Price Variation Formula

A formula to adjust pricing in the future based upon relating changes in cost elements to independent indices. When negotiating long-term pricing arrangements, each party faces risk and uncertainty. The risk is that, if the parties agree a fixed price for an extended period of time, the buyer may pay more or less than the market price prevailing in the future, and the seller may make more or less profit than they might have done if the pricing was subject to a ‘rise and fall’ clause. The uncertainty comes from agreeing a rise and fall clause, as each party has no knowledge of what future pricing may be, so cannot anticipate costs and revenue. As an alternative to a fixed price or a rise and fall clause, the parties may agree a price variation formula. The parties identify the key variable cost elements in the supplier’s cost structure, the proportion of the total selling price represented by each cost element, and the most appropriate index which can be used to assess future changes in the cost element. For example, labour and material costs are typically included, while overheads and profit are typically excluded. The values are baselined at contract start and then reviewed periodically to assess changes in the published indices, in order to gauge whether a change in pricing is warranted and, if so, in what direction and by how much. See also Logic and Price.

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