Why It Is Important To Read And Re-Read Your Contracts Carefully

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.


The Importance Of Nurturing A Healthy Buyer-Supplier Relationship

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.


Essential Considerations And Tools For A Commercially Competitive Tender Bid

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 DEVASTATING EFFECTS OF ERRORS IN CONTRACT PRICE ADJUSTMENT CALCULATIONS

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

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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

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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

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SIX (6) INTERESTING FACTS YOU MAY NOT KNOW ABOUT CONTRACTS

SIX (6) INTERESTING FACTS YOU MAY NOT KNOW ABOUT CONTRACTS 

Irrespective of whether you are running a small business or a large enterprise, contracts will become an integral part of your operating environment. This is especially true given that you will have some form of a contractual commitment relating to the purchase or supply of goods and services as part of the day-to-day activities in your business.  Therefore, it is very important for you to implement and manage contracts effectively.

A contract ensures that the interests of both parties are legally protected, while also ensuring that the parties to the contract fulfil their obligations as agreed to.

Once a contract has been signed, it may be very difficult – and  even impossible – to get out of without such action having an adverse financial impact on your business. To ensure that the outcome of a contract is fair to both the buyer and supplier, there are a number of aspects pertaining to contracts that one has to be cognisant of and be familiar with. These include the following:

1. It is better to have contractual agreements in writing

While contracts can be verbal or written, it is advisable to have all agreements in writing. Verbal contracts are often difficult to prove and may lead to additional disputes when misunderstandings occur.  Moreover, because verbal contracts are difficult to prove, they may put a strain on the business relationship of the parties to the contract and may also lead to project cost overruns when parties cannot agree to the terms and conditions. These types of disputes can be avoided by ensuring that all the terms and conditions are written and agreed to by both parties. 

2. Understand the essential elements to a contract

a. Capacity

It is important that the parties to a contract understand the terms and conditions set out by the contract, and that consent to the contract must be given out of free will and must not be forced or influenced.

b. Offer and Acceptance

The agreement will be in force when an offer is made by one party, which is subsequently accepted by the other party to the contract.

c. Certainty

Contracts must avoid vague terminology and should have definite terms, especially given that a court will not uphold contracts that are vague.

d. Possible

The contractual obligations must be possible to carry out.

e. Lawful

If a contract is against public policy or unlawful, the contract will not be legally valid. 

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3. General terms and structure of an agreement

There is no standard format that a contract must adhere to. The contract will generally include various terms and conditions that will form the basis of the contract. If contract conditions are not met, the contract may be terminated. Moreover, there are different aspects and unique characteristics that are relevant to each contract that one has to consider in drawing up the contract.

4. You do not have to sign the agreement if you don’t understand it

It is important to ensure that both parties to the contract understand the terms and conditions as set out, especially given that the contract is legally binding. If you find yourself in a situation where you are not quite sure what the terms and conditions mean, do not sign and hope for the best. Rather, make sure you get someone to assist you before you sign. This is a very important point, especially if your company is new to the tender and contract space and if you are concerned that you will lose out on a contract being awarded if you do not agree to the terms and conditions that were stipulated at the onset. 

5. Contracts and their contents are negotiable

Contracts contain a lot of details, but  it does not mean that everything is set in stone. The terms and conditions of a contract are negotiable (like the period of the escalation or the size of the fixed portion, etc.). If you do not agree to the terms that are being offered, make a counter offer. For example, if the contract stipulates that a fixed portion of 15 percent should be included in the cost breakdown, you are well within your rights to negotiate a smaller fixed portion. 

6. You need to adjust contracts regularly to ensure that margins and profits are maintained and maximised

More often than not, Contract Price Adjustment-linked (CPA-linked) contracts are escalated on an annual basis. That is because companies (both buyers and suppliers to the contract) regularly cite labour constraints and the administration that is linked to CPAs as reasons for doing escalations annually.  Often times, there is a limited number of employees in a company who are responsible for tendering and contract escalations. If an individual oversees a large number of contracts, there may not be sufficient time to complete normal day-to-day work activities and also do more frequent escalations.

Apart from the work involved in a tender process and contract escalations, parties to a contract generally do not have an understanding of the implications of frequent escalations (e.g. monthly) compared to non-frequent escalations (e.g. annually) on contracts. Generally, input costs change monthly, although there are certain inputs that change on an annual basis, such as labour costs. 

We often receive queries where a supplying company states that the price of some of its input cost components has increased significantly in recent months and that the buying company does not want to accept an escalation to recover the costs. The first point of reference is to refer back to the contract and to determine what was stipulated and agreed upon by both parties. If the contract stipulates that all escalations must be done annually, and if the annual escalation is not currently due, the supplying company will not be able to pass such increases on to the buying company. This will invariably impact negatively on the margins of the supplying company.

Let’s make use of an example to expand further:

For the purpose of this example, we assume that you run a construction company and that you have entered into a two-year contract with a buying company for the building of an office park, and that the parties agreed to an annual escalation. The input cost components may include labour, materials comprising reinforcing steel, cement, bricks, roofing, etc., as well as  transport. 

