Common Challenges for Contract Price Mechanisms

Five price data pitfalls to avoid when linking price data to contracts…and how to avoid them

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Understanding the exact meaning of price data before signing contracts to procure goods and services can mean the difference between money saved and money left on the table during the negotiation process. More companies are linking price data to escalate the value of long-term contracts to mitigate risk and as such, are realizing that identifying reliable and timely price data is a key aspect of mitigating risk (particularly for unforeseen risk) while achieving and maintaining market prices. 

Unfortunately, many contracts that companies are using today are not set up properly. This fact alone prevents buyers from fully capturing the significant drops in commodity prices that IHS has tracked since mid-2014. Ignoring this aspect of the procurement process also exposes companies to undue risk and finds companies potentially wasting and foregoing millions of dollars.
If you feel confident that you’ve received a fair price when negotiating a buy, then linking the contract to a price adjustment index over the course of that long-term agreement (or even to a set of price indices), is a simple and effective way to maintain a market price for your purchases.

Price Volatility is Here to Stay

Price volatility isn’t going away anytime soon, hence the need to pay close attention to the linkage between contracts and price mechanisms. According to the IHS Material Price Index, the pricing for a core basket of tracked materials has fluctuated significantly in recent months. These price fluctuations resonate across the global supply chain, where linking contracts to price data stands as one of the most common ways to effectively capture falling prices right now. In fact, a recent IHS survey found that 55 percent of firms link contracts to price mechanisms as a means of capturing falling material prices.

There are five stumbling blocks that companies tend to run into when negotiating contracts right now. Each of these increases the risk to your company and could translate into millions of dollars of either lost revenues or increased costs.

Not Taking the Time to Understand the Price Data

The first pitfall occurs when buyers lack clear knowledge on what the price data are measuring. Many times there is just not enough documentation to understand what the data include, nor is there enough information on the advantages or disadvantages of the current setup (in some cases due to the exit of an employee who set up the original arrangement). This is a critical issue that can be solved with a simple step: if you get a contract, research the data.

Within the steel sector, for example, spot prices move quite a bit differently than contract prices. This tends to create issues for buyers, many of whom turn to the Producer Price Index to negotiate cold-rolled sheet steel buys when in fact they should turn their attention to carbon-steel specific spot market prices. So while the PPI includes cold-rolled steel (both stainless and electrical), those products move in different directions and at different times. Using a carbon-steel specific spot price is a better choice. The key is to examine the index carefully and make sure it actually measures the product you are buying. At a minimum, it should move in the same direction at the same time, and follow approximately the same magnitude as that commodity.

Ignoring the Indexes

The second obstacle surfaces when buyers do not understand the data update or revision schedule. This scenario can translate into financial loss for your company on both sides of the coin. Most contracts with adjustment clauses are symmetric in nature, so your price rises if the index rises and you get a price cut if the index falls. Sellers are generally very good about billing buyers for any increase to which they are entitled, but they are not always as fast to dole out price cuts, even when warranted.
So while the reductions should happen automatically, you may have to ask for them. Additionally you need to know when the data is updated and revised, and be specific on when you will recognize the price adjustments in the contract.

Not Starting from the Right Point

The third pitfall finds buyers starting the base period values from an inaccurate point. This is happening a lot right now: buyers are using annual or quarterly averages instead of current values. With prices fluctuating significantly, it pays to use the most current, relevant data possible. To maintain and achieve market pricing over the course of your contract, you have to start at the right time.
If you are setting the price for the next year, be sure to start from the correct point. Realize that many prices fell during the 2013-14 period, so if you’re setting your 2016 prices today you’ll want to look at today’s pricing levels, not the average of 2013 or 2014. When prices are rebounding, you will see regular increases. If you add those increases onto the 2014 average, rather than today’s depressed level, you will see 2016 higher than it should be.

Letting Tracking Fall  by the Wayside

The next pitfall involves the tracking of the data itself —or, rather, a lack of those tracking activities. Even if you have the price mechanism set up, you’re not always compelled to track the data—a move that you should be making to understand whether prices are falling, rising, or moving sideways. In today’s commodity environment, this step is particularly important; if prices are falling, you need to be aware of this movement to capture those declines.

Not Using Collars and Price Triggers

Finally, buyers also run into challenges when they don’t build appropriate collars and/or price triggers into their contracts. A price collar is used when you only want to adjust price by significant moves (up or down) in prices. By picking the wrong collar, you could miss out on substantial price declines or spend too much time managing the contract. To select the most appropriate collar, be sure to look at the price variation within the data itself. A calculation of a standard deviation of the quarterly or monthly data would provide an excellent understanding of its past variation and prove useful to pick the collar or price trigger for your contract.

For Best Results, Do Your Research 

By taking the time to understand the price data before signing contracts to procure goods and services, documenting the reasons for your selections, specifying contracts accordingly, and considering all price data advantages and disadvantages, buyers can effectively position their companies for success in today’s volatile price environment. ■