As of January 2022, the Bureau of Labor Statics (BLS) released a metric indicating that inflation over the last 12 months was 7.5%. BLS’s referenced metric is the Consumer Price Index (CPI). Since 1913, the average inflation as per the CPI has been 3.2% per year. At 7.5%, we are seeing the highest inflation rate since the early ’80s. The purpose of this article isn’t to consider the causes of this inflation; rather, it is to look at how the business community can plan for the potential of inflation (and deflation) in their contract strategies.
Contract clauses may be an important part of planning for inflation, but they certainly cannot be the only planning. Planning for inflation includes a comprehensive look into the operation of a business and an understanding of how inflation may affect the business. An appropriate holistic approach may consider adjusting business strategies, hedging and drafting contracts that account for potential inflation. In addition, maintaining accurate accounting and reporting practices is important when considering inflation. If you don’t know your numbers, it may be exceedingly difficult to identify which inflationary factors impact your business. Accurate accounting is also a good practice in general and often may be helpful if legal disputes ever arise.
Each business may be affected uniquely by inflation. For example, a manufacturing business that relies on metal inputs may have its bottom line significantly impacted by inflation on materials. On the other hand, a restaurant may be more impacted by the inflation of food products. One reasonable approach for these examples might be locking prices for a period of time or building an escalation clause into a vendor agreement.
An escalation clause is a term added to an agreement that stipulates a change in price based on a predetermined set of conditions. Escalation clauses may be used with customers, vendors, and other parties. An exemplary escalation clause may stipulate that the contract price may increase in relation to the CPI as put out by BLS. A good escalation clause will select an appropriate index, determine how often the repricing applies and set a pricing floor and ceiling.
Virtually any metric may be chosen when drafting an escalation clause. One of the more common metrics is the CPI. There are many variations of the CPI as put out by the BLS. For example, the BLS issues CPI metrics based on energy prices, food prices, new vehicles and many others. Further, the BLS breaks down the CPI metrics by geographic areas, population types, specific categories and so forth.
CPI metrics may be seasonally adjusted or unadjusted. The BLS recommends against seasonally adjusted CPIs in escalation clauses as seasonally adjusted indexes are subject to revision each year.
An exemplary CPI metric for use in an escalation clause by a clothing store in Fargo might be the Midwest CPI for Apparel. The Midwest CPI represents ten northern states in the Midwest. Picking the Midwest as a geography may be important as inflation may affect the Midwest geography differently than other geographies. For example, the Apparel CPI for the trailing 12 months in the Midwest was 3.1%, whereas it was 5.3% nationwide. A difference of 2.2% could significantly impact a big contract.
Further, selecting the Apparel category is more specific to a clothing company verse Fuels and Utilities. The Fuels and Utilities category increased by 11.2% in the Midwest over the last 12 months. In just the few examples provided, there is a huge range of percentage differences, and this is why picking a specific appropriate metric is important.
Frequency of Repricing
A good escalation clause’s second constraint is regarding how often the repricing should be applied. For example, repricing could occur every month with the release of the latest CPI from the BLS, or it could happen quarterly to provide more stability. Again, this decision is largely a business strategy decision.
Pricing Floor and Ceiling
Inserting a pricing floor and ceiling may be an important element to add to an escalation clause. In some businesses, certain price points may cause the business to no longer be feasible. For example, if a lawn care business contracts with its customers using an escalation clause tied to Motor Fuel, it might not maintain customers if the clause results in the customers paying 40% more as per the current Motor Fuel CPI. Therefore, a lawn care company might want to set a price ceiling increase of no more than a 10% increase in a given year. Such a price ceiling may help incentivize customers to sign up rather than being scared to sign such an escalation clause. Alternatively, a business might consider adding a pricing floor. Say, for example, deflation occurs, and the CPI goes negative, a business might want to restrict the possibility of a price decrease.
Ultimately, the contract terms and decisions a business makes need to be done pragmatically. Proposed contract terms are only possible if the parties to a contract are willing to agree to the terms and the terms are suitable to all parties.
Fargo Patent & Business Law, PLLC is an intellectual property and business law firm. The firm helps innovative businesses and inventors develop opportunities by turning their great ideas into protected assets.
The information provided in this article does not and is not intended to constitute legal advice. All information, content, and material is for general informational or educational purposes only. Information provided may not be the most up-to-date legal information, and it is recommended that readers contact their attorney to obtain advice on any particular legal matter.