Significance of Price Increase Provisions
Well-drafted annual price increase clauses or formulas should be included in any contract that spans a period of time regardless of the type of product or service being sold or purchased. Doing so protects both buyer and seller from ever changing costs based on supply, demand, and inflation. Such clauses or formulas warrant that the price paid by buyer to the seller for any goods or services shall increase each year for the duration of the contract . These clauses or formulas should be drafted to provide a pre-agreed and certain method to determine an increase to the original price. For example, a series of contracts may provide that the price increase must be based on the Consumer Price Index for the immediate preceding calendar year. In those instances where price is so critical to the parties, the inclusion of an annual price increase clause or formula should be a negotiating priority.
Essential Components of Advantageous Provisions
The first essential element is a set percentage increase where the amount of the increase is based on a specific percentage figure that is expressly stated in the contract, such as "an increase of four percent (4%) payable on each annual anniversary of the Effective Date" of the contract. As to the specific percentage or percentages, many supplier contracts specify as much as six or eight percent, which tends to be at or near the consumer price index ("CPI") for a given year. In addition, an increasing number of energy supply agreements identify the CPI as the measure for the increase. That is, rather than using a set percentage figure as described above, the contract specifies that each discount (or the price per unit) shall be adjusted according to the CPI applicable to the previous calendar year. The latter is becoming increasingly popular, particularly with natural gas contracts. The second key element of effective clauses is clear time period parameters such as "each calendar year" or "each anniversary date" of the "Effective Date." The best annual price clauses state the effective date or dates from which renewals, term extensions, and exercise of options are measured. More pointedly, they state the anniversary date for annual price rate increases. The third key element is the definition of what the price is to be calculated from. In fixed-rate contracts, the main purpose of this element is to clarify that the prices calculated as above are from the contracted price. In multi-step contracts, which tend to have higher initial fixed rates, the correct adjustment can only be calculated if the annual price increase clause is clear.
Formulating Unambiguous and Equitable Clauses
The key to successful annual price increases is drafting contract language that is clear and fair to both parties. Start with the clear part. Everyone involved needs to be able to understand where the increase is coming from, and how it will work. Right off the bat, that means including the percentage amount of the increase. Yes, the CPI is a well-respected index. But the market will be better served if your supplier gives you 4% exactly, not "the CPI+1%." And suppliers and customers should agree that 3% should be the maximum annual increase in any given year. No sector of the economy can consistently handle more than that without a business model change.
On the fairness side, annual price increases should also avoid tipping the scales too much, too often, in favor of one party or another. Here, supplier pricing flexibility is limited by rules governing UCC contracts and should also be determined, even when it appears to be in the customer’s favor, by common sense and (yes) fairness. Of course, things can happen. Prompt payment discounts can cause annual price increases to become relatively larger over time. The timing of annual price increases can also tip the scales. This is why annual price increases should be set to occur at the same time each year. Otherwise, one year may see two annual price increases, and another year none at all. The result can be an apparently stable annual price increase and frequent protests from the less-favored party.
Frequent Pitfalls to Evade
Common pitfalls to avoid when crafting or agreeing to price increase clauses include (1) vague language that is susceptible to disputes over how much notice is necessary, (2) the failure to include any cap, even a modest one, on the amount of any annual increase, as this results in dealers routinely charging the new price to consumers even when the freight increase is trivial, and (3) the failure to do any market research on whether the published freight charge on websites is in fact the freight amount charged to brick and mortar consumers, because in many instances the charges are fictional.
Addressing Pricing Hike Negotiations
As with the general business terms of a hospital or other health care vendor’s contract, annual price increase clauses are negotiable. For many hospitals, the price increase terms are one of the most important negotiation points in a contract with a vendor. For the vendor, agreeing to a lower or a non-increase can be a major concession having a significant impact on bottom line profitability. One strategy for negotiating annual price increase terms is simply to change the subject and focus on the value proposition offered by the vendor’s services. Instead of getting lost in the dollar amounts associated with annual price increases, the parties can instead discuss if the service provider’s services should cost more or less based on the potential costs associated with downsizing, outsourcing or eliminating certain services from the hospital. In most cases , the hourly rates or percentage increases become secondary to the positive or negative impact on a hospital’s bottom line. Another strategy for statement of work contracts is to utilize a planned schedule of incremental monthly, quarterly or annual increases of the rates through the initial term of the contract. This allows both the vendor and the hospital to work through any pricing issues by assigning specific amounts to be payed or charged in the next step of the timeline. It provides a level of certainty without binding the parties to any specific return on investment or vague references to market changes. Additionally, it provides a method for the parties to agree on the process for discussing future changes in rates designed to produce agreed-to profits for the vendor while at the same time protecting the hospital from overcharging. All price increase terms have to be negotiated- as part of the contract and as part of the buying process.
