What is Price Escalation Mechanism (PEM)?
PEM is a process or clause adopted as part of a contract for a commodity or category when it is sourced. It elaborates the method that has to be adopted to change the total selling cost with change in cost of the key cost drivers.
Furthermore, the method to formulate PEM can vary from category to category. Broadly speaking this involves identifying the set of key cost drivers contributing towards the Total Selling Price of a category. After the cost driver or cost component has been identified the next step is to design a mechanism or formula. This is to ensure the price quoted would remain valid even if there is change in the price of key cost component based on a pre-decided index.
Why is it required?
Price Escalation Mechanism provides a platform to both the company (Buyer) and the vendor to discuss and mitigate their risks during the contracting phase itself. It thus lays the foundation for a long term business relationship between two parties. This enables them to work together smoothly despite of fluctuations in economic conditions prevalent in the market.
Some of the examples are as listed below:
||Cost Driver (At Basic Level)
||Cost Driver (At Next Level)
||Transportation (FTL. LTL, Air Freight etc.)
||Diesel, Petrol etc.
||BLS, European Energy Commission
||Paper Based Packing and Packaging categories (Corrugated Box, Folding Cartons, Pressure Sensitive Labels etc.)
||Kraft Paper, SBS Paper Board etc.
||Petroleum Based Packing and Packaging categories (BOPP Film, Shrink Film, Plastic Containers etc.)
||BOPP, PE, PP, PET etc.
||Metal Based Packing and Packaging categories (Metal Cans etc.)
||Iron Ore, Tin
||LME, World Bank Data, NYMEX, BLS
Method to Calculate Price Escalation
The first step to calculating the price benchmark will be to identify the biggest contributing cost factors for that category. Refer to the above listed some of the categories, the biggest contributing cost factors vary across categories.
The next step is to select applicable and accepted indexes for those cost factors which can be checked at regular intervals of time. In most cases, there are industry standard indexes that are available which can be applied to formulate the Price Escalation Mechanism.
Any changes in the pricing will get triggered on the basis of already preset benchmark figures for the selected index. This change can thus be implemented in the new pricing at the beginning of any financial period. For example, change can be implemented at the beginning of each calendar month, quarter, half yearly as the case may be.
Applying this process on a periodic basis, will help both the parties calculate the most accurate pricing for their products. This will help maintain transparency and in addition consolidate a long term relationship amongst them.
Best Practices (Adopted as Part of Our Procurement Services)
- In terms of actual designing of the mechanism following points should be considered:
- The best method is not to predict changes, but instead ensure that the mechanism is neutral, beneficial and equally favorable to both buyers as well as sellers.
- Thorough research should be conducted to identify the contribution (%) of the key components; this can be done through both primary as well secondary research methods.
- The structure or mechanism to be adopted or proposed by procurement consulting companies should be as simple as possible and should be easy to understand.
- The method so adopted should remain valid and reliable even with drastic changes in index.
- The index should preferably be published and governed by neutral and non-profit making organizations. (Acceptable to both buyers and sellers).
Thus as part of our procurement data analytics services, we at EmpoweringCPO help our clients prepare Price Escalation Mechanism that takes into consideration the best practices listed in the above paragraph.