A contract is simply a written document that outlines the full understanding of the business relationship and scope of the work so that no one can claim any misunderstandings later down the road. Contracts specify exactly what rights are being purchased and what rights the supplier holds and are legally enforceable.

At their very core, contracts are relationships. This is because  two parties agree to a contract agree to work together and forge a connection that, if fostered well and is beneficial to both parties and the relationship, can last for many years. Contracts also hold each party to their original agreement and is the legally bounding paper trail that holds both sides accountable for the terms they set out and agree to at the beginning of the relationship.

Contracts often go through a negotiation process which ensures that both sides are getting the best possible outcome. Good negotiations should lead to a mutually successful outcome that prevents conflict down the line and sets the foundation for a strong partnership moving forward.

Signing a contract can be an exciting moment, irrespective of whether you’re signing a new client or renewing an existing contract for a period of time. By being so delighted to be awarded a tender, companies tend to make the mistake of just signing the contract without reading and fully understanding the content and its implications. 

The difference between barely making profits and boosting margins to ensure a company’s sustainability comes down to one important aspect – the need to read the contract carefully before signing it. 

Contracts in business are important for a number of reasons. They are binding and legally enforceable; they protect both the client and the contractor and also stipulate how and when payments or escalations are due.

Once a contract has been signed, it may be very difficult – and even impossible – to get out of it without such an action having an adverse financial impact on your business. To ensure that the outcome of a contract is fair to both the buyer and the supplier, one of the most important aspects is that each party reads and fully understands what is stated in the contract. It is also very important to keep in mind that, if a verbal agreement does not appear in writing, it may not be enforceable later on. 

We often get enquiries from companies which are suppliers of products or services in terms of  their contracts seeking clarity on why the buying company is not accepting a specific increase passed onto the buyer.  Our first point of reference is the terms and conditions (Ts & Cs) as set out in the contract, since both parties have agreed to the relevant Ts & Cs.

Some of the Ts & Cs may include:

• The frequency of escalation: the contract may only allow escalation on an annual basis, but the price of some of the cost components may be very volatile and change almost every month;
• The inclusion of a clause on the escalation of input cost components with more frequent price changes;
• The cost component breakdown and indices linked to each of the components; and
• The relevant SEIFSA index to link to each cost component, and whether a fixed portion is included or excluded and the size of the fixed portion.

Below is a practical example of the implications of signing a contract without reading or fully understanding the terms and conditions stipulated in it:

Company A is awarded a tender and signs a contract to supply Company B with various electrical components, delivered and installed at the premises of Company B. Company A did not fully read or understand the content of the contract at the time of signing.  

At a certain point in time, Company A notices that there are huge price increases in the cost of some of the components that it supplies in terms of its contract to Company B. Company A subsequently sends a notification to Company B informing it that the cost price of those components has increased and that Company A is in the process of calculating a Contract Price Adjustment (CPA) to determine the relevant increase to pass on to Company B. 

However, Company B does not accept the price adjustment process and Company A makes contact with SEIFSA to establish why Company B is not accepting the CPA. As earlier stated, SEIFSA refers Company A back to a signed contract and asks the following questions:

1. What is the frequency of escalation agreed upon by both parties in the contract?
2. Is an escalation currently due?
3. Is there a clause in the contract which specifies that a CPA can be completed in cases where the price of a certain input increases or decreases by more than a certain percentage during the period? 

Based on the questions asked, Company A refers back to the contract and states that all escalations are annual, that no escalations are currently due and that no specific clauses referring thereto are included. The answers supplied by Company A clearly set out the reason why Company B did not accept the CPA.

Had a representative or an employee of Company A read and understood the information contained in the contract at the onset, then Company A would have known that price adjustments or price escalations can only be made once a year and that it cannot pass the cost increase over to Company B at that moment.  

Over the years, we have had many phone calls from contractors with queries similar to the one of Company A in our example complaining about not being able to pass increases in costs on to the buying company. Generally, when we ask the contractors what is stipulated in the escalation clauses of their respective contracts, in most cases they do  not know. 

