Should Inflation be a Force Majeure Event?

In a recent LinkedIN forum someone asked the question of whether inflation could be a force majeure event. Under freedom of contract the parties could make anything a force majeure event. The real question is whether that would make sense. The underlying concept of force majeure is an event has occurred that is beyond that party’s control where performance is not possible because of that event, and as such performance is excused until the effected party is able to recover from the event. Inflation is not something that stops performance it just makes performance more expensive.

A fairly common force majeure clause may read something like this:
“FORCE MAJEURE
Neither party will be in default or liable for any delay or failure to comply with this Agreement due to any act beyond the control of the affected party, excluding labor disputes, provided such party immediately notifies the other.”

With such a clause the party that sustained the force majeure event is normally allowed to recover from that event. Neither party is excused from completely performing. The party that suffered the force majeure event simply won’t be in default or be liable for performance during the period. The party that did not suffer the force majeure event is not excused from performance so if a payment was due, they would need to make the payment.

Including inflation in a force majeure clause makes no sense. Delaying performance as a result of inflation only makes sense if you are sure that de-inflation will occur. If it that isn’t the case, delaying performance would only cost more, as performance is not excused. A force majeure does not excuse performance, it simply creates a situation where the party that suffers force majeure event isn’t in default of liable during the period performance cannot be provides as a result of the force majeure. Performance can only be excused by certain conditions: subsequently illegality; impossibility of performance; impracticability of performance; frustration; where the parties agree to rescind or stop the agreement; novation; and lapse of the contract term.

Since it makes no sense to have inflation be considered a force majeure event, how do you deal with inflation concerns? One way to deal with inflation is to allow price adjustment per a pre-agreed formula. As an employer you might what to include an upper limit where work could be stopped at a point where it makes it uneconomical for the employer to continue the work. Since performance can be excused by agreement of the parties to stop or rescind the agreement you could include that in advance in your agreement. I would probably write a separate clause where the parties agree in advance that if there is no pre-agreed formula to adjust the price for inflation, either party has the right to rescind or stop the agreement if inflation exceeds a specific rate. Since you would not want the party to use that simply to walk away from a bad deal, I would want advance notice of their intent to exercise that right and make that right conditioned upon the parties not being able to reasonably agree to a adjustment based upon actual inflation. That way if the buyer agrees to make a reasonable adjustment to the price to cover inflation the supplier or contractor can’t use inflation as a way to walk away from a bad deal they made.

As may be amended from time to time.

In a linkedIN group someone asked the meaning of what “from time to time” means. The most frequent use of the term is with a requirement that a party, their product or service complies with applicable laws. When you say “Supplier shall comply with all applicable laws as may be amended from time to time”, what you are doing is require the supplier to make changes each time an applicable law changes.

Complying with applicable laws as they are changed presents a huge potential risk. You can have labor laws, minimum wages or health care laws enacted. You can have environmental laws enacted. Imagine being a supplier to a company that sells products in well over 100 countries, each of which may have multiple political subdivisions that can each pass laws. A change or new environmental law can also force changes to materials and processes used to manufacture a product.

Should a supplier be forced to comply with all changes that may occur in these various locations? Is it even economically feasible? If a small country enacted an environmental law or other laws the cost to implement the changes may not be worth it for the volume of sales in that market. It may also not be worth it to manufacture a unique item for only that market, nor would a supplier want to burden their cost structure for markets that simply don’t require it.

Even if you require a supplier to make all changes that are necessary to comply with a new or changed law, there are several situations where they won’t be required to make changes. The first is if the change in the law would make performance of the contract illegal. In that case the contract would be voidable. The other situation would be where they would be excused from performance because the change in the law causes impossibility of performance, impracticability of performance, or in some locations results in an economic hardship.

