The Price Adjustment Clause: Inflation-Proof Your Contracts

One of the most important aspects of a commercial contract is determining the price of the good or service provided. However, given the ever-changing nature of economic conditions, such as inflation, the initially agreed-upon price may cease to be fair or accurate over time. Inflation, long held at low rates and considered an afterthought, now presents a serious and ongoing risk to a company’s profit margins. This is where a price adjustment clause  becomes invaluable.

What is the Price Adjustment Clause?

A price adjustment clause is a provision in a contract that allows the price of goods or services to be adjusted based on specific external factors. These factors might include inflation, changes in the cost of raw materials, labor costs, taxes, or other economic conditions. Price adjustment clauses are commonly used in long-term contracts, supply chain contracts, construction agreements, and other scenarios where prices may fluctuate over time. Below, we delve deeper into what a price adjustment clause is, how it works, and why it can help your business adjust to inflationary pressures.

How Does a Price Adjustment Clause Work?

At its core, a price adjustment clause is a contractual tool that provides a method for adjusting the agreed-upon price of a contract to reflect changes in market conditions. The clause stipulates the factors triggering a price adjustment and specifies the formula or process used to calculate the new price.

For instance, if a contract is based on supply chain cost, a price adjustment clause might stipulate that if the cost of goods increases by more than 5%, the contract price will be adjusted accordingly. The goal of the clause is to protect both parties from unforeseen costs or losses that could result from market volatility.

A price adjustment clause typically operates under pre-defined terms and conditions agreed upon at the outset of the contract. Here’s a general outline of how such clauses might work:

1. Define Triggering Events:

The price adjustment clause defines specific circumstances that would activate the price adjustment, such as a particular percentage increase in the cost of raw materials or changes in inflation rates.

2. Define Adjustment Method:

The clause usually contains a formula or method for calculating the new price. Common methods include referencing an external price index, like the Consumer Price Index (CPI), or a specific cost indicator related to the industry.

3. Adjustment Timeline:

The price adjustment clause will define when and how often adjustments can be made, such as quarterly or annually, to preempt continuous price changes.

4. Caps on Adjustment:

Often, a price adjustment clause will include limits, ensuring that the adjustment remains within a reasonable range and doesn’t unfairly burden either party.

Types of Price Adjustment Clauses

Price adjustment clauses can take different forms depending on the industry and the nature of the contract. Here are some common types:

1. Cost-Based Adjustment Clauses:

These clauses adjust prices based on the cost of raw materials, labor, and other inputs. For instance, if the cost of steel rises, a construction contract might adjust prices accordingly.

2. Index-Based Adjustment Clauses:

These clauses reference an economic index, like the Consumer Price Index or a specific commodity index, to adjust prices in line with broader economic trends.

3. Time-Based Adjustment Clauses:

These clauses set price adjustments based on specific time intervals, such as annually, to keep up with inflation or other economic changes.

Sample Clauses that Adjust Price to Inflation

Below are some sample clauses you might encounter in commercial agreements that adjust prices to inflation. These clauses are designed to link pricing adjustments to inflation indexes or external economic factors, ensuring that contracts remain fair and viable over time. It is advisable to consult with your in-house legal team to craft the specific clause that works for your business and industry.

1. Consumer Price Index (CPI)-Based Adjustment Clause

"The contract price shall be adjusted annually on [date] based on changes to the Consumer Price Index (CPI) published by the U.S. Bureau of Labor Statistics. The adjustment shall be calculated as follows:

New Price = Base Price x (CPI Current / CPI Base)

*Where:

• "CPI Base" is the Consumer Price Index published as of the contract start date.
• "CPI Current" is the Consumer Price Index published as of the adjustment date.*

Any increase shall not exceed [X]% per year unless mutually agreed upon by both parties."

2. Index-Based Adjustment Clause

"If the cost of raw materials or inputs increases by more than [X]% as measured by the Producer Price Index (PPI), the parties agree to adjust the contract price proportionately to reflect such increases. The formula for adjustment shall be:

Adjusted Price = Original Price x (Current Index / Base Index)

The Base Index is the index value on the contract start date. The Current Index is the value on the adjustment date."

