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Congratulations you have just landed a very big tender contract!
Despite this significant achievement you are unsure on how to proceed with the process, and different questions come to mind:
- What type of price indices does SEIFSA offer?
- How do you apply these price indices in your Contract Price Adjustment (CPA); and
- What are the benefits of using the SEIFSA price indices in a CPA calculation?
All of the questions are normal to ask, especially to a new user of the SEIFSA Price and Index Pages (PIPS).
The aim of this blog is to assist you as a potential first-time user of SEIFSA PIPS in understanding the price indices and how to apply same in your CPA after landing that big tender. We also want you to better understand some of the advantages that the correct use and application of the price indices in a CPA can have on the profitability of your business.
Before we go into all the detail, lets discuss the spirit of the CPA. For buyers the profitability is expressed as a function of how well they are able to manage and maintain their costs, whilst suppliers aim to contain or recover as much of the cost as possible. Both parties aim to sustain or ultimately improve the profitability of their businesses.
For the company supplying the product or service, you are assured that you can justify the cost increases calculated from your CPA based on what has happened in the market. On the reverse side, the company buying the product or service can be certain that market related increases are paid out as determined by the CPA calculation, ensuring the sustainability or improvement of business profitability.
SEIFSA offers over 200 PIPS indices that relate to the Metals and Engineering sector. We have data for some of these price indices dating back to the 1960s. SEIFSA’s PIPS have been accepted by sales and marketing personnel and contract and procurement managers. Most state-owned entities and mines only allow the use of the SEIFSA Price and Index Pages for calculating CPA on their contracts. The variables include but are not limited to: Labour, transport, steel, stainless steel and metal indices, production consumables and office overheads.
By including data from these indices in your CPA formula to calculate your escalation, you will be able to accurately calculate the changes in the costs of labour, steel, transport and other inputs that affect the final cost of manufacturing in a business. The results from the CPA calculations allow the tenderer to adjust prices in line with unforeseen cost increases.
Applying SEIFSA PIPS
Now that you have an understanding of SEIFSA’s price indices, the next step is on application in a CPA contract. In your CPA the price is adjusted based on the following contract price adjustment example:
- P – Escalated or New price
- P0 – Base price
- L – Labour percentage
- S – Steel percentage
- EI – Relevant index at the end of the escalation period
- SI – Relevant index at the start of the escalation period
NB! This is a basic example of a CPA contract based on merits in labour and steel indices only.
Although the mathematical formula is an important aspect in CPA, it is also vital to understand the optimal combination of indices to link to each of your cost components. This can be explained with the following example:
You are an employee in a financial position in a company with the responsibility of negotiating and/or calculating the contract price adjustment. One of the material components in your contracts is only specified as steel. However, you do not have the technical knowledge regarding the different types of steel and as a result, you might link the steel material component to one of the stainless-steel indices. The hot rolled steel index that you were supposed to use might increase by 20%, whereas the movement in the stainless-steel index that you incorrectly allocated was only 2%, hence drastically impacting your business profit margin.
The basic logic behind a CPA is to adjust the base price with a market related change to get your new price, ensuring a fair outcome for both the supplier and buyer. When you calculate a CPA linked price the risk is spread between both parties to the contract.
It is also very imperative to remember that no 2 contracts are the same. This holds true even if you have 2 or more contracts with the same company to deliver the same product with the same product specifications. Herewith an example which clearly explain the stated scenario:
You work for company AA that is located in Johannesburg and have 2 contracts with company BB. Based on the terms of these contracts you have to manufacture and deliver the same product with the same specifications but to 2 different branches of company BB. According to the terms of your contracts you have to deliver one of the manufactured products to a BB branch that is also located in Johannesburg while the other product has to be delivered to the BB branch in Cape Town. Thus, due to the geographical distance between your offices in Johannesburg and the BB branch in Cape Town, the transport portion that relates to this contract will be higher than the transport portion of the contract where you have to deliver to BB branch in Johannesburg. Therefore, because no 2 contracts are the same, the CPA formula will be unique per company, contract and product or service. You have to be transparent in calculating your contracts in order not to be accused of transfer pricing.
So, to see the improvement in the profitability of your business, subscribe to SEIFSA PIPS and attend one of our contract price adjustment workshops to start making intelligent decisions.