The below article is a piece written by Rob Fafinski III, an attorney in FMJ’s General Corporate & Business practice group.
Between fluctuations in costs of raw materials, labor shortages, and supply chain disruptions, manufacturers face unprecedented times. For most, 2021 has proven more challenging than 2020. Rising costs of inputs and inflexible contract pricing have some manufacturers in the unenviable position of shipping at a loss. However, there are a number of tools manufacturers can use to stave off the negative impacts of shortages and the resulting increase in the price of raw materials and component parts. One of these tools is the addition of a price escalation clause in contracts with customers.
A price escalation clause permits the manufacturer to increase the price of the end product to the customer in the event of a meaningful rise in the cost of raw materials or component parts required to manufacture said product. Absent a price escalation clause in a time where costs of raw materials can skyrocket on short notice, a manufacturer can find itself in the position of needing to manufacture and ship equipment or products at a loss.
As a firm with significant experience assisting with these issues, we recommend that manufacturers first make every attempt to minimize the damage to its bottom line from rising costs: invoke force majeure, renegotiate, stop shipping then renegotiate, and in unique cases, ship at a loss. Fortunately, right now, everyone is well aware of the logistical issues our nation faces. In some such cases where prices have jumped significantly, the customer sees the writing on the wall and agrees to make concessions and participate in some of the downside due to unstable economic times. In other cases, a manufacturer may be stuck shipping product at a loss. To avoid such a scenario, we encourage our manufacturing clients to utilize price escalation clauses in their contracts.
The Percentage Change Escalation Clause
There are several types of price escalation clauses, but the clause we have found most useful for our clients during this economic climate is the percentage change escalation clause. There are three forms of percentage change escalation clauses that we have seen negotiated successfully recently.
First, the Single Material Cost Price Escalation Clause provides the manufacturer with a right to a proportionate price increase where the cost to the manufacturer of a single raw material or component part rises over a previously agreed-upon percentage threshold.
- Example 1: The parties hereto agree to, from time-to-time, but in no event more than once per [insert time period – monthly, quarterly, yearly, etc.], adjust upward the price to Buyer of the Equipment in the event of a Significant Cost Increase, as defined below, in an equitable amount to such increase, for so long as such Significant Cost Increase is occurring. A “Significant Cost Increase” for purposes of this Agreement and any purchase order or similar issued hereunder shall be an increase of [__]% or more of the then-prevailing cost to Supplier of any raw material or component part used to manufacture the Equipment. In the event a Significant Cost Increase is no longer occurring, the price of the Equipment hereunder shall revert back to that of the applicable purchase order.
Second, the Aggregate Material Cost Price Escalation Clause provides the manufacturer with a right to proportionate price to an aggregate increase where the cost to the manufacturer of more than one raw material or component part rises over a previously agreed-upon percentage threshold.
- Example 2: The parties hereto agree to, from time-to-time, but in no event more than once per [insert time period – monthly, quarterly, yearly, etc.], adjust upward the price to Buyer of the Equipment in the event of a Significant Cost Increase, as defined below, in an equitable amount to such increase, for so long as such Significant Cost Increase is occurring. A “Significant Cost Increase” for purposes of this Agreement and any purchase order or similar issued hereunder shall be an increase of [__]% or more of the then-prevailing aggregate cost to Supplier of raw materials and component parts used to manufacture the Equipment. In the event a Significant Cost Increase is no longer occurring, the price of the Equipment hereunder shall revert back to that of the applicable purchase order.
Third, the Combined Price Escalation Clause is a combined approach that benefits the manufacturer in that it provides a remedy for the manufacturer in the event of a single raw material component part rising in price or a rise in the aggregate amount required to manufacture the product.
