Are fixed price contracts good or bad for your business?
Released On 16th Jan 2023
Are fixed price contracts good or bad for your business?
To begin this is a sad tale about a subcontractor in the house building industry, they had to fix their prices to win contracts, but didn’t put measures in place to help better protect them. At a decent margin of 40%, even with price rises of 5 – 10%, they should have made decent money.
But following Covid, then Brexit, and the ramping up on the new build at Hinkley Point, labour was in short supply where prices increased by 30% and materials more than doubled. This meant the gross margin that was expected of £800,000, dropped to nil.
The company couldn’t negotiate cost changes because there was no provision for substantial changes in the contracts. And as most of the contracts were with big corporates, they were not open to price increases. The business was struggling, and with these price rises over a period of about three months, they had no option in the end other than to close the business. And even if the corporates had eventually negotiated, the process would probably have taken so long that they’d have gone out of business anyway. They were so dependent on that money coming in, that if they stopped work on the contracts then they wouldn’t have got any money – so it was unfortunately a lose-lose situation for them.
So are fixed contracts good or bad for your business? There is no simple answer – but pros and cons and points to consider.
What is in a fixed price contract?
Nearly every business has a fixed priced contract. They come in many forms such as sales contracts for example where you’re giving fixed prices for construction or maintenance contracts. They are also relevant in your cost base as you may have suppliers on fixed prices such as a lease for premises or vehicles. Most businesses also have other fixed price contracts in their overheads such as telecoms, mobile phone contracts and software costs etc.
What do I need to consider?
The price (which can be for a multitude of services) can be per product but the contract has other terms. It’s not just the terms and conditions but it also has something called scope or specification.
For example, accountants love widgets, so if we’re talking about a widget you need to know exactly the size, dimensions, the material and the colour of the widget for that price. You also need to know how many widgets you’re supplying and to what time scales. For instance, are you supplying 10,000 widgets in a week or over a period of a year? All of this information can affect your price.
Furthermore, you need to know what the customer is responsible for which is called attendances or dependencies. So, for instance when it comes to logistics – consider are you delivering or are they picking up product? Or if you’re in construction, is the customer providing a free forklift at your convenience?
Other contract items will include terms and conditions, such as any inflationary clauses, guarantees, bonds etc.
Should I seek professional advice?
Professional advice should be sought before entering any contract which may have a major impact on your business. Then it is important you understand and plan for all eventualities.
For instance, if you take on a lease for a premises you’ll go to a solicitor where items such as break clauses will be important to look out for, rather than signing for long lengthy contract (e.g. 12 – 15 years). This way, after a period you can re-evaluate what’s happening and can decide if you wish to leave or remain with that contract. It’s quite common to ask for a two, three or five year break clause, just in case you want to move for whatever reason.
What measures can I put in place for things out of my control?
Over the last 18 months, all businesses have experienced increased labour and materials. Labour has been in short supply meaning extra costs in wage rises, incentives and using agency or subcontract labour.
Supply delivery times have also been an issue, and businesses have been penalised by customers for non-performance. This can be a real risk, especially when you’re under pressure to perform and you can’t due to issues out of your control. There might have been periods where you just couldn’t get materials, where bigger businesses buy up everything suddenly and therefore you can’t get hold of it. Fuel has also increased over the past couple of years. And it goes up and down which also effects the transportation links and getting it through the pipelines. The dollar rate has a major effect on it also. So, if you’re dependent on materials from overseas, make sure you think about maybe a currency clause in case sterling weakens.
If you’re selling at fixed prices you have to look at what affect the above might be having on your costs so perhaps have an inflationary clause inserted based on your largest costs, whether that’s labour, materials, etc. You could look at having some sort of clause there, like force majeure – by force majeure you’re talking about things that are outside of your control.
Are fixed contracts too risky?
No, businesses should consider it. There are lots of fixed price contracts and some you’ve got to take them if you want to, for instance, have fixed phone contracts. But always go in with your eyes open. Especially when you’re supplying, selling etc. We have just discussed terms and risks, but there is a benefit.
The first benefit is certainty. You know what you’ve got to pay or what you’re going to receive. As long as you sort the contract out correctly, you know the terms of payment and when you’re going to get it. That makes it easier for you to control budgeting, planning etc. However, the market could swing the other way; where labour and material prices go down, and if sterling strengthens, suddenly you may be paying much less for your imports so that can be a major benefit. You have to think what’s going to happen in the future.
Are fixed price contracts good only for the buyer in this current climate?
Potentially, but that will change and going forward it will flip to the seller. But are we at that point? Not just yet, but it’s coming. We have done exercises with clients where they’re in a fixed price contract and we’ve been through their pricing and their build-up of their costs to help them identify how they can actually improve the profits on those contracts, so there are some opportunities if you look closely enough and go for it. When people have a bad contract they tend to throw resource at it. Actually, you’ve got to look at it and see if you can do it a different way. Also, you can talk to your customer and just say ‘I can’t do this, sorry, my prices have gone up 40%’. Get advice and think laterally and outside of the box.
How can you make sure you get paid on time?
Try to, as much as you can, to build good relations with your customer. If someone’s not paying you, but they come up and chase you for that widget or that next part of the painting job, you can start asking them “How can I do that? You don’t pay me, so I can’t pay my supply chain”.
If your customers feel for you, and want to help you, they will help you and make sure you’re paid on time and they will listen. But you have to understand your customer. You have to have those relationships built up over time. Following the process is also a crucial part of getting paid on time. Having the right paperwork and making sure that your operations people understand that if you’ve got the documentation and right communications in place that means a higher likelihood that you’ll get paid.
Top Tips
Keep an eye on your existing contracts: Certainly watch contracts that continue after the initial period, such as mobile phones. As we’ve experienced, the phone companies often don’t tell you when the rate has dropped or keep charging the same full rate after you have paid for the phone in the first two years. Or buying software, is it being updated? If you’re on a contract for two or three years are you getting constant updates? Otherwise you could be out of using an old system when a better one is available. So always look at those sorts of contracts as well.
Future planning in an uncertain economy: With heading into recession – prices are still going up in a lot of areas. But will they come down in 6, 12, 18 months time? You’ve got to look at each case in its merits and if you’ve got any concerns, ask for help. Talk to your advisers as they can often lead you through all the pitfalls and how to mitigate them. However, sometimes you have to negotiate that contract to help to get the better terms. Often, you can usually negotiate price, scope, dependencies and timing. You can’t negotiate much with the terms and conditions themselves, although you can put a cap on it, like liquidated damages. If you can’t do anything, then look at mitigation. Can you mitigate, like forward planning currency? Can you buy forward or something such as having a forward rate that will change dollars into sterling at an agreed exchange rate.
Final thoughts…
There are benefits to fixed price contracts, but you need to be fully aware of the risks and how to minimise or mitigate them in case things go wrong.
As a business owner, you need to understand their numbers but it’s also vital that you understand what the words mean in these contracts. This means understanding exactly what you have to supply, what the other party is supplying, how your prices are made up, what are the timings and what happens if things go wrong.
In such a changing, uncertain, lonely world for business owners, you need good management information and support to help you make the right decisions for you and your business.
We advocate Xero, because we believe with the right support it will give you up-to-date meaningful numbers that you need to run your business in today’s changing world.
If any of the issues resonate with you then pop an email over to chatwithgraham@wessexcommercial.com and we’ll set up a one-to-one meeting.
