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San Diego Business Contracts: Using Cost-Adjustment Clauses to Reduce Risks

If your San Diego business is contemplating a long-term contract that involves materials and supplies, you might consider adding a “cost-adjustment” clause to the contract to reduce risks from market price fluctuations. With a long-term contract — one that governs a business relationship for several years — a key risk is that the cost of some product input (for example, steel or fuel costs) might significantly increase thereby destroying the profitability for the supplier. Even minor market changes can have a significant impact. Inserting a cost adjustment clause helps resolve this potential risk of loss of profitability. As the name suggests, a cost adjustment clause allows the cost of some aspect of the deal to fluctuate, usually on a periodic basis. Any business with an office lease is familiar with annual adjustments since most commercial leases provide for an annual rise in the rents and adjustments for common area maintenance and taxes. An experienced San Diego corporate attorney can offer advice and counsel on whether your business should consider such a clause and can tailor a clause to suit your needs. A simple cost adjustment clause might look like this:

“Price Adjustments. The Unit Price is subject to adjustment, effective immediately upon written notice from SUPPLIER to Purchaser, in an amount up to [DEFINED] percent above the then-current Unit Price. SUPPLIER may adjust the Unit Price on [DEFINED PERIODIC] basis to account for changes in SUPPLIER’s cost structure relative with respect to the manufacture of PRODUCT.”

There are many advantages that can be gained by agreeing to a cost adjustment clause. First and foremost is the avoidance of contract failure. If the party with cost inputs can no longer provide the product at a profit, the contract will fail. No business can succeed if it is supplying product at a loss. The supplier will eventually either go bankrupt or, more likely, terminate the contract. Second, a cost adjustment clause helps avoid litigation. Third, cost adjustment clauses can salvage a good business and working relationship. Fourth, there are many variations on the cost adjustment clause including versions that require a downward price adjustment if costs decrease. That type of clause benefits the purchaser as well as the supplier. Other variations include:

Targeting the price adjustment to certain cost inputs only (such as fuel costs or other volatile costs)
Requiring notice before the adjustment takes effect
Requiring documentation before the adjustment takes effect — invoice method
Linking cost adjustment to a published index (for labor costs or some necessary commodity — index method)
Allowing for a direct, automatic, and constant pass-through of certain costs (again, fuel is the common cost used for pass through cost adjustment clauses)

Another option is a “look-in” clause that commits the parties to discuss a price adjustment, but does not bind the parties. A “look-in” clause might read something like this:

“Price Adjustment: If SUPPLIER seeks to adjust the Unit Price, SUPPLIER shall deliver notice to Purchaser of SUPPLIER’s proposed price adjustment. The parties hereto agree to negotiate in good faith after delivery of such notice, but no modification of such pricing shall occur unless and until the parties have both signed an amendment hereto.”

Contact San Diego Corporate Law

For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full array of legal services for businesses including contract review and drafting, mergers and acquisitions, corporate formations, private placement memorandums, and employment-related services like drafting employee handbooks. Mr. Leonard can be reached at (858) 483-9200 or via email. Like us on Facebook.