Inflation, rising costs and supply contracts… the top 7 ways a supplier can hedge against the ever-increasing cost of raw materials.

By Wright Hassall LLP
schedule8th Jul 22

With the UK inflation rate already at a 40 year high, the continuing aftermath of the COVID-19 pandemic, and the general uncertainty surrounding the invasion of Ukraine, the cost of raw materials is rapidly increasing. As a result, many suppliers are concerned about profitability and there is an ever-increasing need to ensure that supply contracts do not leave suppliers exposed. Understandably, they are also concerned whether their current supply contracts provide sufficient protection and flexibility to counter the increased costs in raw materials.

Our top tips to protect suppliers are as follows:

1. 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.

A price review clause may:

  • link to a specific raw material and any increase in its the price;
  • be more general in scope, for example:
    • the price of the goods increases in line with the Retail Price Index;
    • the price of the goods increases by a specific percentage at certain intervals; or
    • it may be that the supplier can propose to change the price of the goods at specific intervals following which the customer is given 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, suppliers should check to see whether any clause exists (and the scope of it).

2. Consider Pricing Options

At the moment it will be beneficial for a supplier to avoid agreeing to a fixed price for the supply of goods, to allow for some flexibility if circumstances change. 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, it is important that a supplier factors in anticipated increases to the cost of raw materials to ensure that it can continue to be profitable. However, predicting the potential increase in raw material prices can be difficult.

3. Consider the Duration of the Contract

It is important to consider the length of any supply contract. At present, it may be beneficial for a supplier to limit the length of the contract until the cost of raw materials stabilises. This will allow the supplier the flexibility to renegotiate terms on a more regular basis. The “flip side” however is that this could potentially encourage a customer to find other, more regular suppliers. Therefore, suppliers will need to weigh up the risk of maintaining their existing customer base in return for flexibility of pricing, against exposure to increasing costs and potential loss of business.

4. Insert a Termination for Convenience Clause

It will be useful for a supplier 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 supplier is unable to insert a favourable pricing review clause. 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).

5. Insert a Change Control Procedure

A supplier may wish to include a change control procedure into any new supply contract, especially if the contract is for a longer duration. This will ensure that there is 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 require that both parties 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 may encourage cooperation.

6. 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.

7. Insert a Change in Law Clause

Particularly in light of Brexit and the impact of COVID-19, suppliers should consider including a provision such that changes in law, or new government procedures etc., give them an opportunity to increase prices (or at least be able to propose an increase).

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. Ensuring that a supplier has a strong purchase contract with its own suppliers of the raw materials will help to limit the impact of the rising costs of raw materials onto the supplier.

As things currently stand, inflationary pressures show no sign of diminishing and prices are almost certain to continue rising so it is likely that suppliers will face these challenges for a good while yet.

If you are a supplier and need advice in relation to your supply and purchase contracts, our Commercial Team can advise you on how to manage your existing contracts and negotiate new contracts, helping you to mitigate the worst effects of the current economic situation on your business.

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