Rising inflation has caused many products and services to cost far more than they did a year ago. But before you pat yourself on the back or curse yourself for signing a long-term contract in advance of the price hikes, it would be smart to check the terms of your agreement.
If you are a seller and your contract allows it, you may be able to increase prices. And if you are a buyer, you should be prepared to mitigate substantial price increases.
You may also want to consider renegotiating your contract, to allow for more — or less — flexibility if you are concerned about future inflation.
Many long-term contracts, including real property lease agreements, employment contracts and those involving the supply of goods and services, employ escalation or price adjustment clauses to account for the effects of inflation. Those clauses are generally based on changes in the Consumer Price Index (CPI), which the U.S. Bureau of Labor Statistics maintains and publishes.
The CPI measures the average change in the prices paid for a market basket of goods and services. There are numerous CPIs for various sectors of the economy, but the two most common are the All Urban Consumers (CPI-U) and the Urban Wage Earners and Clerical Workers (CPI-W), which covers a narrower population of Americans.
Contractual adjustments typically work as follows: The price adjustment clause provides for a fixed annual percentage increase (e.g., 3%) in the price unless the percentage increase in the CPI is in excess of the stated fixed percentage. If the percentage increase in the CPI, year over year, is greater than the stated fixed percentage increase, then the applicable payment or price in the contract (whether rent, product price or service fee) will be adjusted by that greater percentage increase. This type of variable structure (i.e., tied to an index) more accurately reflects real time trends, while requiring slightly more maintenance than its fixed-percentage alternative.
In recent years, the CPI-U had seen modest increases. The index rose at a 1.7% average annual rate over the past decade. Over the past 12 months, however, the all items CPI-U increased 6.8 percent from November 2020 to November 2021, the largest 12-month increase since the period ending June 1982. The increase is broad-based, with the indexes for energy, shelter, food, used cars and trucks and new vehicles serving among the largest contributors.
Some experts believe that while current inflation trends are worse than expected — and might persist longer than originally thought — it will not be as persistent as the U.S. inflation from past decades.
Given the recent trends, it is important for a business to be able to pass along cost increases as best as it can where the competitive market allows. It is also important to understand how to plan for and mitigate such increases if the current trends continue. As these recent developments show, it is always prudent to consider the effects of inflation when it comes to revisiting your current contracts, and while drafting new ones.
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