Meaning
Mathematical expressions used in supply agreements calculate new costs based on changes in raw materials or labor. Using price adjustment formulas removes the emotion from price negotiations by making the change an objective calculation. The formula typically combines several variables into a single weighted result.
It governs the future price of goods but does not change the price of items already shipped.
Input Variable
Specific cost drivers such as the price of steel or labor are the building blocks of the calculation. Each variable is sourced from a public or agreed upon data point to ensure transparency. This ensures that both sides agree on the starting numbers.
Accuracy depends on the quality of the inputs.
Weighting Factor
Assigning a percentage of importance to each variable reflects the actual cost structure of the product being sold. If energy costs are only five percent of the total, then a spike in electricity will only have a small impact on the final price. This precision prevents one volatile material from distorting the whole contract.
Weights are usually fixed for the life of the agreement.
Trigger Level
Setting a minimum threshold for change prevents small movements in the market from triggering an adjustment. A change might only occur if the formula results in a move of more than three percent. Stability is preferred over absolute precision.
