Contracts Can Save Companies from the Worst of Inflation

Published on
22/12/2022 10:41 AM
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Inflation in the United Kingdom hit a 40-year high of 10.1% in July. The Bank of England forecasts that inflation in the UK could reach as high as 18% next year. The impacts on British companies will include higher prices for sourced goods and higher employee salaries.

Once considered a short-term anomaly, inflation now presents a serious and ongoing risk to margins. Companies must turn to their contracts to protect themselves from the worst effects of inflation, with insights into commitments and obligations playing a vital part.

Using contract language to respond to inflation

Certain contracts, especially long-term contracts, often include price-adjustment clauses that allow sellers to ensure their prices keep up with inflation. No matter what side of the transaction you’re on, it’s critical to understand what’s in your contracts: sellers need to know what they’re entitled to; buyers need to know what to expect, and both parties need to plan accordingly. Sourcing and CRM systems rarely provide the necessary information and detail to make informed decisions.

Gaining visibility into your existing contract portfolio is the first step to responding to inflation. However, this task is difficult because inflation clauses are often not standardised across contracts.

Instead, inflation clauses may vary by the index used or the adjustment schedule they follow.

Inflation clauses come in many flavours

Across a body of contracts, some might be tied to CPI, some to ECA, some to COLA, and some to the Foreign Exchange Market (Forex). Some might allow for bi-annual or annual price adjustments. Some contracts have no inflation clause at all.

This kind of variation makes it impossible for companies to take bulk actions across their commercial operations – e.g., a 3% price increase across all contracts may not apply or may not be accepted.

Instead, companies are forced to look at every contract individually and take bespoke action on it. Done manually, this amounts to an enormous effort and is undoubtedly incomplete.

Only through digital management of contracts, with visibility into their clauses, can you truly grasp what's in your contracts and how you should respond.

How technology can help

Contract lifecycle management software platforms, often utilising artificial intelligence and machine learning, can help surface contracts containing inflation clauses; contracts that refer to inflation but do not identify specific indexes; and those with no mention of inflation.

With this data, companies can quickly form a plan of action to address areas where contract value is being left on the table and take concrete steps to address it.

Finding clauses is just the beginning.

Once companies find inflation clauses, the next step is taking action.

Especially in cases where the price adjustment clause leaves room for interpretation, you will likely need to involve your legal department, which may have to rely on dispute resolution clauses to ensure the company gets a fair deal.

The question for large enterprises then becomes: how do you manage hundreds or thousands of these matters as inflation triggers potential conflicts across the board?

The ideal state is to have a single source of truth—the contract lifecycle management system—that can highlight which contracts have the most financial value, the most exposure to price pressures, and the most room for interpretation (because there is no operationalising language for such price adjustment language).

With this centralised information, teams can assign resources to adjustments that maximise return on effort. And because contract data is already extracted and associated with each matter, contracting teams have a head start on understanding what recourse they can pursue.

What happens if there is no inflation clause?

Not all contracts have inflation clauses. Before the recent surge, inflation had been hovering around 1% annually; for short-term contracts, they seemed unnecessary.

A lack of inflation clauses doesn’t necessarily mean nothing can be done for those on the sell-side of the equation. Some lawyers suggest that companies could claim force majeure and/or commercial impracticability to get out of contracts.

Without weighing in on that debate, we will emphasize again that the first step is understanding what’s in these contracts. If companies can identify which of their contracts don’t have inflation clauses and how much revenue they are associated with—that alone gives them a strong view of the risk they face so they can manage it.

Furthermore, they can calendar out when the contracts expire/renew, so they can be sure to exit or renegotiate contracts as soon as possible.

Creating better contracts moving forward

In parallel to understanding the current risks and opportunities around inflation, it’s also important to agree on a clear negotiation strategy when entering into new agreements. 

These strategies will rely on inputs from critical stakeholders in the enterprise—from legal, finance, procurement, and sales. Whatever negotiation strategy is devised, companies will then need to make sure the strategy is followed at the negotiation table. Using CLM technology, proactive businesses can drive their preferred indexation language into new agreements or agree on negotiation strategies that best fit their needs. Specific controls can also be implemented to ensure inflation is thoroughly accounted for.

Conclusion

After the last several years, inflation is just the latest proof that digital systems are critical to responding to today's challenges.

Contracts are the foundation of commerce: They define whom you’re buying from, whom you’re selling to, and the rules governing those transactions. But if you don't know the rules—if you don’t know what's in your contracts—chances are you won’t win the match.

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