One of the comments made in that discussion was “if the Supplier thinks he wants that deal, it is part of the risk they have to take which should be addressed in their quoted price”. If the contract is silent about compensation or other adjustments that may be required to comply with the law, the full responsibility and cost for compliance would need to be borne by the Supplier. Many times a change in the law may simply not be a cost issue, it can also impact the time for performance.

As I always say how you view of issues will always depend upon where you sit. As a buyer, transferring all the risk to meet any changes to the law is clean, but it can also be expensive. For a supplier to assume all risks associated with changes to laws the contractor will include a contingency in their price to cover that risk. The buyer will either win or lose when you force a supplier to carry contingencies. If a new law is passed the buyer may win or lose depending upon the amount of the contingency that was included in the price versus the supplier’s cost to implement the change. If the supplier’s cost is greater than what was included in the contingency, you win. If the cost is less than what was included in the contingency, you lose as you paid the supplier more in contingencies than they had to pay. If the law isn’t changed or a new law isn’t passed you lose as you paid the contingency and the supplier didn’t need to use it, so it becomes additional profit for the supplier.

My view is you should always consider the potential risks in the situation to determine which party should manage the risk. Some risks may be best for the supplier to manage if they can best manage and control the risk. Changes in government laws aren’t always something they can manage, especially on a long-term contract. Some risks may need to be assumed by the buyer. If you assume the risk the first thing you do is eliminate the contingency in your pricing. If the risk never materializes you save all of what you would have paid if there were a contingency. If the risk materializes later you will save. The only time you potentially lose is change occurs and the cost is greater you have to pay in the adjusted price is more than the total amount you would have paid with the contingency. In the interim you also had the use of your money.

If you know something is going to change but are not sure how much, there are a number of approaches you can take. You could agree to adjust the price. You could also set parameters to reduce the amount of the contingency where adjustment are made only if the cost falls outside of the range. If the cost falls below that range you agreed you get a price reduction. If the cost falls above that parameter, you adjust the price. That type of band approach is frequently used when dealing with the risk of fluctuations in currency exchange rates.

I would never agree with language about anything that is "as amended from time to time" unless I also had the right to an equitable adjustments to the cost, time for performance, etc. necessary to meet the changed requirement. A buyer cannot change a specification without compensating a supplier for the added cost of the change. Why should a government mandated change be any different? Even then I might not agree unless I knew that I would be able to recover all investments that were needed to comply. Making a change in a per-unit price or contract amount doesn’t work unless there is a corresponding volume across which one time investments can be amortized.

Many times a supplier that is not contractually required to make changes will make the changes anyway simply because it’s the right decision for their business. For example when the European Economic Union passed RoHS (Restriction of the Use of Certain Hazardous Substance), (which is an environmental law that banned the use of certain materials in products because of concerns over ground water contamination in the disposal of product after the end of their useful life), suppliers knew that if they didn’t meet those requirement, their products would not be used in their customers products that were being sold in that huge market.

If you do push for a supplier to be fully responsible to comply with all applicable laws, don’t be surprised when they seek to limit the scope of that to a limited number of countries that represent the highest volume of your sales, as that will also equate to the highest consumption of their products.

Replenishment Logistics Programs

In a replenishment logistics program what occurs is tbe supplier will stock a replenishment logistics location with goods that can be pulled by the buyer upon demand. The replenishment logistics stock could be held at a supplier location, a third party location such as a warehouse agent, or it could be held in a separate secure area at the buyer’s location. The decision on the best place to have the materials stocked will be impacted by the transit time and where the sale occurs. For example a supplier may not want to stock products at a local site in a different country as that would make it a local sale and would require the supplier to be registered to do business there, and be subject to both local laws and taxes. In many international relpenishment logistics programs (“RLP”) stocking to the closest point without being negatively impacted can be done at bonded warehouses in free trade zones. In non-international RLP’s another consideration in the stocking location is whether the location taxes inventories held within that location. I believe in the U.S. the state of California had an inventory tax and as such many stocking locations were located in Nevada, which didn’t have an inventory tax

When you contractually need to implement an RLP as part of an agreement or as a separate document to be made part of the agreement there are a number of things that you need to address. A RLP document is just like any other contract in that it needs to define the scope of the activity,
all the notices and actions that are required, and what each party is responsible to perform. For example, if the inventory will be held by a third party under contract to the buyer, their responsibilities need to be defined.

