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:
- What is the frequency of escalation agreed upon by both parties in the contract?
- Is an escalation currently due?
- 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.