By ensuring that a company representative reads and fully understands the impact of what is stipulated in a contract prior to signing a contract, a company can effectively negotiate the terms and conditions pertaining to the escalation frequency (which can be up to 12 times a year) and the inclusion of clauses relating to the escalation of certain input cost components.

The Contract Price Adjustment workshops offered by SEIFSA are tailored to provide key insights to contracts, their importance and how to effectively negotiate contracts towards better margins and profits levels.

In addition to publishing the Price and Index Pages and running Contract Price Adjustments, SEIFSA also helps companies by drafting or reviewing legal contracts before they can be signed. The Federation offers this service through its two experienced Admitted Attorneys.

When a buying company awards a tender to a supplying company, it is important for the parties to the contract to understand that a contract, at its core, is a relationship that they are entering into. The reason is that the parties to the contract ultimately agree to work together and build a relationship that is not only beneficial to both parties but will also last for years.

A contract outlines the full understanding of the business relationship that will be forged and the scope of the work to be completed, which in turn, highlights the mutually dependent nature of the client-and-supplier relationship. Why do we say that the relationship is or will be mutually dependent? This is because each party to the contract gives something and expects something in return. Both parties to the agreement agreed at the onset when payments [including Contract Price Adjustment (CPA) payments] are due, and when the manufactured products must be supplied. The buying company, therefore, pays money to the supplier, while the supplier, in turn, manufactures a product and delivers it at an agreed-upon future date. 

From the supplier’s point of view, they manufacture a product that will be delivered on time and expect due payments on time. Both parties have a clear understanding of their respective roles and responsibilities during the project life cycle, which will contribute to the sustainability of both businesses during and after the completion of the project.

It is equally important to achieve a balance in the buyer-supplier relationship, especially given that the outcome of the contract and subsequent CPA escalations should be fair to both parties to the contract. It is imperative, therefore, to set up the terms and conditions (Ts and Cs) in such a way that the outcome of the CPA calculation does not benefit or disadvantage either party unfairly. By having a balance in the buyer-supplier relationship, both parties would be in a position to highlight their concerns at the onset of signing the contract and be able to negotiate Ts and Cs that are fair.

Imagine the following scenario from the supplier’s perspective: 

You, the supplier, applied for a tender for a CPA-linked contract that spans a period of three years (with the option of renewal), with escalations due at the end of each year. Given that you were new to the tendering process you did not fully understand the implications of not submitting a detailed cost component breakdown (such as labour, materials, transport and overheads) in the tender bid application, and you subsequently just listed the main cost components (i.e. labour and material). You also did not consider that transport and overheads (such as rent) should form part of your company’s cost component breakdown.  

At the end of the first year, the first annual escalation was submitted and approved. Thereafter, you decided to attend a workshop presented by the Steel and Engineering Industries Federation of Southern Africa (SEIFSA) on the Theory and Calculation of a Contract Price Adjustment. During the training session, you realised that you made a big mistake when you compiled the cost component breakdown and that you erroneously excluded important cost components from the breakdown which should have been included.

From the onset, you – the supplier – and the buying company forged a good relationship, with both parties understanding what is required of them. You subsequently meet with the relevant individuals of the buying company and explain the situation. The buying company states that it understands the predicament, and while it cannot change the terms and conditions of the contract as it is legally binding, it is willing to compromise. The buying company further states that when the contract is up for renewal at the end of the third year, it will allow you to put a new cost component breakdown together and that you should ensure that all the relevant costs are included.

In this instance, had it not been for a good/healthy buyer-supplier relationship, the outcome would most probably have been completely different. The fact that the buying company was willing to compromise is a clear indication that it understands the importance of having a good buyer-client relationship and that this is an aspect that must continuously be improved upon. It is imperative, therefore, to understand that just because you are in a position where there currently is a balance in the buyer-supplier relationship, it does not mean that there is no further room for improvement. Continuously improving the buyer-supplier relationship is crucial throughout the project life cycle.

In order for any business to remain sustainable, a company has to monitor price escalation trends;  in other words, it has to keep track of the increases or decreases in the price of the various cost components that are relevant to a specific contract.

The price of the cost components may change as a result of unforeseen circumstances, including inflation and exchange rate fluctuations, which may also affect the cost of doing business. Given that inflation captures the average increase in the price of goods and services over a period of time, it is, therefore, important that businesses account for underlying volatility in changes of prices of, say, raw materials if they want to survive.

