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 already at a 40 year high (albeit now showing signs of steadying), international logistics delays (including 2021’s temporary closure of the Suez Canal), the war in Ukraine, surging energy prices and the rising cost of raw materials, difficulties for suppliers in particular 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 must resist the temptation to make short-term, unscheduled changes (such as trying to sidestep agreed invoice approval procedures) for the sake of reputational credibility and maintaining good customer relations – customers may well be unable to pass on costs to their end clients so it is critical that all parties maintain open dialogue to weather this particular storm.
However, there are also some practical steps that businesses can take to protect themselves, particularly when negotiating new contracts, that should not prejudice ongoing commercial relationships. Here are our top tips to help counter the inflationary effect of rising raw material prices and supply chain costs:
- Insert a Price Review Clause (and make use of it!)
It is important to include a price review clause into a supply contract so that a supplier can cover off any cost increases in raw materials that are used in the manufacture or supply of the goods, but which also provides the customer with visibility and certainty where possible.
A price review clause may:
- link to a specific raw material and any increase in its price
- be more general in scope, for example:
- specify that the price of the goods increases in line with the Retail Price Index.
- specify 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 (and in absence of such acceptance, the contract will either automatically continue at the revised price or potentially terminate).
The nature of the goods being provided will determine which approach is most suitable, however:
- for any new contract it is important to ensure that a price review provision is inserted into a supply contract; and
- for any existing contract, the parties 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
From a supplier’s perspective fixed prices are currently difficult to accept and ideally should be resisted by a supplier to allow for some flexibility to take account of changing circumstances. In contrast, a customer may hesitate to accept this because of price uncertainty; however, inserting a procedure for determining the price should provide the customer with some comfort whilst protecting the supplier from a potentially unprofitable contract.
If a customer will only accept a fixed price, a supplier should consider factoring in anticipated increases to the cost of raw materials so that it can continue to be profitable, bearing in mind 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. At the moment, a supplier is likely to find it more beneficial to try and limit the length of the contract until the cost of raw materials stabilises. This will give the supplier more flexibility to renegotiate terms on a more regular basis. The “flip side”, however, is that customers may perceive this approach to be potentially too volatile and may motivate them to find other, more regular suppliers. Therefore, both parties will need to weigh up the risk of uncertainty in return for flexibility of pricing to hedge against exposure to increasing costs and potential loss of business.
- Insert a Termination for Convenience Clause
It will be useful for the parties to insert a termination for convenience clause into any supply contract with a reduced notice period in order to limit any hardship if the cost of raw materials becomes so high that the contract is no longer profitable. This clause should (if possible) be inserted into all new contracts and especially if the parties are unable to agree a price review clause which is mutually acceptable. Whether a customer will accept such a provision will be a matter for negotiation (suppliers may find that a customer insists on a reciprocal clause, or that a customer will push back on (for example) an exclusive arrangement as a result).
- Insert a Change Control Procedure
The parties may wish to include a multi-step change control procedure into any new supply contract, especially if the contract is for a longer duration. 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. It should also oblige both parties to act reasonably to negotiate such changes (and for example would require that neither party could unreasonably withhold or delay agreement to a proposed variation).
Although this procedure does not guarantee any variation, it allows a party to understand why the other party is requesting a variation to the contract and as such should encourage cooperation.
- Insert a Material Adverse Change Clause
It may be useful to include a provision allowing for a party to renegotiate the contract if an unforeseen situation arises which causes a severe disparity between the parties on performance of the contract (this is known as "Material Adverse Change”). This may provide the supplier with an additional layer of protection against any additional, unforeseen increases to raw material prices.
- Insert a Change in Law Clause
Particularly in light of Brexit and the impact of COVID-19, 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. From a customer’s perspective, the scope of such a clause needs to be carefully considered (for example, COVID-19 should no longer be seen as a force majeure event given that businesses should have suitable risk management plans in place to addresses any recurrence; further, if a change in law specifically affects a customer then it may be prepared to accept an increase in costs, but where that change is a broader general change in law which the supplier would have to adhere to in any event, the customer should not be expected to pick up all additional costs arising).
- Amending an existing contract
Although many of the points outlined above could be incorporated into an existing contract, this would require considerable renegotiation. Nonetheless, given the importance of maintaining a free-flowing supply chain, a collaborative approach between customer and supplier should make this achievable with goodwill on both sides.
However, if the position between the parties remains largely intractable, either party may seek to terminate the contract – but this would be, for many, the “nuclear” option and the relevant contractual clauses will need to be closely considered (such as notice periods and methods for serving notice) to avoid a breach or anything that might escalate into a dispute.
- Don’t Forget your own Supply Chains
Suppliers should think about their own supply chains and not just the contracts put in place with their customers. Negotiating a strong purchase contract with its own raw material suppliers will help to limit the impact of the rising costs of raw materials on the customer. Suppliers should also explore if they can realistically source the goods from elsewhere if the cost implications are favourable assuming, of course, that quality control remains unchanged. It is also worth reviewing if technology can be applied to deliver cost savings in the supply chain, to help offset rising costs.
As things currently stand, inflationary pressures show no sign of diminishing and prices are almost certain to continue rising in the immediate future so it is likely that suppliers will face these challenges for a good while yet. As with the fall-out from COVID-19, this unusual chain of events will undoubtedly provide valuable lessons: in due course, suppliers should analyse their supply chain procedures, protocols, and overall resilience. This “lessons learnt” review will enable businesses to identify vulnerabilities and consider how similar risks and events could be mitigated in future. UK-based businesses may also wish to consider bucking the trend of recent years and onshoring their supply chain to get greater transparency and to help negotiate logistics delays.
Ultimately, to coin a phrase “it’s good to talk” - a degree of transparency about how the current economic situation is affecting both customers and suppliers will help to promote more constructive dialogue between the parties, regardless of whether a new contract is being negotiated or an existing one reviewed.
As with any finely-balanced negotiation, seeking professional advice to help steer the conversation can help to avoid pitfalls; making sure that a contract has sufficient flexibility will mean that the contract helps, rather than hinders, the long term business relationship between supplier and customer.