Examining the impact of inflation: how businesses can navigate rising costs and long term contracts
Thursday August 25, 2022
In our latest Expert Q&A, Forensic Services Partner Henry Pocock explores the impact of the cost of living crisis and how businesses can better understand the impact on their contracts.
The “cost of living crisis” is putting serious pressure on households, with many having to make difficult decisions as to what they can and can’t afford.
This pressure is being felt by businesses who rely on those households to buy their goods and services and by companies in the supply chain, who are seeing their costs of production – raw materials, labour and energy – rising rapidly.
In some sectors the pressures are more acute than others. In consumer goods for example we have already seen Tesco and Heinz at odds about whether rising commodity and production costs would be passed on to customers – and McDonalds has taken the unprecedented step of increasing the price of a cheeseburger for the first time in 14 years. While a spat between two household names over the price of baked beans grabs the headlines, many businesses up and down the country are facing up to the same challenges.
Every affected business is carefully analysing the impact of rising costs on profit margins and cash flows. These businesses must first work out how much they can afford for these to be squeezed before having to raise prices, and then think through what a price increase will do to customer demand.
For companies who are in long term contractual relationships with their customers and suppliers, this raises a series of important questions:
- What can I do if my supplier tells me the cost is going up?
- If I say “no” to the supplier, what can they do?
- If my costs are going up, can I raise my prices?
- If my customer says “no”, what can I do?
What does the contract say?
Understanding the terms of the contract is a key first step. For businesses that operate with many contracts and where standard terms are not the norm, this task is not always straightforward.
It is rare that a contract will allow the supplier free rein when it comes to pricing, but some may have specific provisions to allow the business to pass along certain cost increases. Often these are limited to raw materials where there is a market price” so will not cover rising energy or labour costs.
Other contracts will allow prices to be uplifted at set intervals which will help, but if the next price rise is months or years away, the business will have to bear the increased costs until the price rise kicks in which may not be sustainable.
Finally, some contracts may be entirely fixed, leaving the business exposed to increased costs.
In recent years we have seen organisations placing increasing importance on proactive contract management, developing contract repositories, seeking to standardise key terms, identifying risk areas and measuring compliance.
Understanding if, when and how a contract permits prices to change is clearly a key step to take, and if businesses have not done so already, one that should be done now. On paper this might seem like a straightforward exercise, but where the contract estate is widely dispersed, may benefit from dedicated resource. In this regard, the use of technology assisted reviews is becoming more widespread with cost effective tools being developed that can cope with a wide variety of contract formats.
What is the commercial position?
Having understood the contractual position, establishing the commercial position is at least as, if not more important.
Basic economics tells us that if price goes up demand goes down. Even if the contractual position allows a business to pass on increased costs to its customers it does not mean that course of action will make commercial sense if it results in a loss of sales.
While it will depend on the nature of the good or service being sold, businesses should be modelling the impact on demand, looking at profit margins and break-even points to determine the likely impact of any price rise. Commercially, it may make sense to absorb some or all the increased costs, at least in the short term, even if that means reduced profit margins.
Businesses should also be looking at the financial position of their suppliers. Refusing to accept a price rise when not contractually obliged might have adverse consequences for the supplier, leaving the company without a key component or forced to source from an alternative provider (which may well be at a higher cost).
Having done the analysis, engagement with the customer or supplier can only be beneficial. Irrespective of what the contract says, a mutual understanding of positions may well resolve the issue and, if not, at least puts some context around the difficult decisions that need to be taken.
Careful assessment of the commercial position is therefore a prerequisite before deciding upon which course of action to take.
What happens if I breach the contract?
If the analysis shows that the position is unsustainable and a compromise cannot be reached, you might find yourself in the undesirable position of having no choice but to breach the contract by imposing a price increase on your customer or by refusing to accept a contractual cost increase from a supplier.
Consequently, you may find yourself on the receiving end of a claim for “loss of profits” from the customer or supplier. If this is the case, engagement with legal and accounting advisers will be needed to provide clarity over liability and the quantum.
Claims for “loss of profits” are typically calculated as the difference between: (i) the profits that were expected from the contract; and (ii) actual profits (now the breach has occurred). The resulting figure is then adjusted for any additional overhead costs incurred any overhead costs saved.
The most crucial area of the calculation will be expected profits. While past performance is often a good guide to what might have happened, assumptions will need to be made as to how the market might have evolved and whether sales would have mirrored that movement. The impact of the “cost of living crisis” will be an important factor as demand may have dropped following customers tightening their belts.
While the remaining period of the contract might be the obvious starting point for a “loss of profits” calculation, the customer or supplier may argue that the breach has caused a longer term or even permanent loss. An assessment will need to be made as to how realistic this is and whether there are any other factors that might have affected performance in the longer term.
Finally, the customer or supplier will have a duty to mitigate its losses and therefore, the claim will need to take account the impact of mitigating actions. It may be that the customer has managed to obtain an alternative supplier, thus limiting the “loss of profits” to a shorter period and/or to any differential in pricing.
What happens if my supplier or customer breaches the contract?
If you are in a position where your supplier or customer has breached a contract, you may feel that you have no choice but to bring a claim for “loss of profits.”
Again, engagement with legal and accounting advisers will be needed to bring the claim and assess quantum.
Being able to show what expected profits would have been for the supplier or customer breaching the contract, assessing the appropriate period of loss and showing the impact of mitigating actions will all need to be considered.
Ultimately any claim for “loss of profits” will need evidential support, and therefore identifying and retaining relevant financial and accounting records is crucial. Where, for example, the company has incurred costs in mitigating the losses arising from the contract breach (e.g. in marketing expenses to attract new customers), invoices should be retained to show the expenditure along with records that substantiate why the cost was incurred (e.g. meeting minutes).
Additionally, being able to demonstrate the steps taken to mitigate the loss and showing efforts to secure alternative suppliers or customers, will add credibility to any claim.
How to decide upon the best course of action?
The “cost of living” crisis presents significant challenges to many businesses and their customers, not least coming at the end of a period of serious disruption during the pandemic.
The implications of rising material, labour and energy costs for the price at which companies need to sell their goods and services to break even is complicated where the business model is based on long term contracts with customers and/or suppliers.
Deciding how best to respond requires a careful understanding of the contractual and commercial position, including obtaining an understanding of the counterparty’s financial position.
Breaching a contract is something that is not done lightly and may be indicative of the counterparty suffering or anticipating financial difficulties. If this is the case, alternative approaches such as, renegotiating terms or deferring or limiting price rises may give a better outcome, particularly where there is an interdependency between the parties. Having open and honest conversations may help the parties reach a solution that allows the contractual relationship to continue on terms that are beneficial to both parties.
In the event that one or other of the parties decide they have no choice but to breach the contract then legal and accounting advice will be needed to either bring or defend a claim for “loss of profits”. Any such claim will need to be based on expected versus actual performance and it is very likely the “cost of living crisis” will have an impact on both. In addition, mitigating actions will need to be taken into account as these may well reduce or even extinguish any claim.
Whatever the course of action taken, it will potentially only be a short term solution to the underlying issue. Businesses, especially those in long term contractual relationships, should be thinking more widely about their exposure to cost increases and whether there are ways to proactively protect themselves. These actions will likely include both how inflationary pressures are addressed in future contracts and how the business can protect itself through mechanisms such as hedging or inventory management or by seeking to diversify its customer and supplier base.
Deciding how best to respond requires a careful understanding of the contractual and commercial position, including obtaining an understanding of the counterparty’s financial position.Henry Pocock Forensic Services