SEIFSA

Tenders are put out when large-scale buyers such as State-owned enterprises advertise their needs and invite bids or tenders from a range of suppliers. They constitute an offer in writing for a company to carry out work or to supply goods or services at a certain price. 

If you are bidding for a high-value tender, plan your tender carefully and consider the requirements involved. For example, ask yourself:

• What is the cost component breakdown as well as the weight for each of those components?
• What is the base date for escalation stipulated?
• What is the frequency of escalation in the contract?

Cost component

A cost component breakdown is a listing of items that will be included in delivering the goods or services being tendered for. It can also be described as the “shopping list” of the components that are being bought by a buying company from a supplying company, whether it is goods or services. Supplying companies are, therefore, advised to put a lot of thought into developing the cost component breakdown. 

If we use a hypothetical example of the manufacturing and supply of a pen, the cost components could typically consist of Labour (to produce the pen), Material (which will in this case be plastic, metal and ink), as well as Transport (to deliver the pen to the buying company). Each of those components will have a weighting agreed upon by both parties assigned to it. For example, labour can have a weight of 30%, material 50%, etc. 

The supplying company must provide the buying company with a cost component breakdown, as the buying company does not know exactly what costs would be undertaken to provide the goods or services required by the tender bid. Some tender bid documents have examples of a cost component breakdown included. 

It is very important to ensure that the supplying company reads and understands the document carefully and properly, and not to simply use the example of the cost component breakdown provided, when completing the tender bid.  The reason is that this might include components that have no relation to the supplying company’s cost components whatsoever, and may have an enormous impact on price adjustment calculations in due course.

Base date 

Each tender bid would specify the base date to be used when completing a price adjustment calculation. This date is normally specified as either the date as at the close of a tender bid, or two months prior to the close of a tender, as the relevant indices may not be available in the current month. The base date of a contract can also be referred to as the starting date for escalation, hence it is very important to ensure that a base date is agreed upon by both the supplier and the buyer and that it is clearly specified for escalation purposes. 

Escalation frequency

The frequency of escalation will depend on the type of goods or services that are being tendered for. Suppliers that complete the tender document must understand fully and specify what the frequency of the adjustment of prices in a contract will be, especially in tenders with very volatile components which are included in the cost component breakdown. 

Referring to the earlier example of the manufacture and supply of a pen, the frequency of escalation could be annually.  On the other hand, if the product or service involved in the tender process is the supply of transport for goods, the frequency of the adjustment of prices on the fuel component of the contract will very likely be more regular than the frequency of the balance of the components. You might find that a transport company stipulates the frequency of escalation as annually, whereas the fuel component would need to be escalated more frequently, most likely on a monthly basis.

SEIFSA Price & Index Pages 

The SEIFSA Price and Index Pages (PIPS) is a tool that is commonly used for Contract Price Adjustments (CPA). The aim of the publication is to provide users with an independent source – based on the arm’s-length principle – from which price benchmarking and adjustments can be made fairly and equitably for suppliers or manufacturers and their respective clients. 

SEIFSA’s PIPS tracks the escalation costs or prices of over 240 different variables. This information is condensed into various price escalation indices and published on a monthly basis. SEIFSA’s independence from any financial gain in these contracts places it in a perfect position to mediate between parties in case of disputes, underpinned by well-researched and audited information. SEIFSA PIPS, therefore, provides a tool for parties in a contract to come to a fair and equitable price increase based on agreed principles, as earlier explained. 

SEIFSA is any company’s best insurance against price increases eroding its company’s profitability and sustainability. 

Contact us for more information on the subscription options for the SEIFSA Price and Index Pages.

The most important factor regarding contract price escalation is that the basis on which this is achieved must be fair and equitable to both parties to a contract. The recovery process should be easy to calculate and administer.

Fixed price contract

A contract that does not contain a clause permitting an adjustment to current price changes that have occurred during the execution of the contract is called a fixed price contract. When the interval between the contract’s date of the tender and the date of the completion is so short that the contractor’s or supplier’s costs vary to a negligible extent, a contractor may be expected to enter into a fixed price contract.

As the general rate of inflation increases, a contractor’s or supplier’s costs are likely to change over a relatively short period of time, so when a supplier commits himself to a fixed price contract, he has no certainty that he will maintain his profit margin.

