23 July 2009 | Douglas Mathie

Indexation clauses in contracts, originally there to protect suppliers, are worth examining in times of deflation to see if they can benefit the buyer, says Douglas Mathie

In April the measure of the annual change in the UK's Retail Prices Index (RPI) went negative for the first time since the late fifties. That means the RPI is lower now than it was a year ago.

But what impact does this have on the management of your existing contracts, and on negotiations for future deals? In some contracts the price will vary with a specific industry index. In one I negotiated, for bulk printing of bank statements, the price was affected by movements in the cost of paper.

However, many contracts also contain indexation clauses that allow price variations linked to more general inflationary indexes such as the RPI, RPIX (RPI excluding mortgage interest), and the Average Earnings Index (AEI). A software maintenance agreement, for example, will tie in the supplier for a fairly long period, but in exchange will give the supplier the right to increase its price in line with changes in an inflationary index.

Similarly many outsourcing contracts contain indexation clauses. Often these clauses are inserted to protect the supplier against inflation. However, where there is deflation then an indexation clause could potentially be used to obtain a price reduction. So now is probably a good time to review any such clauses in long-term contracts. Check the clause is not "upwards only". Sometimes it will only allow a price increase, and not a price reduction. It is also often the case that only the supplier can initiate the price reduction process.

Understand the time restrictions. Typically an indexation clause will have restrictions on when and how often it can be used - no more than once every 12 months is common. You also need to understand the measurement period - the length of time over which the change in the index is measured. Is it the net change in the RPI since contract signature? Or the net change in the preceding 12 months? Or some other period? All these factors may influence if, and when, you decide to start an indexation.

When negotiating a new deal you should make sure that any indexation clauses allow you a price reduction in the event of deflation. You should also consider what index to use. Notably both RPI and AEI are negative, but other indexes such as RPIX and the Consumer Prices Index remain positive (at least for the time being).

Generally the best index to use is one that reflects the supplier's cost base. Where the supplier's main cost is people then the AEI is a good starting point. But you can be more specific, using the published indexes of IT salaries for example.

However, these are usually only available at a cost, and can be quite volatile. For example, the IT salary index went crazy in 1999 as a result of Y2K work. It is also possible to have a hybrid index for price variation, for example 60 per cent AEI and 40 per cent RPIX.

An indexation clause that was designed to protect the supplier may now work in your favour, but there can be restrictions that might prevent you getting a price reduction. In future contracts try to avoid those restrictions.

* Douglas Mathie is a partner in the technology, information and outsourcing group at Brodies