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
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.
Contracts must avoid vague terminology and should have definite terms, especially given that a court will not uphold contracts that are vague.
The contractual obligations must be possible to carry out.
If a contract is against public policy or unlawful, the contract will not be legally valid.
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.