to hold pricing, even the material cost factor or even lower the pricing is through cost reduction based on value analysis. Value analysis is the process of reviewing the fit, function or form of existing product to determine ways to improve or maintain value at a lower total cost. By encouraging the supplier to participate with your company in value analysis sessions, cost reduction may be achieved. However you as the customer have the responsibility to provide your supplier with the channel and resources to achieve the value analysis programs. All too often, suppliers simply give up because they felt this program was one-sided (they supply all the suggestions) and their ideas did not make it past the purchaser's in-basket. In addition to value analysis clauses in the agreement, some purchasers go a step further to propose a 50/50 sharing of the benefit from these ideas. A sample clause based on the above could be stated as follows:
"PRICING ADJUSTMENTS RELATED TO COST REDUCTION EFFORTS
Both Customer and Supplier agree to work together on cost reduction projects through value analysis. When such efforts lead to tangible and measurable cost reduction over a 12 month period, the dollar savings will be shared 50/50 between both parties (or depending on your negotiability you may stipulate a minimum amount to you with any percentage over to be shared equally). Supplier's capital investment and all other related expense attendant to the realization of the actual cost reduction will be recouped at 100% through the cost reduction before customer is entitled to receive financial benefit from the effort. Customer will receive it's share of the reduction in the form of price reduction on the products directly effected by the cost reduction effort. "
Parting Thoughts. Since we are personally evaluated on how well we manage our suppliers and one of the key components of managing the supply base is pricing, a well defined and agreed to price adjustment clause is crucial to the success of our company, our supplier and our personal future. As mentioned above, we have assumed that a written agreement or contract is already in place with the supplier. If not, then you should start at the beginning with some type of written agreement that can incorporate the clauses illustrated above. As with all major projects, apply the 80/20 rule, apply these clauses and your time to those procurements that can do the most for your organization and which the resulting price change issues will have the greatest impact on your bottom line.