Monday, February 13, 2012

Raw Material Adders and Surcharges:

When you are purchasing items that are subject to frequent changes in the cost of materials or labor used or where the supplier is responsible for the payment of freight, you may need to include a provision that adjusts pricing accordingly. In a way this is similar to needing to manage currency exchange when you have a supplier or buyer that operates under a different currency where changes in currency can affect their costs or profits.

The first thing to consider is which party should take the risk. If the buyer expects the supplier to assume all the risk, you can expect that the supplier will build contingencies into their price to cover the risk. As long as the contingency covers their costs the supplier will never lose. If the changes to the raw materials are less,the supplier makes more of a profit. So having the supplier take all the risk is the lowest risk but highest potential cost for the buyer.

If the buyer assumes all the risk, it’s not much different than agreeing to pay in a foreign
currency, the key question is what steps can you take to hedge against the risk. Unlike currency exchange where you can hedge against the risk by purchasing the foreign currency at forward rates, hedging against changes to material costs are harder to manage as in most cases you would hedge against the risk by making firm commitments today that the supplier can also use to make firm commitments to their material suppliers at today’s prices for delivery in the future so you are not impacted by the change. You may not need or want to make a firm commitment for all you expected volume, and you can always have some portion hedged by advance purchases and some that you have as floating where the price will be adjusted based upon what the costs are at the time.

Any time you agree to allow for price changes for things like raw materials or other items that are subject to their prices being changed, your contract need to establish a baseline for measuring the amount of the changes to the price. For raw materials you need to establish
the quantity that will be consumed or scraped in the process so you understand the true impact of the change in the price in what you are purchasing. If you were buying a product that had a bill of materials, you would also identify how many of the items that were subject to changes in pricing would be affected. Next you want to understand what impact a Supplier’s inventory has on their cost. Just because the price of the material has gone up or down when they need to make future purchases of it does not impact the cost the supplier had for what they paid for any existing inventory. Next you need to establish the basis for the cost adjustment. Are you paying it based upon their actual cost they paid or is it based upon quoted market prices or market indexes? If its based upon actual cost you would want to have the right to audit that cost. The last things to decide is the frequency of price changes that would be allowed and how any additional costs or credits will be managed. All these things would need to be included in the contract.

In activities like contract manufacturing the price paid will frequently be a combination of a percentage or firm amount for both overhead, profit, a firm amount for manufacturing value added and the actual cost of the materials used. There are requirements that on some period such as monthly, the supplier must disclose the actual costs of both the inventory they consumed and new purchases to agree upon any adjustment required for what has been been shipped and to set the price for future purchases. Adjustments (either additions or reductions) may be made as a separate payment to the supplier or refund to the buyer, or the parties could agree have the adjustment be applied to the price of future purchases. However you manage it any time you agree adders or surcharge you want to make sure that it goes both ways so if their costs go down your price goes down.

To make sure you only pay what you need to pay or get back what you should get back, you need to manage the activity. You also need to make sure that your contract and contract file makes it clear what your price is based upon so anyone that assumes responsibility to manage the contract in the future will know it needs to be managed just like if you amortized one time costs into the price so the price gets reduced once those one time costs are liquidated. It’s like many things where you may need to tell them they need to provide it or they might conveniently forget about it, This is especially true when forgetting about it would be to their benefit.