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

Malcolm

Author Malcolm

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