- Example 3: The parties hereto agree to, from time-to-time, but in no event more than once per [insert time period – monthly, quarterly, yearly, etc.], adjust upward the price to Buyer of the Equipment in the event of a Significant Cost Increase, as defined below, in an equitable amount to such increase, for so long as such Significant Cost Increase is occurring. A “Significant Cost Increase” for purposes of this Agreement and any purchase order or similar issued hereunder shall be an increase of: (i) [__]% or more of the then-prevailing cost to Supplier of any raw material or component part used to manufacture the Equipment, or (ii) [__]% or more of the then-prevailing aggregate cost to Supplier of raw materials and component parts used to manufacture the Equipment. In the event a Significant Cost Increase is no longer occurring, the price of the Equipment hereunder shall revert back to that of the applicable purchase order.
In determining whether to seek the Combined Price Escalation Clause (which, of the three, generally benefits our manufacturing clients the most) we defer to our clients’ knowledge of the product, volatility in cost of inputs, and relative strength of the parties.
Customers and the Escalation Clause
In approaching customers to agree to amend an existing agreement to add an escalation clause, manufacturers should explain to their customers the obvious: everyone is struggling, and inflation, supply chain issues, and shortages are here and show no signs of slowing. Explain that the existing agreement is untenable and that from the manufacturer’s perspective breaching the agreement may be more beneficial than fulfilling orders. Another approach is to remind the customer that many of their costs have likely risen recently and 2021 has been no different on manufacturers, if not worse. Note that the increases under any price escalation clause only kick in when the costs actually rise. Price escalation clauses are not simply straight price increases.
In calculating an effective threshold for the price escalation clause to trigger, the employee responsible for the customer relationship should carefully vet proposed price escalation clauses with the appropriate financial officers at the manufacturing company. In theory, the financial personnel of the manufacturer should be able to work with the employee in modeling out increased costs and set the percentage threshold to ensure the level of profitability before the price escalation clause kicks in. Be sure not to wait until production is unprofitable for the price escalation clause to kick in. A thought-out layered approach is best.
Price escalation clauses are not without risk. The customer may insist on the flipped scenario where, if prices decrease, they get a corresponding decrease in the price. Carefully consider this. Sometimes the customer will not require this as many customers are ambivalent to the manufacturer’s profit so long as it still receives the product for the agreed-upon price.
The Pitfalls
There are, however, potential pitfalls to seeking price escalation clauses with customers. Questions to consider:
- How do you, as the manufacturer, convey your costs to your customer in an appropriate manner?
- To what will you peg a percentage increase?
- Are you comfortable opening up your books to prove the increase in costs?
- What is the strength of your relationship with the customer? There may be times when it makes sense to ship goods at a loss for a time to keep a large or profitable customer happy for a while. Perhaps you are or plan on negotiating a much bigger contract with that customer and short-term losses make strategic sense.
- In return for agreeing to a price escalation clause, some customers will require the manufacturer to show that it has undertaken reasonable steps to obtain a low price for the materials. Are you able to show such steps were taken? Does taking such steps incur costs that outweigh potential benefits?
- How often are costs be tabulated? Is that frequency reasonable for that particular material or component part?
- Finally, consider the interplay between force majeure clauses and price escalation clauses. Does one cancel out the other? Does one diminish the other?
Price escalation clauses can be a useful tool for manufacturers. While these clauses are not the ultimate solution for all of today’s disruptions in the supply chain, they are a tool in the manufacturer’s arsenal. Manufacturers should carefully consider the business relationship, relative power of the parties, and the burdensome nature of proving cost increases as well as other strings the customer may attach in any return for agreeing to such a clause. Fortunately, incorporating a price escalation clause into an existing contract for new deals with customers is generally not expensive from a legal fees perspective. Negotiating such a clause will, in most instances, pay for itself many times over in the event a manufacturer invokes the clause.
If you have any questions about price escalation clauses, our Manufacturing practice group and General Corporate & Business practice groups are here to help. Please reach out to Jim Seifert at james.seifert@fmjlaw.com, Heidi Carpenter at heidi.carpenter@fmjlaw.com, or Rob Fafinski III at fafinski.robertiii@fmjlaw.com.
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