In this penultimate post of this eight-part series, I’m going to help you understand the subtleties of using escalation clauses.
Wait. There’s a problem already.
Do you know what it is?
Well, think about the term “escalation clause.” What does that imply?
That there is only one way for a price to go: up.
And, as we saw in late 2008, prices for many commodities can go down. Way down.
The last thing you’d want is for your supplier to say after you approach them for what you thought was a contractually guaranteed price reduction would be “But the contract has an escalation clause. It’s clear from that terminology that the intent was to only adjust the price upward.”
So some people use the term “escalation/de-escalation clause” or “price adjustment clause” to avoid such situations. Hey, any way that you can prevent a possible dispute is a good thing.
Now, what might a price adjustment clause communicate?
It may communicate that “The price for paper on October 1, 2008 is $40.00/box. The price will be adjusted on October 1, 2009. The price will increase or decrease by the same percentage (rounded to one decimal point, example: 1.1%) that the Producers Price Index for ‘Writing and Printing Papers’ Series ID WPU091301 increased or decreased during the period from July 2008 to July 2009.”
What is the new price?
I always ask my seminar attendees this type of question and give them the applicable Producer’s Price Index table. About 5% of the attendees get it right.
Then, I give them a formula. About 12% of them get it right.
And when it has come time for suppliers to calculate their new price, I’ve seen them get it wrong, too.
This is a problem. When you are accepting bids, it is important for every supplier to base its price on the price adjustment formula and how they expect it to change their price in the future.
Doing so ensures against the possibility that one supplier can come in with a low bid, win your business, arbitrarily adjust its price in a year, and then end up being a worse deal than if you selected another supplier. Using a price adjustment clause while bidding ensures that all suppliers are on a level playing field for your sake and theirs.
In the next post – the last one of this series – I’ll give you some tips for ensuring that your price adjustment clause is understood and adhered to by your suppliers.