It is important to highlight that the prices of the majority of the input cost components in your company’s cost breakdown (excluding labour) will change (increase or decrease) on a frequent (i.e. monthly) basis.

In the process of building the office park, your company will incur costs on a frequent basis through the purchase of various materials used in the construction process. Moreover, the price of the items purchased might differ from one purchase to the next as a result of changing input costs that the manufacturer passes on to its buyers – in this case, your company. 

While the price of your inputs will change as a result of changes in the price of the inputs of the manufacturer from whom you bought the products, you will not be able to do an escalation and pass the change in the price onto the buying company. This is because you entered into a contract for the building of an office park where escalations are done on an annual basis, and the annual escalation may not be due yet. This will invariably eat into your margins and profits, in the process impacting on the sustainability of your company, especially given that your company will need to have sufficient cash flow available to continue with the project and to absorb various price increases.

Had you entered into a contract where more frequent escalations were agreed upon, the situation would have been different as you would have been able to pass changes in the price of the inputs used in the construction process on to the buyer on a more regular basis, ensuring the sustainability of your company. Therefore, it is crucial to adjust contracts regularly to ensure that margins and profits are maintained and maximised.

Contract Management is a crucial part of a business and can account for significant leakages in finances and can also have a long-term impact.

SEIFSA can help, both with your Contract Price Adjustment and the drafting or reviewing of your contract or Service Level Agreement, through our Economic and Commercial Division and our Industrial Relations and Legal Services Division.

Ends 

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What are the SEIFSA Indices?

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.

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Let me show you with an example:

 

seifsa-indices 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.

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The Benefits of a Contract Price Adjustment - Linked Contract

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

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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.

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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)


SEIFSA PIPS: A FUN FACTS GUIDE

The SEIFSA Price and Index Pages (PIPS), a Steel and Engineering Industries Federation of Southern Africa publication, has reached its 60th successful year of production. Subscriptions to PIPS have more than doubled since 2010 from 800 to more than1200 companies.

An estimated readership of 16 000 comprises mainly of buyers and contract procurement managers of most large companies in the transport, construction and manufacturing industries, as well as government and large parastals such as Eskom, Transnet and the water boards.

PIPS consists of more than 200 independent market- or product-specific indices that SEIFSA reviews and updates on a monthly basis. These indices are widely used to determine and negotiate Contract Price Adjustments to ensure a fair and equitable deal for both client and supplier.

In fact, Eskom insists that all of their suppliers use SEIFSA PIPS in their cost escalation exercises.

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THE INDICES: OUR CATEGORIES

  1. Labour Indices
  2. Consumer Price Index
  3. Steel Indices
  4. Metal Indices
  5. Construction Material Indices
  6. Distribution and Power Transformers
  7. Road Freight Indices
  8. Petroleum Products
  9. Production Price Indices
  10. Electrical Cable Manufacturing Materials
  11. Stainless Steel Indices
  12. Aluminium Indices
  13. Chemical Indices
  14. Commodities
  15. Export and Import Price Indices
  16. Interest Rates
  17. International Production Prices Indices
  18. Exchange Rates

THE MISSION OF SEIFSA’S ECONOMICS AND COMMERCIAL DIVISION

It is the mission of SEIFSA’s Economics and Commercial Division to give voice to and raise the profile of the metals and engineering sector in the national discourse on economic, industrial and trade policies. The Economics and Commercial Division also produces its PIPS product and hosts training workshops in which the Division highlights the essence of the indices and the importance of Contract Price Adjustments.

The metals and engineering sector is a strategic industry for South Africa, comprising 45% of manufacturing and contributing 6% to the gross domestic product of the country. Real output in the manufacturing sector accelerated to 4.3% in the third quarter of 2017, following an increase of 1.5% in the second quarter, as activity in manufacturing expanded at a faster pace,  contributing 0.5 percentage points to overall GDP growth. The companies in the sector export 52.1% of their production to the rest of the world, earning valuable foreign currency for South Africa.

The health of the industry is vitally important.

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The SEIFSA Economics and Commercial Division accomplishes its mission through:

  • Research of economic and cost trends;
  • Communicating sector market intelligence to its members, associates and the general public;
  • Monitoring the international and domestic economic and policy environment;
  • Supporting companies in the sector to make more informed business decisions;
  • Having a particular focus on small and medium size businesses; and
  • Offering a comprehensive advisory service on black economic empowerment and assisting companies to achieve this business imperative.

SEIFSA INFLUENCE

The Economic and Commercial Division strives to influence the business environment positively by representing the sector in debates and forums about monetary, fiscal, industrial and trade policies.

This is done through:

  • Direct interaction with the relevant institutions in the public sector, like the South African Reserve Bank, the National Treasury, the Department of Trade and Industry, Customs, the National Empowerment Fund and many similar organisations or institutions.
  • It is also done through participation in multilateral forums through Business Unity South Africa and the National Development and Labour Council.

Particular ad hoc research is done from time to time on subjects like the electricity crisis, or the extent and impact of import penetration into the metals and engineering market. In many instances, the very rich knowledge present amongst individuals, or within associations or sub-industries is harnessed and utilised in compiling position papers on issues of importance to the sector.