Other things that normally get defined are:

"The Liability Horizon". This is frequently required when what you are purchasing is custom or unique. It will establish the period of time for each specific product that the buyer would be liable. This is similar to negotiating the point at which a product becomes non-cancelable and non-returnable. This is used to establish the maximum liability for each product that is being replished as a result of a pull from the RLP inventory.

"The Liability Horizon Quantity". This is the specific quantity of Pull Products that you want to have included in the RLP process. specified in the Planning Schedule contained within the Liability Horizon. The quantity may be adjusted based upon the Buyer’s forecast of products that the buyer will need to provide and update.

"Planning Schedule. To allow the supplier to manage the inventory and the replenishment of stock, the buyer needs to provide an initial forecast of requirement for the products to be managed under RLP, and provide periodic updated forecasts of future requirements. The better you manage this the less inventory you may have to purchase in the end if you don’t consume it.

"Replenishment Time" means the total elapsed time from Supplier receipt of a Pull Notification to their replenishment at the stocking location. The negotiation of replenishment time is the same as negotiating leadtime with the exception that it needs to include transit time to the stocking point.

When products are drawn from the inventory that is called a “pull”. So when you have RLP you will normally establish and define:
Pull Products that identifies the specific products that will be subject to the RLP process.
Pull Product profiles that provide the specific information about the iten included in the RLP Process such as Product Type, Part Number, Liability Horizon, the Liability Horizon Quantity and the Replenishment Time.
Pull Buffer that means a quantity of Pull Products that are desired to be held in inventory at the stocking location. In a pull replenishment system the supplier needs to use both the actual pulls made, the forecast and the known replenishment time to try to manage the on-hand stocking and replenishment to meet the desired buffer stock. For the buyer to make a pull, they need to notify the stocking location to either make the goods available or to ship the goods to buyer. Once pulled, the supplier needs to be notified for two reasons. One is so they can order replenishment stock. The other is so they can invoice the Buyer. As such there may be two pull notifications or a buyer may notify both the stocking location and the supplier of their authorization to deliver the specific quantity the buyer requires.

Most replenishment logistics programs are managed using blanket purchase orders that provide a billing reference. Those blanket purchase orders are never a firm commitment to purchase the full amount of the order. Individual "Pull Purchase Order" usually managed electronically make the actual purchase commitment.

If flexibility is required a RLP document will include parameters for potential upside flexibility in demand that will also require overage limits on the liability quantity to meet the required upside.

One of the keys in managing replenishment logistics is adjusting the pull buffer as demand changes so you don’t wind up with excess materials that you may be liable to purchase if they were custom or unique. Suppliers want your forecasts to be accurate and not overstated as they are effectively financing the cost of the inventory until you pull it. Suppliers may want the right to terminate a replenishment logistics program if you contiually abuse it by forecasting a higher demand than you actually require.


Supplier Responsibilities

The supplier responsibilities under a replenishment logistics program will vary based upon where the goods are stocked and who controls the stocking location. For example if the supplier has the materials stocked and a supplier stocking point their responsibility is priarily to stock what was agreed and manage the pull and replinishment processes. If the stocking will be at a third party warehouse that they will manage, you want them to contract with that warehouse agent to ensure that both buyers rights and protections and the suppliers rights in the material are protected and the material is properly stored, handled and managed to prevent any loss or damage as you wouldn’t want to be liable over an activity you don’t control. You also want that contract to establish the activities they are required to perform such as making the goods available or shipping the goods opon receipt of a pull notice and notifying the supplier of the specifics of what was pulled for their records and to invoice the buyer. If the stocking point was at the buyer site the resonsibilities and requirements would different. They would need access to the site to stock inventory and be able to audit the quantities actually consumed. You would want them to comply with your rules or guidelines for on premises work such as safety, security and personal conduct. Responsibility for the material, stocking area, and authorization for individuals that could pull from the inventory would be negotiated. From a delivery perspective you would want the supplier to pay everthing that is necessary to get the materials to the stocking location. The last thing you want the supplier to do is to manage the inventory using their best efforts so they keep track of pulls and manage internal orders for replenishment so replenished product arrives within the agreed replenishment time after the pull.