When entering into a fixed price contract for an extended contract period, the supplier should factor in a contingency provision for inflation into the price or quotation.

Suppliers of goods and/or services are becoming increasingly reluctant to incur cost escalation risks. Their customers are also becoming reluctant to incur the cost of a risk premium in contract prices or to be involved in consideration of whether or not suppliers have over-provided for possible future cost increases in their quotation.

Contract price adjustment clauses seek to establish tender prices at the date of the tender based on known cost and to deal with the subsequent cost escalation risk separation.

Contract Price Adjustment-linked contract

An important aspect of recovering escalations in a contract between two parties is the inclusion of an agreement by both parties on all aspects of a contract escalation or CPA.  The basic logic behind a CPA is to adjust the base price (the price at the start of the period under review) with a market-related change to calculate a new price, ensuring a fair outcome to both parties to the contract.

By using SEIFSA’s Price and Index Pages (PIPS) in a CPA, the buyer in the contract can be certain that market-related increases are paid to the suppliers (as determined by the CPA calculation), ensuring the sustainability/improvement of profitability.

If companies do not stipulate in the contract that an escalation be based on SEIFSA’s formula and indices, suppliers to a contract can submit price increases as they please. Similarly, buyers in the contract can reject any claims as they please. Thus, companies/trading partners

maximise potential benefits from their contracts by using SEIFSA PIPS in their CPA calculations.

The formula method

The formula method of recovery breaks an item into its various components including fixed costs, labour, material and overhead costs. Each of these components are linked to an index against which escalation is recovered. For example: labour is linked to SEIFSA Table C-3. Table C-3, however, contains four indices ranging from low-skilled labour to skilled labour, and it also contains an index which calculates the average increase in the labour rate across all 13 job gradings as per the Metals and Engineering Industry’s Bargaining Council (MEIBC).

It is, therefore, important to specify the exact index contained in Table C-3 to link to the labour component of a contract i.e. SEIFSA Table C-3: All Hourly-paid employees. The rate of increase of each component is, therefore, directly linked to the increase of the index to which it is linked. The formula method also defines the period over which the escalation will apply for each component.

Advantages of the formula method

Confidentiality

The formula method recovers escalation by using indices which are impartial indicators of cost movement. No supporting documentation is required to substantiate the claim , hence full confidentiality is maintained regarding the source and price of goods.

Administrative cost

If a formula and its component definitions have been clearly stipulated and contractually agreed upon, the process of calculating the escalation is fairly simple.

Indirect Costs

These costs are included in the formula and many indices which are compiled from actual costs in the industry include the indirect element of costs.

Profit margins

The original quoted selling price forms the basis on which escalation is calculated. If a formula is applied, the profit margin is maintained.

Control over increases

The formula method only allows increases in relation to the indices defined with it. Since bodies independent of the parties to a CPA agreement supply information which is used to publish indices, neither party can influence or manipulate them. Indices generally reflect the average cost increases within the industry as a whole and not those of any individual supplier.

Challenges in using the formula method

Accuracy

In order to keep the formula simple and workable, a formula rarely represents more than 10 components of cost.  As a consequence, it can never be entirely representative of a specific product, group of products or service being escalated. In addition, indices are not always entirely representative of each of the components of the formula.

If indices are not available

It sometimes happens that there is not an index contained in the SEIFSA PIPS which is relevant to a specific product. There is, however, an alternative. SEIFSA refers users of the PIPS to the PPI for final or intermediate manufactured goods. The decision will be based on whether the product is used in the intermediary process or not or, alternatively, which one of the two indices tracks the closest the movement in the cost component.

Conclusion

The need for escalation procedures is clear. In analysing the method of recovery in this section, the conclusion is that the use of a formula is usually the efficient method recovery. The features of the formula method supporting this statement are:

• A formula gives a clear contractual base by which price increases or decreases can be calculated;
• Profit Margins are maintained;
• Minimal time is taken up in the calculation process and administrative costs are low;
• Confidentiality of price and sources is maintained;
• Using indices usually caters for indirect costs; and
• A formula linked to indices is immune to manipulation by either the supplier or the customer.

Although a formula is a mathematical entity, each component is subject to a definition. It is, therefore, vital that each component of the formula agreed upon is clearly defined and is fair to both parties.

Contact Marique Kruger at SEIFSA (marique@seifsa.co.za)