3. Threshold Trigger Clause

"If, during the term of this agreement, the cost of goods, labor, or materials increases by more than [5%], as evidenced by the Consumer Price Index, the price shall be renegotiated to reflect the actual cost increase. Any price adjustments shall be made in good faith and will take effect on [date]."

4. Cap-and-Floor Price Adjustment Clause

"To account for inflation, the contract price shall be adjusted annually based on the CPI. However, the adjustment shall be subject to the following limits:

• The price increase shall not exceed [X]% per year.
• The price decrease shall not fall below [Y]% per year.

The adjustment formula is:
New Price = Original Price x (Index Current / Index Base)
Where “Index Current” is the published value on the adjustment date and “Index Base” is the value on the contract start date."

5. Fuel or Commodity-Specific Adjustment Clause

"Given the volatility of fuel prices, the contract price will be adjusted quarterly based on changes to the Fuel Price Index as published by [source]. Any price changes shall reflect increases or decreases in the index above or below a threshold of [X]%. Adjustments will be calculated using the formula:

New Price = Base Price ± [(Change in Index Value) x Adjustment Factor]."

6. Labor Cost Adjustment Clause

"The contract price will be adjusted annually to reflect changes in labor costs, as measured by the Employment Cost Index. Adjustments will be proportional to the percentage increase or decrease in the index relative to the base year. Any adjustment will take effect within [30 days] of the publication of the index."

Benefits of a Price Adjustment Clause in Mitigating Inflation

A recent surge in the inflation rate has demonstrated the importance of managing price fluctuations in business relationships. A price adjustment clause can be a powerful tool to help businesses manage the impact of inflation, providing a structured way to adapt to changing economic conditions. Here’s how  price adjustment clauses can support businesses during inflationary periods:

1. Protects Profit Margins

Inflation drives up the cost of raw materials and goods, labor, and operational expenses, which can erode profit margins if prices remain fixed. A price adjustment clause enables businesses to pass some of these increased costs onto clients, preserving their profitability and protecting them from losses as expenses rise.

2. Maintains Financial Stability

With this clause in place, businesses can forecast revenues more accurately, even in inflationary markets. This stability helps companies to budget more effectively, invest in growth, and maintain cash flow without the constant threat of unmanageable cost increases.

3. Adjusts Prices in Real-Time with Market Conditions

By linking prices to an inflation index (like the Consumer Price Index or commodity prices),  the price adjustment clause allows businesses to adapt prices dynamically as inflation fluctuates. This real-time adjustment helps companies remain competitive and reduces the likelihood of needing to renegotiate terms continually or absorb unmanageable costs.

4. Builds Long-Term Business Relationships

Agreements with built-in  price adjustment clauses provide transparency and predictability, which can strengthen trust with clients and suppliers. Instead of renegotiating prices or risking disputes whenever inflation spikes, such a clause outlines the terms of adjustment from the outset. This clarity allows both parties to confidently navigate inflation and build long-term, stable business relationships.

5. Encourages Long-Term Contracts in Inflationary Times

When inflation is high, clients may hesitate to enter long-term contracts for fear that prices will soar. A price adjustment clause can alleviate these concerns by providing a controlled and agreed-upon method for adjusting prices over time. This can make clients more open to longer-term agreements, knowing they won’t face unexpected, drastic price increases.

6. Minimizes the Need for Price Re-Negotiations

Constant price renegotiations can strain business relationships and slow operations. By having a  price adjustment clause in place, businesses can rely on a predefined method for price adjustments, reducing the administrative and relational burden of repeated negotiations. This setup can save time, minimize friction, and keep projects moving smoothly despite inflationary pressures.

7. Supports Employee Retention and Wage Adjustments

Inflation often translates to higher wage demands. With a price adjustment clause, companies can adjust contract prices to account for these increased labor costs, which allows them to pay competitive wages to retain their skilled employees without risking profitability.