Buyer Responsibilities

In a replenishment logistics program where the stocking location is controlled by the supplier, the buyer has a limited number of responsibilities. They need to create all the documents needed for the pull – the
pull products, pull profile and the pull buffer. Once those are in place they need to provide and update the planning schedule (forecast) on a periodic basis (usually monthly). If there are custom or unique products that are being inventories, you frequently will be required to purchase any that you don’t consume. This means that the buyer should also be managing and potentially reducing the quantities held in the pull buffer, when there are known potential changes to the demand such as the introduction of a new product that would take sales away from the product for which the pull program was created or potential end of production for the product that uses those materials. Lastly the buyer has to pay for both the items they pulled that weren’t defective and returned and the buyer may need to pay cost to have the inventory re-deployed to a location where is may be consumed.

Liability Concerns

While a supplier may agree to do a pull replenishment program and assume the costs of doing that they may want to include those extra costs in the price. Many times the motivation of a supplier in doing a repenishment logistics program is it locks you more into using them and change from them may be timely so they will have certain business guaranteed. Their biggest concerns are when: there is excess quantity of materials in stock; the buyer makes changes to their product design that obsoletes their product; or the buyer’s product that it is used is in end of life without further consumption. How this gets managed in the contract will again be dependent upon whether the product is standard (where it could be used elsewhere) or unique (which may or may not be able to be used elsewhere) or custom where it has no use elsewhere other than for potential scrap value.

For a standard product that has an excess inventory you would normally allow or even require the supplier to re-deploy it. For standard product that isn’t consumed by you, re-deployment should also be required. One of the reasons why you want the supplier to manage the inventory is many products may have a shelf life and if that date has passed in may not be saleable. Who pays for the cost of shipping that would be subject to negotiation. If there are unique products that would be usable by other supplier customers you would also want those to be re-deployed.

For unique product that don’t have a market or custom products, when they become excess or obsolete,
the buyer must normally purchase those products. Sometimes they may be set aside for spare parts inventories incase the original one breaks and is no longer covered by warranty. With these same types of products since you required automatic replenishment to meet your pull buffer requirement you will also be responsible and work in process (WIP). Many times what makes something custom or unique may not happen until the latter stages of production, so you only want to be responsible for WIP that has gone through those stages. In that the decision always comes down to which is better for you. Do you pay the additional cost to complete the product and inventory it or do you pay the supplier’s costs to have the material scrapped. In that you would pay them the value of their work in process less any scrap value.

Joint activity
In managing a replenishment logistics program the buyer and supplier need to work together. They both need to agree upon the pull profile and the pull buffer. They need to work together to make adjustments based upon existing inventory levels, forecasts and changes in demand. They need to work together and with any warehouse agent to communicate transactions and changes in consumption. For example if a buyer pulls a product and it turns out to be defective, they will pull another one from the stock, but they also need to promptly notify the supplier and return the material for warranty repair so it may be place back into stock. They also need to work together to reconcile any differences in consumption and they will need to work together to reconcile liability.

Consignment

In a linkedIN group an individual in the oil business who was concerned about the low value received in selling back excess product wanted to consider a potential consignment model instead and wanted to know the positives and negatives of doing a consignment. My initial reaction was that if you had a supplier that would be willing to do a consignment model, the buy-back price with that same supplier should not be low. I thought I would share my thoughts about consignment with my readers.