A Contract Price Adjustment (CPA) is a mechanism which can assist any business to understand, monitor, contain and adjust for volatility applicable variables such as exchange rates and inflation. SEIFSA monitors these and other variables through price indices. It is imperative that parties to a tender stipulate from the onset that all escalations should be based on SEIFSA’s indices, which are compiled using internationally recognised formulae. If escalations are not guided by a mutually recognised set of indices, suppliers to a contract can submit price increases as they please in attempts to prevent project cost overruns, while buyers in the contract can reject claims as they please in attempts to align with budgets and remain sustainable. 

Let us make use of an illustrative example to highlight the potential negative effect that inflation can have on the margins and sustainability of a business, especially when a contract does not stipulate that the SEIFSA Price and Index Pages (PIPS) must be used in the calculation of a CPA, or when there is an error in the escalation calculation. The valuation can be explained from the perspective of a selling or supplying company.

Scenario 1 – Selling or supplying company’s escalation:

1. Contract which spans a period of 20 years
2. Initial contract value of R5 million
3. Prevailing inflation rate of roughly 7 percent
4. Instead of using the prevailing 7 percent, a supplying company calculates an incorrect annual increase of roughly 4 percent, which results in a 3-percentage point error yearly.

Table 1: Potential negative effects of inflation on the margins and sustainability of a supplying company

Source: SEIFSA’s EC Division, April 2020

The example in table 1 above shows the potential annual loss which the supplying company could incur, as well as the cumulative loss which may be the result of an error in the escalation calculation or because the supplying company did not make use of the SEIFSA formula and PIPS indices in completing the CPA. 

Initially, the annual loss to the supplier might not be that significant (R150 000 in the 2nd year) and the supplying company might be in a position whereby it can absorb the loss. However, the situation changes after each year, and if one looks at the cumulative loss over an extended period of time, it is evident that the sustainability of the supplier will be compromised. 

Let’s analyse the impact of the calculation error on the supplying company after five years. Based on the data, we see that the supplying company incurred a cumulative loss of R1 185 000 after five years. The cumulative loss increases more than double to R3 680 000 after 10 years.  Over a 20-year period, the calculation error equates to a massive R13 650 000 cumulative loss to the supplier. 

Given the current challenging economic environment, with two technical recessions over the past two years, compounded by a persistent coronavirus pandemic, a company cannot afford to lose that kind of money. Moreover, when small businesses do not use – or incorrectly apply – SEIFSA’s PIPS in their CPAs, the impact will be significant and may lead to a company’s closure due to the unsustainability. Over a longer time frame, the profitability of medium-sized and large companies will also be affected. Moreover, large companies may not also be in a position to service their debt obligations, resulting in a situation of business rescue, liquidation or closure of key businesses in the industry.

In this scenario, it is clear that the buying company will benefit from the situation as the amount of money it pays to the supplying company on an annual basis is actually less than the amount that should be paid. This leads to a massive cumulative saving of R1 185 000, R3 680 000 and R13 650 000 over five, 10 and 20 years respectively for the buying company.

Now let us look at the valuation exercise from the buying company’s perspective.

Scenario 2 – Buying or receiving company’s escalation:

1. Contract which spans a period of 20 years
2. Initial contract value of R5 million
3. Prevailing inflation rate of roughly 4 percent
4. Instead of using the prevailing 4 percent, buying company calculates an incorrect annual increase of roughly 7 percent, which results in a 3-percentage point error yearly.

Table 2: Potential negative effects of inflation on the margins and sustainability of a buying or receiving company

Source: SEIFSA’s EC Division, April 2020

Through an error in the escalation calculation, the buying company overpays the supplier every year. After two years, the amount by which the buying company overpays is only R150 000, and the buying company might not even notice the overspending. After a couple of years, the sustainability of the buyer will be at risk. Over a period of five, 10 and 20 years, the buyer would have cumulatively overpaid the supplier by R1 185 000, R3 680 000 and R13 650 000 respectively.

