Examine your target’s price-index contracts

With high inflation, due diligence must include scrutiny of price-index contracts to protect against price spikes and margin erosion.

Randy Fike

Randy Fike

Managing Director, Deal Advisory & Strategy, KPMG US

+1 850-247-5888

Today’s extended supply chain is an important part of a manufacturer’s value and should be a focus of any careful M&A due-diligence process. Now that inflation has heated up, one aspect that merits scrutiny is a target company’s price-index agreements.

Price-index agreements are used by vendors to prevent their margins from being eaten by unexpected price spikes. Sometimes, a company will develop a web of such agreements. In one recent deal involving the acquisition of a contract parts manufacturer in Asia, the target company’s entire value chain was indexed to the price of key materials; their third-party logistics provider’s charges were indexed to labor and freight costs, while the U.S.-based final assembly was cost-plus based, and indexed to the assembler’s invoiced prices.

In normal times, these kinds of contracts do not require much scrutiny, but when supply-chain costs are so volatile, such agreements can have a major impact on a target company’s profit margin—whether they stay in place after M&A, are broken, or renegotiated.

Indexing basics

Writing a price-index contract is a game with two sides. If you’re a buyer, your supplier wants to offload as much risk as possible onto you, whereas you want to pay no more than what you have paid before. Indexing agreements can be particularly risky for the buyer. As such, you want the price-index contract to be written in a way that keeps your suppliers healthy, but not so they profit at your expense. Such details can be easily overlooked in the heat of an M&A negotiation.

In your due-diligence process, review every price agreement with three questions in mind. Firstly, does the supplier have a legitimate case for indexing? This type of agreement is intended either to minimize the target’s supply-chain risk, or to help stabilize a partner’s costs. It should cover only those materials that constitute a high proportion of the target company’s cost of goods bought and sold.

Secondly, how much of the indexed material does the buyer need? Often, the amount of raw material used in a component is only a portion of the purchase. Be aware, too, that for some materials, such as aluminum from scrap metal, production surcharges may be separate from the cost of the material itself. Sometimes, the prices of the material and the surcharge may even move in opposite directions.

And thirdly, is the contract appropriate for the situation? There are four basic types of index contracts to choose from:

  • Fixed-price contracts are agreements where the price is held constant throughout the contract, even if there is a change in the underlying cost of the input. This protects against price fluctuations, but its rigidity can make it expensive and constraining.
  • Floating-market-price index contracts fluctuate with the underlying input costs. This eliminates mispricing but gives little protection against extreme price spikes.
  • Straight-collar index contracts allow the price to move freely within a fixed band (e.g., plus or minus three percent), but freezes the price if the seller’s cost goes above or below that band. This buffers against extreme cost spikes, although the price can still change rapidly.
  • Adjustable-collar index contracts allow the price to go up and down within a moveable band, but the final parameters can be reset by mutual agreement. This reduces the risk of mispricing and volatility but can be cumbersome to implement.
"Cost-indexing agreements are a powerful tool for managing price volatility, but like any tool, they are useful only in certain contexts."

There is also a risk they may be broken at the precise moment they are most needed. After all, price pressure can’t be eliminated, only reallocated; at some point, it will be felt in the system. Before you buy, it’s a good idea to understand where and when those points are likely to lie in the target company.