Industries Where Price Adjustment Clauses are Commonly Used

Price adjustment clauses are widely used in industries where pricing volatility is high or where contracts are long-term. While not an exclusive list, below are some key sectors where they are used today:

Manufacturing:

Companies dealing in bulk materials and global supply chains frequently use price adjustment clauses to adjust for the cost of goods.

Construction:

Construction contracts often include price adjustment clauses to accommodate fluctuations in material costs, such as lumber, steel, and concrete.

Energy and Utilities:

Price adjustment clauses are essential in contracts for fuel, gas, and electricity, as prices are heavily impacted by market trends and regulatory changes.

Government Contractors:

Many government contractors, especially for defense or infrastructure projects, include price adjustment clauses to ensure they remain financially viable over the long term. In many government contracts, the price adjustment process on a federal contract is also known as Economic Price Adjustment, or EPA for short.  

Leveraging Contract Management Software to Standardize Your Price Adjustment Clause

To effectively use contract language to address inflation, we must first identify any existing inflationary clauses within our contracts. This can be challenging due to the lack of a centralized repository where all contracts are stored and standardized inflation clauses across them. Moreover, these clauses often vary in terms of the index used and the specific adjustment schedule.

Addressing these difficulties is where contract management software comes in. With AI and automation, organizations can ensure that inflation and other price adjustment clauses are systematically included in every contract.

1. Use Contract AI to Automate Discovery

The best contract management platforms often come equipped with AI. With contract AI trained to identify price adjustment clauses, companies have been able to surface contracts containing clear inflation clauses, contracts that refer to inflation but do not identify specific indexes, and those with no mention of inflation at all. With the contract data so structured, the organizations have quickly formed a plan of action to address areas where the contract value is being left on the table and take concrete steps to address it.

2. Single Source of Truth on a Centralized Platform

Price adjustment clauses often leave room for interpretation. Typically, in such cases, your legal department may rely on dispute resolution clauses to ensure your organization gets a fair deal. With a centralized platform, all contracts, including those with price adjustment clauses, are stored in a centralized repository. This ensures easy access and quick retrieval when needed. Advanced contract management software can automatically calculate price adjustments based on predefined formulas and market data, saving contracting teams time and preventing manual errors.

A single source of truth also helps organizations be more effective in resource assignments. With centralized information, teams can assign resources to contract adjustments to maximize return on effort. And because contract data is already extracted and associated with each matter, contracting teams have a head start in understanding what recourse they can pursue. The goal is to quickly surface which contracts have the most financial value, the most exposure to price pressures, and the most room for interpretation fast-tracked for reviews and terms adjustments.

3. Creating Playbooks

Where negotiations are common or third-party paper is used, contracting teams should create playbooks that help them quickly respond to redlines so they can protect the business without throwing negotiations off track. It is easier than ever to create company playbooks with contract management software. Standardized company language can be added to clause libraries and contract templates, ensuring that all new contracts use the most up-to-date language.

4. Get Trigger-Based Alerts

The software can be configured to send your team automated alerts when specific triggering events occur, such as changes in market indexes or input costs. Timely notifications ensure that price adjustments are initiated promptly, minimizing the potential for miscommunication or financial losses.

5. Monitoring Contract Performance

The software can track a contract’s performance, monitoring key metrics like executed price adjustment clauses, obligation fulfillment, compliance, and more. It also maintains a comprehensive audit trail, ensuring compliance with regulatory requirements and facilitating internal audits.

By leveraging contract management software, companies can effectively manage price adjustment clauses through automated, centralized workflows, ensuring that they are negotiated optimally and applied correctly, minimizing legal and financial risks.

Consider Icertis

In today's economy, where costs are rising and the future is uncertain, automated contract management is essential. By using AI-powered solutions such as Icertis Contract Intelligence, businesses can prevent revenue loss, protect margins, and ensure contract compliance. Icertis is a global leader in AI-powered contract management. Today, 30% of the Fortune 100 trust Icertis to realize the full intent of their contracts in 90+ countries.  

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