It is evident that the supplying company benefits in this scenario, especially given that the amount of money it received from the buying company on an annual basis is significantly more than the amount that should have been received. 

Conclusion and key recommendation

Given the potential negative effects of inflation on the margins and sustainability of both the buying and supplying companies, as illustrated above, market-related changes in variables should be monitored closely by a recognised reference point which is accepted by both the buyer and the supplier. SEIFSA, which has a traceable record in monitoring changes in related variables through its PIPS, can assist businesses in this regard.

SEIFSA PIPS is any institution’s – buyer, supplier or any other service provider –  best insurance against inflation eroding its profitability and sustainability. Inflation, exchange rate volatility and unpredictable input cost fluctuations have the potential of reducing profits/gains from new or existing contracts signed by a company with another party. It is, therefore, important to protect a company’s sustainability against potential losses. This can be done by periodically reviewing and adjusting your contracts by using the SEIFSA PIPS, which is a useful tool for any company.

Moreover, it is imperative to ensure that calculations which relate to changes in the price of various cost components in a contract are accurate, given that invariably they impact on the margins and long-run sustainability of any company.

Ends

So, you are in the process of tendering for that big contract and it is a requirement that you make use of the SEIFSA indices to assist you in accurately pricing your tender contract. At this point in the tendering process you might not be aware of who SEIFSA is or that SEIFSA even has price indices available. At the same time, you might not have a clear understanding of what an index is, or what the purpose of using an index is, let alone have knowledge of a SEIFSA price index.

The aim of this blog is to give you as a tenderer a basic understanding of indices and to give you an overview of the SEIFSA indices on offer. Lastly, we aim to give you a brief explanation as to why you should use the SEIFSA price indices in the tendering processes and subsequent escalations.

In the most basic sense you use an index as a statistical measure of changes in two or more data points. What I mean here is that one index point (e.g. 102) tells you nothing. In order for indices to have meaning, you need to have at least two index points to calculate the percentage increase or decrease between any two periods. Just by looking at the indices you should already have an indication whether the price of what you are interested in (e.g. domestic merchant steel) increased or decreased between two periods.

Let me show you with an example:

The table above is a hypothetical example giving index points which reflect domestic merchant steel prices for the months of January 2017 and February 2017. Without doing any calculations you can see that there was an increase in domestic merchant steel prices. How? The index value in February 2017 is higher than that of January 2017. Now that you know that the price of domestic merchant steel increased between these two months, you can easily calculate by how much. You can make use of either of the following formulas to calculate the percentage change in the price of domestic merchant steel:

1. ((New/Old) – 1) *100
2. (New-Old/Old) *100

Both of the above formulas will give the same results. Based on both formulas and the figures cited in the example, the change in the price will be 2%. There are some advantages to using indices.

Firstly, an index hides sensitive information such as the source of the information or the actual price level and secondly, it minimises errors in computation that are often associated with larger numbers. It is much easier to type 125.1 as opposed to 138 789, which allows for reduced errors. It is also important to understand that a price index only indicates the extent to which the price of an item has changed when compared to some earlier point it time. Moreover, a price index does not give you an indication of the actual level of the variable which means that you won’t know what the exact price of the item (i.e. domestic merchant steel) is. Important to understand is that when the domestic merchant steel price increases by 10% in a given month, that 10% increase will be reflected in the index for that same month.

Now that you have some background on indices, allow me to go into a little bit more detail regarding the SEIFSA indices. Every month SEIFSA updates and publish over 200 price indices in the SEIFSA Price and Index Pages (PIPS). We have time series for some of these price indices dating as far back as the 1960s.

SEIFSA PIPS cover a wide spectrum of price indices which includes but is not limited to labour, transport, overheads and materials. The SEIFSA labour indices cover all 13 job gradings as set out by the Metal and Engineering Industries Bargaining Council (MEIBC). Although our labour indices relate mostly to the Metals and Engineering sector, we also publish labour indices for other industrial sectors.

In addition to indices for petroleum products, we publish two road freight (transport) indices that you will apply based on your primary activity of business. For overheads, SEIFSA PIPS offer you indices for both office and production. We also have indices that you could apply if you have an imported component in your cost breakdown. These include exchange rates and imported unit value indices (UVI).

