As the costs of raw materials and freight rise, some suppliers are faced with the price dilemma of products stranded with customers and an inability to meet declining profit margins. Historically, suppliers have been able to manage or absorb generally minimal cost fluctuations internally. However, the continued disruptions to the global supply chain due to shortages of shipping containers, a pandemic, a boat stuck in a canal, forest fires, extreme cold spells and many other reasons. have driven up the costs of some raw materials and freight. quickly and to extremes that suppliers cannot afford. For example, shipping costs by sea skyrocketed in August 2021 at a rate roughly 6 times higher than just two years earlier, as evidenced by the Drewry World Container Index below. .
Source: Global Container Index, Drewry Shipping Consultants Limited, https://www.drewry.co.uk/supply-chain-advisors/supply-chain-expertise/world-container-index-assessed-by-drewry.
Given the rapidly changing supply chain landscape, how can a supplier meet their rising costs by pricing their 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 the increased costs. First, if the parties are operating under a framework agreement or framework agreement without any specific volume requirement, the supplier may not be obligated to continue supplying goods at the price stated in the ‘OK. Second, the agreement may already have a pricing mechanism, such as the index pricing described below, to resolve the issue within the terms of the contract.
In the absence of such a pricing mechanism, a vendor may determine that the best approach is to negotiate with affected customers in order to find a business solution. A supplier may ask a customer to share certain expenses (such as freight costs), citing financial pressure to continue providing the products to customers with a negative balance. Thus, a supplier may attempt to maintain a friendly relationship with its customers while meeting the constraints imposed by an unexpected surge in costs.
Many vendors consider an excused request to perform a contract through a force majeure provision. Unfortunately, force majeure is generally not an appropriate method for suppliers to factor their increasing costs into the price charged to buyers for a product. Courts generally interpret force majeure provisions with a narrow focus on contract language. In addition, the courts tend to be opposed to the excused execution of contracts on the sole basis of increased costs, at least without any other cause involved.
Instead of trying to manage rising costs through force majeure provisions, suppliers may prefer to address the potential for increased costs upfront through pricing terms.
During the initial negotiation of a contract, a supplier may seek to include language dealing with potential increases in future costs with a number of approaches, including the approaches listed below.
Order by order base. A supplier may seek to avoid long-term pricing by offering prices on an order-by-order basis. This will allow the supplier to have more flexibility to change prices as circumstances change without changing the terms of an overall framework agreement.
Right of cancellation. A supplier can negotiate a fixed price at the start of the agreement, but also include a clause that a new price can be offered by the supplier. In these circumstances, the supplier reserves the right to withdraw from the contract in the event that the customer does not accept the new price offered. This allows the supplier to avoid being blocked by a fixed price agreement without the right of withdrawal 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 transport costs directly to the customer. The clause must clearly indicate how the new price is calculated and only increases directly related to the cost invoiced to the supplier can then be passed on to the customer. In this situation, pricing should be clearly linked to a direct increase in external costs, without arbitrary adjustments by the supplier. A customer may require the supplier to provide documented evidence of such cost increases in order to invoke this provision.
Indexed pricing. Another mechanism that 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 indexes or shipping indexes. This allows the supplier to stand out 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 the price increases.
Uncertainty is the only certainty 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.