Price adjustment clauses: a useful tool in times of economic uncertainty
A price adjustment clause is a contractual provision that allows the parties to adjust the contract price, often in response to certain trigger events.
They are important to ensure that a contract remains commercially viable for the parties given that the prevailing financial, commercial and economic conditions that exist at the time a contract is formed often change throughout its term.
Contractual price adjustments are generally triggered by factors which affect the value of the contract price or the price of the seller’s input costs. For a seller, the inability to pass these costs down to the buyer can expose them to business risk and damage their profitability. On the other hand, a buyer who is subject to such pass-through costs might find its own profitability adversely affected. This is why it is important to clearly define the price adjustment mechanisms in a contract so that the parties have transparency and can assess the contract risk presented by price adjustment clauses at the outset.
Here are a few things to consider when negotiating a price adjustment clause:
1. What can trigger a price adjustment and how are they calculated?
The first step in drafting a price adjustment clause is to define what circumstances will allow a party to vary the contract price. One of the most common triggers is a change in the inflation rate over a specified period. Others include changes in exchange rates, increases in the cost of raw materials or increases in the supplier’s production costs.
In any event, the triggering event should be clearly and objectively defined, as should the method for calculating the related price adjustment. For example, if a price adjustment clause allows for the contract price to be increased if there is an increase in the inflation rate, the clause should state that the price can only be increased by the percentage increase in such inflation rate and no more. Equally, the contract may cap the total percentage by which the price can increase in a specified period (e.g. no more than 5% per year).
2. How often can a price adjustment occur?
In addition to defining the events which can trigger a price adjustment, the contract should also set out how often a price adjustment can occur. This allows for greater transparency between the contracting parties and allows the buyer to know exactly when a price increase can occur so that they can factor the additional expense into their budget for the upcoming year.
The most common frequency for price adjustments is on an annual basis but ultimately it is for the parties to determine.
3. In what direction can the price be adjusted?
Many price adjustment clauses allow for the price to be increased in response to certain triggers but make no provisions for the price to be decreased. This is generally beneficial for the seller but not so much for the buyer. It is arguable, for example, that if the buyer allows the seller to increase the price where the seller incurs an increase in its cost of production, the buyer should get the benefit of a decrease in the price where the seller gains a decrease in its cost of production. Therefore, a buyer might be more inclined to want a price adjustment clause to go both ways, allowing for decreases if the market conditions provide for it.
If you would like any further information on incorporating price adjustment clauses into your contracts, please speak to a member of our Commercial Team who will be happy to help.