Meaning
Contractual arrangements that allow a seller to transfer increases in raw material or logistics costs directly to the customer ensure margin stability. The pass through rate defines what percentage of the cost change is reflected in the final invoice. This mechanism protects the supplier from volatile commodity markets and ensures the buyer receives a fair market price.
Price Adjustment
Frequency of the updates depends on the volatility of the underlying index or market price. A pass through rate might be calculated monthly or quarterly to keep the sales price aligned with the current cost of production. These adjustments happen automatically based on the formula agreed upon in the master service agreement.
Cost Sensitivity
Exposure of the final product price to changes in input costs varies by industry. When the pass through rate is one hundred percent, the customer bears all the risk of a price spike but also receives all the benefit of a price drop. Some contracts include a floor or a ceiling to limit the impact of extreme market moves.
Surcharge Trigger
Specific thresholds must be met before a price change is implemented to avoid constant small fluctuations. The pass through rate only becomes active when the cost of fuel or steel moves by more than a set percentage. This prevents the administrative burden of updating price lists for minor variations in the supply chain.