A simple consignment agreement would address the following issues.

Right to sell: The consignee would normally not have the right to sell the product.
Right to use As the intention is to consume the consigned materials, the rights to use them would be determined by the terms of the consignment.
Risk of loss for transfer to location This is normally borne by the Consignor for shipments they control. For shipments they don’t control the risk would normally belong to the Consignee.
Risk of loss or damage to the property heldThis is normally the covered by a requirement that the Consignee maintain insurance in the amount of the value of the property consigned.
Responsibility to report shortagesThis is a responsibility of the consignee.
Responsibility to report damages This is a responsibility of the consignee.
Acknowledge receipt of materials This is required so the consignee acknowledges both the quality of product shipped (not damaged) and the quantity.
Ensure goods are not encumbered / pledged This is normally a contract requirement and most consignment agreements will require that consigned materials be maintained separately and marked as owned by the Consignor.
Report transactions This is a responsibility of the consignee as payment for the consigned materials is tied to when they are consumed.
Make settlement and payment This is a responsibility of the consignee and payment needs to be made per the terms of the agreement.
Maintain books and records of transactions As the consignee is responsible for all the materials they were shipped, they need to maintain a record of the materials used, damaged or scrapped as they will be billed for all materials not returned.
Permit inspection of materials A consignor may want to include a requirement that they can inspect the goods to make sure the reporting is accurate and the consignee has not sold the materials
Remove materials A consignor will want the right to remove the materials if there has been any breach of the consignment agreement or if there is a financial problem with the consignee. Even if the consignee goes bankrupt, as long as the consignor can prove their ownership in the materials, they can remove them.
Maintain Insurance to replace materials if lost or damaged This is normally a responsibility of the consignee as they will have to pay the consignor for any materials that were lost of damaged.
Return of materials Normally a consignor will want all good products returned to them when certain events occur such as termination or expiration of the agreement or by a specific date and any held after that date would be considered sold and the consignee invoiced. Cost of shipping and risk of loss or damage while in transit would be normally borne by the consignee.

From a business perspective whether a consignment works will usually depend upon a number of things, most of them financial. First is whether what you use is both standard sizes and standard materials where the supplier could readily resell the returned product. Unique or custom items may have only scrap value. Items that do not have an immediate resale market create an additional inventory carrying cost for the supplier. A second issue is whether the elements will have any affect on the product or its appearance. A supplier that has products with a limited shelf life because of exposure to the elements may require specific storage requirements or may not be willing to accept returns. Anything that would cosmetically change the appearance of the product will reduce its value. If you have consigned materials that could be quickly resold and would suffer no ill effects from being exposed to the elements, the supplier might be willing to do a consignment model. That decision is usually financially driven.

The real issue that will decide whether it will work or not is which company has the higher cost or value of money. Cost of money is what you would need to pay to borrow it. Value of money is what type of a return could you get if you invested that money elsewhere. Under a consignment model the supplier will have occurred all their costs at the time the products are shipped for the consignment, but they need to wait until products are consumed before they are paid. They may have to wait further until you return excess. The time it takes to resell the excess until they get paid on that also adds an additional cost to them. This means that they will have a carrying cost for all that time and an inventory carrying cost on the returned materials that they will need to build into selling price. This means that it will probably cost you more to purchase the product under a consignment model versus outright purchase as they are using their money, not yours until it gets consumed. If their cost of money or value of money is higher than yours, you will be paying more. How much more it will cost will depend upon your requirements for delivery of the consigned materials. If you wanted a large stock delivered up front it would definitely cost more that a form of pull replenishment model where the quantity of finished product on hand in consignment would be less. Other than the financial difference consignment requires more administrative work as you need to keep track of what's in that inventory, and when it's consumed for payment purposes. It will impact your payment term as most will not agree to extended payment terms having already covered the cost in the consignment. Other differences would be dependent upon the terms of the consignment agreement.