Editor’s Note: Dr. Hough is a frequent contributor to this blog.
Buyers use escalator clauses to allow suppliers to maintain a profit when their costs increase. Suppliers otherwise would be reluctant to enter into long-term agreements during periods of high inflation. They fear that possible increased costs for their raw material, labor, overhead and administrative expenses might complete.
One way that suppliers protect themselves without entering into an agreement that contains an escalation clause is to make the price high enough to offset any expected increases. The problem with this is that the buyer pays more than is justified up front, and could pay an excessive price over the entire duration of the contract if the expected cost increases never occur. It is usually better if the buyer and seller agree to include an escalation clause. This allows the seller to increase the price by the percentage of cost increases. Buyers usually require documented proof of actual cost increases. The proof may be in the form of previous and current invoices for raw material. Other proof may be labor contracts that show the effective dates and amount of hourly wage increases.
For the last sixty years buyers have become so accustomed to inflation that price increases are expected. Therefore, escalator clauses seldom include a provision for deflation or cost declines. It should be a two way street for price adjustments. If the supplier is allowed to maintain the same profit margin when costs go up, then the buyer should be protected if there is a decline.
The whip saw economic waves of the past 25 years prove that prices can fall as much as they can rise. If you make long term agreements to purchase at fixed prices or without a provision for price declines, you would be forced to pay the higher prices while your competition might be paying less.