Key points
- Winning or negotiating longer-term service contracts can provide greater certainty to your business but also lock in pricing, which brings its own risks.
- Accurate and considered cost modelling is essential, with input from people who understand the operational, technical, and financial aspects well.
- Indexation clauses are the primary protection against inflation, designed to adjust payments in line with cost changes including wages and fuel.
Winning or negotiating longer-term service contracts can provide greater certainty to your business and ultimately help underpin value. But they also lock in pricing, which brings its own risks. Before signing, it’s important to understand the common pricing risks and commercial factors that come with these agreements.
Many of these risks are common and manageable within limits. But bidders should submit pricing and enter contracts with a clear understanding of the risks involved and make sure they are reflected in both your pricing and the contract terms.
General principles
At the start of any service contract, the agreed price sets the foundation for future profitability. While this price may shift over time through service growth or indexation, getting the base annual price right from the start is essential.
Businesses should ensure:
- The base price accurately reflects the full cost of service delivery.
- Cost increases that occur over time are accounted for through indexation or other contractual protections.
- Service change rates are structured to fairly compensate for future adjustments.
When assessing contract pricing risks, it is worth considering the individual costs (wages, maintenance, insurance, plant and equipment) required to deliver the services. Consider when they will be paid over the life of the contract. Then compare this to the nature and timing of how the contract will compensate you for those costs, plus a return. Understanding these inflows and outflows for each specific cost makes it easier to see where the specific risks lie.
Price risk
Perhaps the single biggest risk is the commitment to deliver the contracted services for a fixed price. There are numerous reasons why the costs incurred during a contract term may be different to what was anticipated at the time of contracting. These include underestimating costs and indexation mechanisms that don’t keep pace with actual cost increases, and foreign currency and interest rate exposure. We discuss these in more detail below.
Accurate and considered cost modelling is essential, with input from people who understand the operational, technical and financial aspects well. Some costs will always be uncertain, so it helps to identify and document these risks early. This provides a basis for setting appropriate contingency amounts and margins.
Understanding indexation
Indexation clauses are the primary protection against inflation, which are designed to adjust payments in line with cost changes including wages and fuel. While these mechanisms may seem straightforward, they can become complex in practice. For example, wages might rise mid-year, but revenue adjustments may only happen annually. This timing differential needs to be factored into pricing.
Pricing capital costs
Capital costs, including plant, equipment and infrastructure, often make up a large share of the total cost of delivering a service. Given that these assets can be utilised through the term of the contract, and potentially beyond, it’s important to determine the term over which capital costs should be amortised. This means considering the estimated useful life of the asset, the contract term, and its estimated residual value at the end of term. At the same time, it’s equally important to consider whether any assets will need to be replaced during the contract term.
Fixed or floating interest rates
If plant and equipment for the contract is financed, those costs are usually recovered through the contract price. When factoring in financing, consider whether the debt facility will have a fixed or floating rate. With a floating rate, you may carry interest rate risk for the life of the contract or the facility.
There can also be interest rate risk where you plan to use fixed rate facilities. Be aware of any risk between signing the contract and drawing down the debt, especially if equipment is delivered months or years later. Also, if the contract allows extensions and you plan to refinance residual amounts, factor in the potential interest rate risk at the time of refinance.
Foreign currency risks
Some projects may require buying major equipment, raw materials or other supplies in foreign currencies. Managing exchange rate risk is crucial to protect the profitability of a contract. Strategies include:
- Passing exchange rate risk to the customer through contract clauses that adjust payments based on exchange rate movements.
- Offsetting exchange rate risk through natural hedges. Natural hedges occur when foreign currency exposure is offset by positions or cash flows in the same foreign currency. For example, a product firm that receives US dollars for the products it sells, can use these cashflows to pay costs charged in US dollars (or another currency pegged to the US dollar).
- Using financial instruments such as forward contracts, options, and swaps to lock in exchange rates for future transactions. These tools work in different ways depending on the nature of the business. These instruments come with their own risks that need to be managed.
Emerging technologies and cost uncertainty
When incorporating new technologies or service models such as electric vehicles, automation or digital platforms, there is often no historical data to draw on. The new technologies can add significant value to a contract bid, but they also make it harder to estimate costs. It is sensible to include contingency costs to allow for these unknowns.
Service expansion and unit rates
It’s common for services to be increased or expanded during a contract. For this reason, service growth or change rates — the prices agreed in advance for extra work –are often priced separately from the base contract. However, these rates can be overlooked under tight bid timelines but become critical when service volumes increase significantly.
In pricing service unit rates — the prices for each part of the job–contractors should have a clear understanding of incremental costs associated with higher volume and how service units are defined.
Additionally, some contracts may not cover extra overheads like insurance or administration costs that may increase with service expansion. If they’re not covered, you should build them into your unit rates.
Termination for convenience
Many service contracts include a termination for convenience clause, allowing the customer to end the agreement early without cause. While this provides flexibility for the customer, it introduces financial risks for the supplier. To mitigate this:
- Negotiate fair compensation for early termination, including unrecovered capital costs, redundancy costs and demobilisation expenses.
- Some contracts include amounts to compensate the contractor for the loss of profits associated with early termination.
- Structure capital investments to minimise exposure, such as leasing or shorter asset life assumptions.
Understanding the financial implications of early termination is essential to protect long-term viability and keep the contract commercially sound.
Assessing competitiveness
At the end of the day, not all risks can be mitigated, and businesses are often rewarded for the risks they choose to take. Contingency can help cover some risks but it impacts the competitiveness of a bid. If you’re the incumbent provider, you can benchmark your bid against your actual cost base and the existing contract price. For new contracts, you’ll need to rely on benchmark data from other contracts or reliable available sources.
It’s also worth measuring return metrics such as internal rate of return to assess the financial viability and competitiveness of your bid.
Next steps
Before committing to a new contract, talk to your Pitcher Partners representative. We can help you identify and understand risks, refine your pricing, and protect your long-term profitability.
