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Based on the terms and conditions set out in the tender awarded to you, it is now time for you to take stock of what has happened to the price of the product or service you provided over the last couple of months/year. You also need to supply the information to the buying party to your contract. So where to from here?
Unfortunately, you cannot go to the buyer and tell them that your costs have increased by 11% and expect them to pay it, especially if you do not have proof. Without substantial proof to support the increase in the costs you want to pass onto the buyer, your request will not be met. So how do you get the proof? Easy, through calculations in a Contract Price Adjustment (CPA) with the use of relevant industry related price indices which will give you a true and accurate reflection of what has happened in the market.
Alright, so you know you must do a CPA but you have no idea what it is, let alone how to apply it or why it is beneficial to you. The aim of this blog is to do just that – give you a better understanding of what a contract price adjustment is.
In the simplest terms, a CPA is a process in which you calculate the extent to which the price of inputs of the product or service you supply, has increased or decreased over a specified period of time. This means that due to unforeseen circumstances (i.e. inflation) the cost of doing business has changed and you have to account for it in some way because it ultimately impacts on the price of the contract over the duration thereof.
Both parties to the contract aim to sustain or improve the profitability of their business. Buyers therefore try to manage and maintain their costs, while suppliers want to recover as much cost as possible.
Let me explain the importance of a CPA with the use of an example:
You are a supplier to a contract. The initial contract value was R10 000 000, the contract term was for 10 years and you were allowed to escalate (do your contract price adjustment) once a year. At the end of the 10-year period the contract value that you calculate by taking costs into account amounted to R14 233 118. One of your colleagues came to you and mentioned that you made an error in your calculations and that the contract value was actually supposed to be R16 894 790. Through discussions with your colleague you actually realise that you applied the calculations incorrectly because you didn’t understand the contract price adjustment process. As a result, your company lost R2 661 671 on the contract. What is worse is that the profit calculated at the start of the contract was R2 000 000 which means that your company actually has to pay in, in order to finalise the project (thereby putting your company in a worse position).
This example can be explained from the buyer’s side as well. Let’s assume the same contract over the same period as in the above example. At the end of the 10-year span the contract cost you R16 894 790. Your colleague then tells you that the cost of the contract was supposed to be R14 233 118. Unfortunately, your company overpaid by R2 661 671 because you didn’t understand the process and applied calculations incorrectly.
As the company supplying the product or service, you are therefore assured that you can justify the cost increase you are passing on to the buyer and that the costs were accurately calculated from your CPA which is based on what has happened in the market. The correct application of the CPA also allows the company buying the product or service to be certain that market related increases are paid out, ensuring the sustainability or improvement of business profitability.
In order to accurately calculate your costs, you need to make use of SEIFSA’s price indices and apply them to the mathematical formula which is based on the inputs of your product or service. Although the mathematical formula is a very important aspect to your CPA, it will be of no benefit if you do not use the correct price indices. The use of the incorrect indices could have an adverse effect on the increase you calculate. Often times the CPA process is handed to staff in financial positions due to the calculations involved. However, it is very important that the technical people in the company assist with the process, especially when tendering. This is because the technical people have a better understanding of what inputs are used in the manufacturing of a product. If for example your company manufactures power transformers, the technical person would know that one of the materials used is electrical steel.
SEIFSA’s Price and Index Pages (PIPS) currently offer a wide variety of steel indices and because you lack the technical knowledge you might link the incorrect steel index to the material component.
If you are worried about changes in the input costs in your tender application or the right time to escalate (that is, make adjustments to your contract), subscribe to SEIFSA’s Price and Index Pages and join a CPA workshop to better understand the process involved.
Click here to download a free version of PIPS.