The Dangers of Customer Contracts

Let’s say you sign a contract with a client. You agree to provide a product or service for a set price for the time period required by the contract. The good news is that you have a known revenue stream during the life of the contract. However, signing a contract with a customer also carries some risks.

A stark reminder of these risks was explained in a Wall Street Journal article, "$1 Billion Blunder Trips Up Walgreens" (8/20/14). Here’s a link to the article:

http://online.wsj.com/articles/walgreen-shakeup-followed-bad-projection-1408494546

Walgreens enters into contracts to sell drugs under Medicare Part D. As stated in the article, Medicare Part D subsidizes the cost of prescription drugs for the elderly and disabled. The firm enters into long-term contracts with health insurers to provide these services.

Unfortunately, the price Walgreens pays for the generic drugs they sell went up. Since the contract provided for a set price, Walgreens couldn’t raise prices to offset their cost increases. According to the article, the group writing the contracts did not communicate with the finance group.

Say that your pharmacy contracts to provide a 20-pill antibiotic for $50. Your firm’s cost is $40, so your profit is ($50 - $40 = $10). Profit margin is defined as (net income)/ (sales). In this case, your profit margin is ($10/ $50, or 20%). Assume that net income and sales both mean the same thing.

Assume that your cost for the antibiotic went up to $45. Your new profit is $5, and the profit margin is now ($5/$50, 10%). Your profit margin has been cut in half. You’re stuck, because your contract does not allow you to raise the price.

Consider how to can manage an increase in your costs for a client contract:

·            Inventory: Consider carrying more inventory- which would allow you to “lock-in” the current cost. While this may not be possible for all industries, it’s a consideration.

·            Multiple Suppliers: If one supplier raises prices, maybe a second supplier is willing to keep prices down to get your business.

·            Higher Initial Profit Margin: Build a higher initial profit margin into your contract. If your costs rise, some of the impact can be absorbed into the larger profit margin.

·            Shorter-Term Contracts: Your customer is signing a contract to give themselves some certainty about their own costs. You can use the term of the contract as a way to negotiate a higher profit margin.

Check out my podcast on this subject:

http://accountingaccidentally.podbean.com/e/the-danger-of-customer-contracts/

For blog and article writing, tutoring and speaking on investments and finance, contact me here:

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies (2015)

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