Price adjustment in commercial contracts

February 10, 2023

Eleanor McClelland and Harry Gillen consider some of the rights that customers may have to mitigate the risk of price increases in commercial contracts.

Price adjustment clauses are becoming a key focus for many organisations. High levels of inflation and increased costs (including fuel, raw materials and logistics costs) mean that suppliers’ margins are being squeezed. While some sectors will be more exposed than others, this can pose a significant threat to profitability, especially under fixed price contracts. In order to protect against inflationary and wider macro-economic pressures, suppliers will often seek to include price adjustment clauses in their contracts.

Types of price adjustment clauses

There are various mechanisms through which price adjustment can be achieved, and may include:

Discretionary price increases: Allowing the supplier to increase prices how and when it wishes.
Indexation: Price adjustment in line with an inflation-tracking index.
Changes in law: Price increases to take into account additional costs associated with a change in law or regulation, either linked to indexation or to reflect actual additional costs incurred by the supplier in providing the goods or services.
Supply chain costs: Allowing the supplier to pass on increases in supply chain costs (e.g. increased cost of utilities, petrol, labour, logistics or raw materials), either linked to indexation or to reflect actual additional cost.
Currency fluctuation and exchange: In cross-border commercial arrangements, the parties may wish to clarify who will bear the risk of currency fluctuations (e.g. if the customer’s currency weakens, will the price be adjusted proportionately?)

Fixed vs variable prices

Customers should resist any clause that allows the supplier to increase prices at its discretion (although this is not uncommon when contracting on the supplier’s standard terms, especially where the contract is for the supply of goods). Alternatively, the customer should ensure that it has sufficient flexibility to exit the contract in the event that it becomes commercially unviable, and that it is not bound by onerous order commitments.

Although fixed pricing would be most preferable for customers, this will not always be commercially achievable, particularly where the contract is for a lengthy term. The volatility of the market in which the goods or services are sold will also be a factor relevant to whether a supplier will accept fixed pricing. For example, the price of food is very volatile, while software is less so (particularly off-the-shelf software).

In most cases, a customer is likely to accept a reasonable right for the supplier to adjust prices. Where possible, this should be within defined parameters.

Indexation

Indexation is a common price adjustment mechanism, and one that can be negotiated to achieve a balance between the parties. This can take various forms, and there is no single “right” way in which to draft an indexation clause. The table below explores some key considerations when drafting or negotiating an indexation clause.

Consideration	Guidance
To which services should indexation apply?	It may be appropriate for some charges to be fixed, while others are capable of increase over time. For example, charges for the implementation of services should be ascertainable on commencement and it is therefore reasonable for these to be fixed. However, ongoing charges for operational services are less certain: the supplier’s own costs are likely to increase over time and in order to ensure ongoing profitability, it may be permissible for the customer to allow periodic increases. This may be in respect of all operational costs, or certain identified costs (e.g. employment costs, raw materials, consumables).
Which index should be used?	Indexation is commonly linked to the Retail Price Index (RPI) or the Consumer Price Index (CPI), but other indices such as the Average Earnings Index (AEI) may be used. Industry-specific indices may also be used, including the BCIS’ indices applicable to the construction sector. As between RPI and CPI, the latter is generally considered to be the more accurate measure of general inflation.
When should indexation be applied?	The contract will need to make clear when indexation will apply. A supplier may want prices to automatically change in real time to reflect a change in the index. Meanwhile, from a customer’s perspective, it is advisable for indexation to apply periodically (e.g. once per contract year).
Should there be a max / min threshold?	To overcome the administrative burden of increasing prices where there has been only a small fluctuation in the index, a de minimis threshold can be used: e.g. the index must change by more than 1% for the price adjustment right to be triggered. As a customer, it is often advisable to also include a cap on the value of any price increase: e.g. where the index increases by more than 5%, the charges can only be increased by 5%.
Should compound indexation be permitted?	The contract will need to address whether indexation will apply on a compound basis or not: i.e. whether each percentage increase will be calculated on the basis of, and applied on top of, (a) the original contract price or (b) the contract price payable in the immediately preceding year. Option (a) will generally be a preferable position for customers, as each price increase will not take into account previous price adjustments.
Should indexation be one-way or mutual?	Indexation can apply solely for the supplier’s benefit (i.e. prices only increase where the index goes up) or for both parties’ benefit (i.e. prices increase where the index goes up, and prices decrease where the index goes down). In volatile market conditions, inflation can be unpredictable and may decrease as well as increase. Customers will often wish to have the right to decrease prices where the index moves in its favour, although suppliers may resist this.

Where contracting in the public sector, additional considerations may apply. In particular, amending the terms or pricing of an existing contract should be considered in light of the applicable public procurement regime (e.g. the Public Contracts Regulations 2015). When modifying the terms of a public contract, legal advice should be sought. Our specialist public procurement team has extensive experience in advising on modifying public contracts.

Other protections for customers

Where a customer has sufficient bargaining power, it may also look to incorporate other contractual provisions to protect itself against unreasonable price increases. These may include:

Evidence of cost increases: A condition that price adjustment in line with inflation or increased supply chain costs can only become effective after the supplier has provided satisfactory evidence of such increase.
Continuous improvement: An obligation on the supplier to take active steps to improve the efficiency of services or manufacturing processes during the term. This will be particularly relevant under an open book charging structure, where the supplier will pass through its operational costs.
Most Favoured Nation / Customer clause: An obligation on the supplier to offer goods or services to the customer at a price that is at least as favourable as the price offered to the supplier’s other customers. Most Favoured Nation clauses such as these can give rise to significant competition law issues for all parties to the contract, and advice should be sought on a case-by-case basis. Our competition team has extensive experience in advising on Most Favoured Nation clauses.
Benchmarking: Allowing the customer to benchmark pricing (itself or via a third party benchmarker), to ascertain whether the contract continues to represent good value for money during the term. This can be accompanied by an obligation on the supplier to decrease prices where they are found to be higher than the benchmarked level.
Order commitment adjustment: Where the contract includes minimum purchase commitments, the customer may wish to include a mechanism whereby such commitments are reduced in proportion to any increase in prices, such that the overall minimum spend commitment remains unchanged.

If you are looking to include an appropriate price adjustment clause in your standard contract, or need support in negotiating a price adjustment clause, please feel free to get in touch with our Commercial team.

Eleanor McClelland is a Partner and Harry Gillen is an Associate at TLT.