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An example of our market commentary can be seen in our press releases like the one issued  on 28 February 2018, which highlighted the impact of the Producer Price Index (PPI) data released by  StatsSA.

The Stats SA data showed that the PPI for intermediate manufactured goods decreased to 1.5 percent year on year in January 2018, from the 3.2 percent recorded in December 2017.

“This is a poor performance, especially given the four consecutive months of PPI increases for intermediate manufactured goods prior to December 2017,” SEIFSA Economist Marique Kruger said.

Also, given the volatility of input costs in the sector, the deceleration in the PPI data leaves manufacturers with little leeway to pass cost increases on to the market. Correspondingly, SEIFSA’s composite input cost index, which tracks the average cost structure for the M&E sector, was recorded at 1.4 percent in January 2018, up from 3.4 percent in December 2017.

Ms Kruger said it is important to maintain a positive differential in the selling price inflation and input cost inflation in order for the sector to stay attractive for existing and new investments.

“Hopefully, the PPI for intermediate manufactured goods will rebound against the backdrop of a continued improvement in business confidence, especially in light of recent developments in South Africa’s political landscape,” Ms Kruger said.

This analysis on PPI Provides insights into SEIFSA’s Economic and Commercial Division and demonstrates its capacity and wide-ranging media influence.


PIPS: NOT JUST ANOTHER SET OF INDICES – A TOOL FOR THE FUTURE OF YOUR BUSINESS

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.

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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.

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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.

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What is cost price adjustment and why is it so important

Based on the terms and conditions set out in the tender awarded to you, it is now time for you to take stock of what has happened to the price of the product or service you provided over the last couple of months/year. You also need to supply the information to the buying party to your contract. So where to from here?

Unfortunately, you cannot go to the buyer and tell them that your costs have increased by 11% and expect them to pay it, especially if you do not have proof. Without substantial proof to support the increase in the costs you want to pass onto the buyer, your request will not be met. So how do you get the proof? Easy, through calculations in a Cost Price Adjustment (CPA) with the use of relevant industry related price indices which will give you a true and accurate reflection of what has happened in the market.

Alright, so you know you must do a CPA but you have no idea what it is, let alone how to apply it or why it is beneficial to you. The aim of this blog is to do just that – give you a better understanding of what a contract price adjustment is.

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In the simplest terms, a CPA is a process in which you calculate the extent to which the price of inputs of the product or service you supply, has increased or decreased over a specified period of time. This means that due to unforeseen circumstances (i.e. inflation) the cost of doing business has changed and you have to account for it in some way because it ultimately impacts on the price of the contract over the duration thereof.

Both parties to the contract aim to sustain or improve the profitability of their business. Buyers therefore try to manage and maintain their costs, while suppliers want to recover as much cost as possible.

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Let me explain the importance of a cost price adjustment with the use of an example:

You are a supplier to a contract. The initial contract value was R10 000 000, the contract term was for 10 years and you were allowed to escalate (do your cost price adjustment) once a year. At the end of the 10-year period the contract value that you calculate by taking costs into account amounted to R14 233 118. One of your colleagues came to you and mentioned that you made an error in your calculations and that the contract value was actually supposed to be R16 894 790. Through discussions with your colleague you actually realise that you applied the calculations incorrectly because you didn’t understand the contract price adjustment process. As a result, your company lost R2 661 671 on the contract. What is worse is that the profit calculated at the start of the contract was R2 000 000 which means that your company actually has to pay in, in order to finalise the project (thereby putting your company in a worse position).

This example can be explained from the buyer’s side as well. Let’s assume the same contract over the same period as in the above example. At the end of the 10-year span the contract cost you R16 894 790. Your colleague then tells you that the cost of the contract was supposed to be R14 233 118. Unfortunately, your company overpaid by R2 661 671 because you didn’t understand the process and applied calculations incorrectly.

As the company supplying the product or service, you are therefore assured that you can justify the cost increase you are passing on to the buyer and that the costs were accurately calculated from your CPA which is based on what has happened in the market. The correct application of the CPA also allows the company buying the product or service to be certain that market related increases are paid out, ensuring the sustainability or improvement of business profitability.

In order to accurately calculate your costs, you need to make use of SEIFSA’s price indices and apply them to the mathematical formula which is based on the inputs of your product or service. Although the mathematical formula is a very important aspect to your CPA, it will be of no benefit if you do not use the correct price indices. The use of the incorrect indices could have an adverse effect on the increase you calculate. Often times the CPA process is handed to staff in financial positions due to the calculations involved. However, it is very important that the technical people in the company assist with the process, especially when tendering. This is because the technical people have a better understanding of what inputs are used in the manufacturing of a product. If for example your company manufactures power transformers, the technical person would know that one of the materials used is electrical steel.

SEIFSA’s Price and Index Pages (PIPS) currently offer a wide variety of steel indices and because you lack the technical knowledge you might link the incorrect steel index to the material component.

If you are worried about changes in the input costs in your tender application or the right time to escalate (that is, make adjustments to your contract), subscribe to SEIFSA’s Price and Index Pages and join a CPA workshop to better understand the process involved.

 

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