SEIFSA PIPS offer a wide array of indices relating to materials. In terms of steel, our offering includes but is not limited to domestic merchant and producer price and stainless-steel indices. A number of material indices relevant to different type of engineering activities are also available along with commodity indices.

When you make use of PIPS in your tender submission you can be assured that your tender bid is comprehensive and competitive because you will be able to accurately calculate the changes in inputs that affect the final cost of manufacturing. SEIFSA PIPS is the best tool to use to use for contract price adjustment as well.

As a business owner, you might just feel as if you are under siege. Your input costs seem to be rising constantly. From fuel, to a weak currency and soaring administration prices, the inflationary attack never seems to stop.  Being profitable is the single most important reason people start businesses. Sustainability, to be able to maintain the business at a certain level now and into the future, is a direct result of remaining profitable. So the questions become: How can you prevent inflation from completely eroding the sustainability of your business? How do you grow your business in such challenging times?

For the past six decades, SEIFSA has been honing, incrementally improving and delivering to members its premier product. A product specifically designed for businesses to use for adjusting price escalations in contracts. The goal is to ensure fair and equitable relationships between buyers and sellers involved in a contract. By having the right information which is available on a timely basis, correctly calculated and interpreted, all from a central source, SEIFSA has managed to advance the interest of businesses and to keep the doors of many businesses open. SEIFSA, through its PIPS subscription service, has provided the industry with the opportunity to ensure companies’ sustainability.

To demonstrate the importance of PIPS to any company and the reasons why a business simply cannot afford not to use the service, we should look at an example showing the devastating impact an incorrect calculation and or not using the service can have on a business. The example assumes a 10-year, R10 million contract. The inflation experienced by the company is 6%, but the company mistakenly calculates its escalation as 4% annually, yielding a 2% error every year. In short, the error equates to a R2.7 million cumulative loss after 10 years. In such tough times, can any company really afford to lose that kind of money?

In light of the importance of the service to the metals and engineering sector in particular and other businesses in general, SEIFSA is always innovating and adding new features to the PIPS product. The improvements are always in response to business needs, requests and frequently-asked questions from the membership and the wider SEIFSA community of stakeholders.

Some of the highlights include:

• Free monthly commentary on the state of price escalation for that relevant month;
• Theory of Cost Price Adjustment Courses, which are held nationally and at the SEIFSA Head Office;
• The acquisition and creation of new indices almost on a quarterly basis;
• Support for companies involved in international trade such as providing:
  • The exchange rates of major trading partners countries, and
  • International Production Price Indices;

• Ensuring quality of our data by continually checking our processes against reputable authorities such as Statistics South Africa;
• SEIFSA understands that friction may arise between buyers and sellers as a result of not understanding the contract price adjustment process or its mechanics – thankfully, SEIFSA is able to review the process from an objective perspective and suggest a way forward based on best practice;
• SEIFSA helps companies directly by providing guidance and implementing the actual escalation calculations, with the escalation carried out by SEIFSA experts and prepared for submission; and
• The PIPS online portal is now live and functioning well, with members getting almost immediate updates and more features, which are now easily loaded online.

PIPS: The Future

SEIFSA will continue to invest time and resources into enhancing PIPS as the Federation’s contribution to creating sustainable South African business. In  future we will also be moving our training online into a webinar format so that you can learn at your own pace. So, watch this space, and always visit www.localhost/pips for the latest news and updates.

Contact SEIFSA today to find out how our PIPS experts and economists can assist your organisation to avoid project cost overruns and manage the corrosive effects of inflation and keep your business competitiveness in an extremely tough economy and against international competition.

Attend one of our training sessions and convince your management and finance team to become PIPS members and you, too, will be able to de-risk your operations in a volatile environment.

Reaching sustainability is a multi-faceted process. It is often difficult to harness the skills that are potentially available to us. The ability to position a company in the global market needs a mind-set change. Real value can only be added to achieve sustainability and unlock the profit potential. Therefore, an intense focus on competitiveness and sustainability would more likely remove barriers to entry to the local and global market. SEIFSA PIPS is a low hanging fruit, a tool that can help you have 20-20 vision going forward.