Renegotiating Long-Term Commercial Contracts for Greater Cost Savings

All long-term commercial contracts that represent significant and fixed costs for a business are suitable for renegotiation. A comprehensive approach with flexible pricing terms and robust performance management leads to significant savings and greater resilience.

In the ever-evolving global business landscape, effectively managing commercial and supply chain contracts is crucial for controlling costs and ensuring operational efficiency. Renegotiating long-term contracts offers a strategic opportunity to optimize costs, improve terms, and enhance supplier performance.

This chapter explores key strategies for renegotiating long-term supply contracts with a focus on cost optimization.

Why renegotiating long-term commercial contracts is important for cost optimization

Market conditions can change significantly over time due to factors like economic shifts, new regulations, or technological advancements. Renegotiating contracts allows businesses to adjust terms to reflect current market realities, ensuring they are not overpaying or locked into unfavorable terms.

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Regularly renegotiating contracts can provide leverage to negotiate better terms, whether it’s pricing, payment terms, or service levels. This can help in reducing procurement costs and overall operational expenses, as well as lead to more favorable provisions that align with the company’s current needs and market conditions.

In principle, all long-term commercial contracts that represent significant and fixed costs for a business are suitable for renegotiation. In addition to supply chain contracts, renegotiating lease contracts can yield substantial cost savings for companies. For instance, amidst the rising vacancy rate of office buildings, one of our clients successfully negotiated a discount of over 30 percent with the landlord, along with an RMB 1 million cost-sharing arrangement for renovations.

Key considerations in long-term commercial contract renegotiation

Depending on the type of commercial contract, the key renegotiation points and considerations may vary. In this section, we’ll explore supply chain contracts and lease agreements as examples.

Supply chain contract renegotiation

Supplier review mechanisms

Given the increasing financial difficulties faced by many companies and new supply chain compliance requirements resulting from geopolitical tensions, it is crucial to incorporate supplier review mechanisms into long-term supply chain contract renegotiations. These reviews should focus on various aspects, including inventory management, financial health, operational status, environmental and good governance practices, and mandatory human rights compliance. Such regular reviews help identify potential risks and ensure that suppliers meet the required standards. This proactive approach can prevent costly disruptions and ensure a reliable supply chain.

Price adjustment mechanisms

Incorporating price adjustment mechanisms in contracts is important for managing cost fluctuations and to maintain fairness. Contracted parties can agree to adjust prices when certain factors change, such as:

• Changes in laws, regulations, and national policies (e.g., VAT rate changes).
• Design changes, significant workload increases (e.g., by 10%), or new customer requirements.
• Exchange rate fluctuations.
• Raw material price fluctuations exceeding a certain range (e.g., 3%-5%).

These mechanisms provide flexibility and ensure that contracts remain fair and relevant over time. For example, if the cost of raw materials increases significantly, a price adjustment clause can prevent the supplier from incurring losses, which could otherwise lead to supply disruptions.

Managing currency risk

When engaging in international business, managing currency risk is essential. Companies can use various financial instruments, such as forward contracts, futures, and options, to hedge against currency fluctuations. These tools help stabilize costs and protect against adverse exchange rate movements. For instance, a forward contract can lock in an exchange rate for a future date, providing certainty in pricing and protecting against unfavorable currency shifts.

Designing favorable payment terms

Payment terms play a significant role in managing cash flow and capital costs. In contracts with customers, businesses can consider implementing payment in advance, deposits, and several payment installments based on delivery milestones. Shortening payment terms (e.g., 90 days) can also help save on capital costs by reducing the time capital is tied up in receivables.

Conversely, in contracts with suppliers, businesses should try to lengthen payment terms to improve cash flow. Utilizing financing facilities like factoring can also be beneficial. Factoring involves transferring accounts receivable (AR) to a bank or factoring company, which pays the seller in advance. Typically, the factoring fee and interest are paid by the buyer. This arrangement can provide immediate cash flow to suppliers, ensuring they can continue operations without financial strain.

Ensuring back-to-back contracts

To minimize risks and ensure consistency, the contract with the supplier should align with or be stricter than the contract with the customer. This alignment helps prevent discrepancies and ensures that the terms agreed upon with customers are met by suppliers. For instance, if a customer contract includes strict delivery timelines, the supplier contract should mirror these timelines to ensure compliance and avoid penalties.

Implementing anti-bribery measures

Inserting anti-bribery clauses in supply contracts is essential to avoid under-the-table costs and ensure ethical practices. Larger companies may sign separate anti-bribery agreements with suppliers or establish internal anti-bribery systems. Organizing training for both suppliers and internal staff can further reinforce these measures and promote a culture of integrity. This proactive approach can prevent legal issues and protect the company’s reputation.

Lease agreement renegotiation

In lease contract renegotiation, businesses must establish a bargaining position to initiate negotiations with the lessor. Our experience indicates that lessors are willing to negotiate under certain scenarios:

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• The Lessor is a reputable company/group with reasonable in-house legal team.
• The Building is new, and the Lessor wishes to attract new Tenants.
• The Tenant is renting a large area for a reasonable long term.
• The Tenant can introduce other potential Tenants into the Building.
• The Tenant is a famous or reputable group/company.
• The Tenant can point out several obvious faults of the Lessor or flaws of the Building to push the Lessor to negotiate on other conditions.

When initiating lease contract renegotiation, companies should carefully consider all terms that impact costs, not just the rent term:

(This article is an excerpt from the latest issue of China Briefing Magazine, “Cost Reduction Strategies in China“.)

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