As raw material and freight costs rise, some suppliers face the dilemma of locking in product prices with customers and being unable to respond to declining profit margins. Historically, suppliers have been able to manage or absorb usually minimal cost fluctuations internally. However, continued disruptions to the global supply chain due to shipping container shortages, a pandemic, a boat stuck in a canal, wildfires, extreme cold spells and a host of other reasons have driven up the costs of certain raw materials and freight. quickly and to extremes that suppliers are unable to sustain. For example, ocean shipping costs skyrocketed in August 2021 to about 6 times the rate of two years ago, as seen in the Drewry World Container Index below.
Source: World Container IndexDrewry Shipping Consultants Limited.
Given the rapidly changing supply chain landscape, how can a supplier respond to its rising costs in its prices to its customers?
For existing contracts with customers, the options available to deal with rising costs are limited. A review of the terms of existing contracts is necessary before a supplier can determine how best to manage rising costs. First, if the parties are operating under a framework agreement or framework agreement without any specific volume requirements, the supplier may not be obligated to continue to supply goods at the price specified in the contract. ‘OK. Second, the agreement may already incorporate a pricing mechanism, such as index-based pricing described below, to address the issue within the terms of the contract.
In the absence of such a pricing mechanism, a supplier may determine that the best approach is to negotiate with affected customers to find a commercial solution. A supplier may ask a customer to share certain expenses (such as transportation costs), citing the financial pressure of continuing to supply products to customers with a negative balance. In this way, a supplier can try to maintain a friendly relationship with its customers while responding to the difficulties imposed by an unexpected increase in costs.
Many vendors consider a request for excused performance of a contract via a force majeure provision. Unfortunately, force majeure is generally not an appropriate method for suppliers to factor their rising costs into the price charged to buyers for a product. Courts generally interpret force majeure provisions by focusing narrowly on contractual language. Further, courts tend to oppose excused performance of contracts solely for increased cost, at least without any other intervening cause.
Instead of trying to manage increased costs through force majeure clauses, suppliers may prefer to address the potential for increased costs upfront through pricing conditions:
During the initial negotiation of a contract, a supplier may seek to include language addressing potential future cost increases with a number of approaches, including the approaches listed below.
Order by order basis. A supplier may seek to avoid long-term pricing by pricing on an order-by-order basis. This will allow the supplier to have greater flexibility to change prices as circumstances change without changing the terms of an overall master agreement.
Right of Cancellation. A supplier can negotiate a fixed price at the beginning of the agreement, but also include a clause indicating that a new price can be offered by the supplier. In these circumstances, the supplier reserves the right to terminate the contract if the customer does not accept the newly offered price. This allows the supplier to avoid being locked into a fixed pricing agreement with no right to cancel and allows the supplier to offer new terms if necessary.
Impact of rising costs. Alternatively, the parties may decide to include a mechanism that allows the supplier to pass increases in specific inputs or transportation costs directly to the customer. The clause should clearly state how the new price is calculated, and only increases directly related to the cost charged to the supplier can then be passed on to the customer. In this situation, the pricing must be clearly linked to a direct increase in external costs, without arbitrary adjustment on the part of the supplier. A customer may require the supplier to provide documented evidence of such cost increases to invoke this provision.
Indexed pricing. Another mechanism parties could use to keep prices aligned with costs is to link the price of a product to an industry-specific index, such as steel indices or shipping indices. This allows the supplier to distance themselves from the increase for the customer by providing a clear external figure over which neither party can exercise control. It also saves the supplier from having to open their books to the customer to justify price increases.
Uncertainty is the only certain thing about the global supply chain for the foreseeable future, and suppliers will need to continue to look for ways to mitigate the effect on their bottom line.