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

Author SEIFSA

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