Price Adjustment Clauses: How They Work in B2B Deals

A fixed price works well for a short deal. In a long deal, costs can move a lot. Metal, fuel, parts and wages may all change over a year or two. If the price cannot move, one side takes the whole hit. The seller may lose money on a rising market. The buyer may overpay on a falling one.

A clause shares that risk. The price can follow real costs, up or down, so neither side has to carry all of it.

The US Bureau of Labor Statistics (BLS) notes that businesses use price adjustment, also called escalation, clauses in long-term sales and purchase contracts. It says deals worth trillions of dollars are adjusted using its Producer Price Index (PPI) family of indexes.

Sources: US Bureau of Labor Statistics, "Producer Price Index (PPI) Guide for Price Adjustment" (Price Adjustment Guide for Contracts)

The Federal Acquisition Regulation (FAR) describes three general types of economic price adjustment. Private deals use the same ideas.

• Established prices. The price moves up or down from an agreed level as a published price for an item changes.
• Actual costs. The price moves with the seller's real costs of labor or material during the work. The seller must show what it paid.
• Cost indexes. The price moves with a named index of labor or material costs that is written into the contract.

Index clauses are the easiest to run. Both sides can look up the same public number, and neither side controls it. Actual cost clauses need more paperwork and more trust.

Sources: FAR 16.203-1, Description (acquisition.gov)

The FAR gives a useful test. It says a fixed price with adjustment may be used when there is serious doubt about how stable market or labor conditions will be over a long period. It also requires that the risks be identified and covered separately in the contract.

The same rule says price changes based on labor and material costs should be limited to events beyond the seller's control. A seller should not be able to pass along its own poor buying. The rule also warns against double counting. If the base price already includes a cushion for a risk, the clause should not charge for that risk again.

For a short deal with stable prices, a plain fixed price is usually simpler.

Sources: FAR 16.203-2, Application (acquisition.gov)

BLS publishes a worked example. The base price is $1,000 per unit, set in December 2010. The clause uses a PPI called Materials and components for manufacturing. That index stood at 178.4 in December 2010 and 187.7 in December 2011.

The steps are simple:

1. Divide the new index value by the base index value: 187.7 divided by 178.4.
2. That shows a rise of about 5.2 percent.
3. Raise the price by that share: $1,000 becomes $1,052 per unit.

A second method adjusts only part of the price. Say $700 of the $1,000 follows the index and $300 stays fixed. Each 1 percent move then changes the price by $7. A 5.2 percent rise adds $36.40, and the price becomes $1,036.40. This fits a product where only some costs, such as materials, are expected to swing.

BLS strongly discourages using raw index points instead of percent change. When an index sits far from its base of 100, point changes give a distorted picture of the real price move.

Sources: US Bureau of Labor Statistics, "Producer Price Index (PPI) Guide for Price Adjustment," guideline 9

Most disputes come from vague wording. The BLS guide warns that these clauses should be written with great care. Its advice points to a short checklist:

• Base price and base month. State exactly what price is adjusted, per unit or per volume, and the month it was set.
• The exact index. Give the full title and code. BLS notes there is no single index called "the Producer Price Index." It is a family of indexes.
• Choose costs, not the product. The guide suggests an index that tracks the inputs to the product. An apparel buyer, for example, might track yarn or raw fabric rather than finished fabric.
• Not seasonally adjusted. In general, seasonally adjusted data is not a good fit, since the clause is meant to capture actual price changes.
• How often. Say whether prices reset monthly, quarterly, or yearly, and on what date.
• Which data version. Index values can be revised for up to four months after they first appear. Name whether first-published or final values count.
• A backup index. Detailed indexes can have gaps or be discontinued. Name a fallback.

Sources: US Bureau of Labor Statistics, "Producer Price Index (PPI) Guide for Price Adjustment," guidelines 1 to 9

A clause can swing both ways. If the index falls, the price falls. In the BLS example, the index later fell and the adjusted price fell with it. Sellers should understand that before agreeing.

Some parties add a cap or a floor, or a trigger that only starts an adjustment after the index moves a set amount. These are choices for the parties to negotiate. Neither the BLS nor the FAR requires them.

Not every contract needs a formula. Under the Uniform Commercial Code, a sale contract can be made even if the price is not settled. If the parties leave the price open and cannot agree, the price is a reasonable price at the time for delivery. A price left to be fixed by one party must be fixed in good faith. If the parties do not intend to be bound unless a price is set, no contract exists without one. An open price is a gamble on a court's view of "reasonable," so a written clause is usually safer.

Sources: Uniform Commercial Code 2-305, Open Price Term (Legal Information Institute, Cornell Law School); US Bureau of Labor Statistics, "Producer Price Index (PPI) Guide for Price Adjustment," guideline 9

1. US Bureau of Labor Statistics, "Producer Price Index (PPI) Guide for Price Adjustment." bls.gov
2. US Bureau of Labor Statistics, "Contract Escalation." bls.gov/bls/escalation.htm
3. Federal Acquisition Regulation 16.203-1, Description. acquisition.gov/far/16.203-1
4. Federal Acquisition Regulation 16.203-2, Application. acquisition.gov/far/16.203-2
5. Uniform Commercial Code 2-305, Open Price Term. law.cornell.edu