Supply chains that were already showing increasing signs of strain as a result of the global COVID-19 pandemic and, in Europe, from the fallout from Brexit, are coming under even greater pressure. With the UK inflation rate dropping, but still coming back off a 40 year high, international logistics delays – including January’s Red Sea attacks, the war in Ukraine, surging energy prices and the rising cost of raw materials, difficulties for suppliers show no sign of abating.
With all this uncertainty, it is not surprising that many suppliers are worried that rising prices will erode their profit margins, potentially leaving them exposed if their supply contracts are not sufficiently flexible to protect against the increased costs of raw materials.
By the same token, their customers will also be struggling with inflationary pressures so suppliers should resist the temptation to make short-term, unscheduled changes – such as trying to sidestep agreed invoice approval procedures – for the sake of credibility and maintaining good customer relations.
However, Pete Maguire, a partner and head of Commercial at Wright Hassall, thinks that there are some practical steps that suppliers can take to protect themselves, particularly when negotiating new contracts, that should not prejudice their relationship with their customers.
He offers nine suggestions to help counter the inflationary effect of rising raw material prices:
Insert a price review clause
It is important – and makes sense – to include a price review clause into supply contracts so that a supplier can cover off any cost increases in raw materials.
As Maguire outlines, a price review clause may link to a specific raw material and any increase in its price or be more general in scope. He says that “for example, it may specify that the price of the goods increases in line with the Retail Price Index; that the price of the goods increases by a specific percentage at certain intervals; or it may set out specific intervals at which the supplier can propose changing the price of the goods while at the same time, giving the customer the option to accept.”
Of course, the nature of the supply will determine which approach is most suitable, however for any new contract Maguire says that “it is important to ensure that a price review provision is inserted into a supply contract; and for any existing contract, suppliers should check to see whether any clause exists, and the scope of it, before considering whether or not it would be appropriate to renegotiate.”
Consider pricing options
Regardless of the economic situation, it’s rarely advisable for a supplier to agree to a fixed price because it removes the flexibility to take account of changing circumstances. However, a customer may hesitate to accept this because of price uncertainty. But for Maguire the solution is to insert a procedure for determining the price as that should provide the customer with some comfort whilst protecting the supplier from a potentially unprofitable contract.
However, he points out that “if a customer will only accept a fixed price, it is important for the supplier to try and factor in anticipated increases to the cost of raw materials so that it can continue to be profitable.” That said, he knows that predicting the potential increase in raw material prices can be difficult.
Consider the duration of the contract
It is important to consider the length of any supply contract. Logically, given the market, Maguire thinks that suppliers are likely to find it more beneficial to limit the length of the contract until the cost of raw materials stabilises as “this gives them more flexibility to renegotiate terms on a more regular basis.”
But on the ‘flip side’, he warns that customers may perceive this approach to be potentially “too volatile and may motivate them to find other, more regular suppliers.” Therefore, his advice is to “weigh up the risk of losing an existing customer base in return for flexibility of pricing to hedge against exposure to increasing costs and potential loss of business.”
Insert a termination for convenience clause
The next suggestion from Maguire is for suppliers to insert a termination for convenience clause into any supply contract along with a reduced notice period to limit any hardship if the cost of raw materials becomes so high that the contract is no longer profitable. Again, he says that “this clause should, if possible, be inserted into all new contracts and especially if the supplier is unable to insert a favourable pricing review clause.”
Of course, whether a customer will accept such a provision will be a matter for negotiation. As Maguire comments, “suppliers may find that a customer insists on a reciprocal clause, or that a customer will push back with, for example, an exclusive arrangement as a result.”
Insert a change control procedure
Another option that Maguire advances is for suppliers to include a multi-step change control procedure into any new supply contract – especially if the contract is for a longer duration. In describing what he means Maguire says that “this is a way of encapsulating a formal arrangement for requesting a variation to the contract, and any timescales for raising such requests.
The procedure can be tailored to include discussions relating to pricing and it could also include any issues relating to the supply and cost of such raw materials.” If put in place, he says that “it should oblige both parties to act reasonably” to negotiate such changes. For example, it would require that neither party could unreasonably withhold or delay agreement to a proposed variation.
Although this procedure does not guarantee any variation, Maguire has seen it help a party understand why the other is requesting a variation to the contract and as such should encourage cooperation.
Insert a material adverse change and a change in law clause
Some may find it useful to include a provision – known as ‘Material Adverse Change’ – that allows for renegotiation of a contract if an unforeseen situation arises which causes a severe disparity between the parties on performance of the contract. This, according to Maguire, “may provide the supplier with an additional layer of protection against any additional, unforeseen increases to raw material prices.”
And in light of Brexit and the continued impact of COVID-19, Maguire thinks that “suppliers should consider including a provision giving them an opportunity to increase prices” – or at least be able to propose an increase – “to accommodate changes in law, or new government procedures etc.”
Terminating an existing contract
Although much of the previously mentioned terms could be incorporated into an existing contract, this would require considerable renegotiation. Nonetheless, given the importance of maintaining a free-flowing supply chain, Maguire has seen the collaborative approach between customer and supplier make this achievable with goodwill on both sides.
However, he says that “if the position between the parties remains largely intractable, suppliers may seek to terminate the contract – but this would be, for many, the nuclear option.”
He cautions suppliers to tread carefully as “termination can be minefield depending on provisions such as timescales and methods for serving notice, and both parties need to be wary of any move that might put them in breach.” In his view all parties should “try to avoid anything that might escalate into a dispute.”
Don’t forget own supply chains
Just because suppliers are examining their ability to pass on cost, so they shouldn’t forget about their own supply chains; they should negotiate a strong purchase contract with their own raw material suppliers to limit the impact of the rising costs down the line.
Maguire states what some, but not all consider – seeing if it’s possible to “source the goods from elsewhere” if the cost implications are favourable and “if the quality remains unchanged.”
He points also to reviewing whether technology can be applied to deliver cost savings in the supply chain, to help offset rising costs.
Learn the lesson
Maguire’s last point is something that not everyone is good at – learning lessons from the past. He says that “in due course, suppliers should analyse their supply chain procedures, protocols, and overall resilience. A ‘lessons learnt’ review will enable businesses to identify vulnerabilities and consider how similar risks and events could be mitigated in future.”
Interestingly, he’s seen a degree of transparency about how the current economic situation is affecting both customers and suppliers and is helping “to promote more constructive dialogue between the parties, regardless of whether a new contract is being negotiated or an existing one reviewed.” Maguire has also seen UK-based businesses considering bucking the trend of recent years and onshoring their supply chain to help negotiate logistics delays.
In summary
As with any finely balanced negotiation, seeking good advice to help steer the conversation can help to avoid inadvertent pitfalls while inserting sufficient flexibility to ensure contracts help, rather than hinder, the long-term business relationship between supplier and customer.
Now is the time to address contractual issues.
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