Care For Legal Requirements
We’ve written in the past about the importance of having your contract language that determines annual price increases ("API contract language") review by legal counsel, but even more important is knowing the legal requirements for API contract language. For example, in certain jurisdictions, an annual price increase cannot be "subject to" a "reasonable compensation" clause, because such a clause contradicts the model to which it is attached. In other jurisdictions, price is not a topic for which there could be a dispute, so the "subject to" clause should never be used.
Legal counsel can advise you on how the jurisdiction prefixing the contract will affect the API contract language and guide you through a contractor’s objections if the language needed for legal compliance is not to their liking.
Laws affecting price increases may be specific to a jurisdiction. In addition to guidance on the contract language, legal counsel can also advise on regulatory requirements. For instance, the 2005 revisions to the Price Act require a contractor to provide a trade-off between "cost and performance," usually through a trade-off strategy in the RFP. Contractors are accustomed to this, but perhaps not when it comes to solutions for contract negotiation. According to a 2011 U.S. Government Accountability Office Audit Report for the Department of Defense: "DoD policy encourages cost performance trade-offs by requiring that contracts include annual price increases that include some trade-offs in showcasing innovations and alternative solutions to offset increases, in order to incentivize contractors to be creative in ways that add value during contract performance." Differences such as this, while specific to the applicable regulations, rarely come up unless contractors have had extensive experience with this type of contract before.
Exploring Case Studies and Examples
Case studies are invaluable in understanding the efficacy of annual price increase contract language. Depending on the dynamics of a particular industry or sector, annual price increase clauses can be more or less beneficial to suppliers.
Industries that tend to use an annual price increase clause are energy, where annual increases are common to account for inflation; cable television, where cable television providers raise pricing each January; and healthcare where Blue Cross-Blue Shield providers increase prices each July. Other industries where annual price increases occur include utilities and consumer goods, such as Campbell Soup.
For example, in Gardner v. Intersil Corporation, with the assistance of a strategic hire made by TCU, Intersil entered into a nondisclosure agreement ("NDA") with Gardner regarding Gardner’s qualifications for a technology position. As a result of the NDA, which contained annual price increase language providing for a scheduled price increase each year during the term of that employee’s employment, Gardner was entitled to a minimum price increase each year. Intersil claimed that the price increase clause contained in the NDA, which Intersil’s corporate counsel had approved, was too broad and that the price increase should not have occurred. The Court was unwilling to rewrite contract language which was readily understandable. The Court refused to rewrite the language and held that Gardner was entitled to a price increase in accordance with the terms of the NDA. This case highlights the importance of having counsel draft and review documents with annual price increase language to ensure clarity. Otherwise , there can be disputes over the terms of the annual price increase language.
As to whether price increase language was drafted effectively, we look to Isolagen, Inc. v. Timmins, which involved separate agreements containing annual price increase language between Ernst & Young and its Audit Partners. In this case, Isolagen, the plaintiff, alleged Ernst & Young, the defendant, breached the contracts by failing to provide price increases after Isolagen had entered into various professional service agreements with Ernst & Young. In analyzing the contract language used by Ernst & Young (which was consisted of almost half a page), the Court held that: The contract language contained price increase language that was easy to understand and gave a clear outline of what increases Ernst & Young would give Isolagen. In contrast, in Peters v. Omaha Com., L.L.C., the Court would not enforce the annual price increase language in an agreement between an Omaha newspaper and a distribution company. The agreement stated, "[The deposit] will increase each January by the cost of living as recorded by the government of the United States of America." This type of phrase, i.e. "cost of living" or "cost of living index," is not specific enough for a contract to be enforced properly and is practically meaningless. It is imperative that the price increase be clearly defined.