Two different numbers hide behind the cost of getting out of a contract, and mixing them keeps businesses in contracts that lose money every month.
The cost of terminating a supply contract early is the price premium you keep paying through the notice period plus the one-off costs of leaving: committed materials, unamortised tooling, new tooling and requalification. On an illustrative component bought at 112.00 against a market price of 98.00, with 12 months' notice, walking away costs 1,357,000. Against staying to expiry, though, only the costs caused by leaving early count, and with 30 months left exiting still saves 708,000.
Worked in full in Contract Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Two different questions hide behind "what does it cost to get out". The first is what the contract costs you against buying at market from today, which is the number that should be computed at signature, when the notice period and the tooling clause are still negotiable. The second is whether to exit now or ride the contract to expiry, which is the number that decides the exit. They use different costs, and mixing them is how a business talks itself into staying in a contract that is losing money every month.
| Input | Value |
|---|---|
| Units a month | 4,000 |
| Contract price, per unit | 112.00 |
| Market price available, per unit | 98.00 |
| Months remaining on the term | 30 |
| Termination for convenience notice, signed / offered by the other bidder | 12 / 6 months |
| Materials the supplier committed for the forecast, payable on termination | 180,000 |
| Unamortised tooling balance, payable on termination | 120,000 |
| Tooling at the new supplier (the old tooling stays with the supplier) | 300,000 |
| Qualification of the new source | 85,000 |
Cost of walking away = (contract price − market price) × units through the notice + all one-off exit costs
Net benefit of exiting early = premium avoided after the notice ends − termination-specific costs
In Excel, with the price gap in B1, monthly units in B2, notice months in B3, remaining months in B4 and termination-specific costs in B5: =B1*B2*MAX(0,B4-B3)-B5. Switching costs that would be paid at expiry anyway are left out of the second formula.
Step 1, the price gap: 112.00 − 98.00 = 14.00 a unit, 14.3 per cent above market, or 56,000 a month. Step 2, the notice premium: 12 months × 56,000 = 672,000. Step 3, the one-off costs: 180,000 + 120,000 + 300,000 + 85,000 = 685,000. Step 4, the cost of walking away: 672,000 + 685,000 = 1,357,000, or 28.27 a unit over the notice year.
Step 5, the decision. Staying to expiry costs 30 × 56,000 = 1,680,000 above market. Exiting now ends the premium after the 12 months of notice, so it avoids 18 months of it, 1,008,000. Of the one-off costs, the new tooling and qualification, 385,000, are switching costs: they fall due whenever the business changes supplier, now or at expiry. Only the committed materials and the unamortised tooling, 300,000, are caused by leaving early. The net benefit of exiting is 1,008,000 − 300,000 = 708,000.
| Notice | Notice premium | Cost of walking away | Premium avoided after notice | Net benefit of exiting now |
|---|---|---|---|---|
| 12 months, as signed | 672,000 | 1,357,000 | 1,008,000 | 708,000 |
| 6 months, as the other bidder offered | 336,000 | 1,021,000 | 1,344,000 | 1,044,000 |
Six months of notice conceded at signature cost 336,000 the day the business decided to leave. A notice period and a tooling clause never appear on an invoice; they are priced only when someone computes the exit, which is why the exit should be computed before signature, as part of the total cost comparison of the bids.
The arithmetic ignores the time value of bringing the 385,000 of switching costs forward by 18 months, from expiry to the end of the notice, and any price movement after the notice. Over a horizon this short both are small next to the 708,000; on a long remaining term, discount the monthly premium.
| Months remaining | 12 months' notice | 6 months' notice |
|---|---|---|
| 12 | −300,000 | 36,000 |
| 18 | 36,000 | 372,000 |
| 24 | 372,000 | 708,000 |
| 30 | 708,000 | 1,044,000 |
| 36 | 1,044,000 | 1,380,000 |
Exiting pays once the remaining term exceeds the notice plus 5.4 months, the time the avoided premium takes to repay the 300,000 of termination costs: 17.4 months on the signed notice, 11.4 on the shorter one.
| Gap to market, per unit | Cost of walking away, 12 months | Net benefit, 12 months | Net benefit, 6 months |
|---|---|---|---|
| 2.00 | 781,000 | −156,000 | −108,000 |
| 4.00 | 877,000 | −12,000 | 84,000 |
| 8.00 | 1,069,000 | 276,000 | 468,000 |
| 14.00 | 1,357,000 | 708,000 | 1,044,000 |
| 20.00 | 1,645,000 | 1,140,000 | 1,620,000 |
The break-even gap is 4.17 a unit on the signed notice and 3.12 on the shorter one. Below that, the contract is cheaper to finish than to leave.
Charging the switching costs to the exit decision. Count the 385,000 of new tooling and qualification against leaving early and the net benefit falls to 323,000, and the break-even term stretches to 24.2 months. A business with 20 months left would then conclude it should stay, pay 56,000 a month above market until expiry, and then pay the same 385,000 to switch anyway. The switching costs belong in the comparison only if staying means renewing, never changing supplier at all.
Compute two numbers. The cost of walking away, 1,357,000 here, prices the notice and tooling clauses and belongs in the bid comparison at signature. The net benefit of exiting, 708,000, counts only the premium avoided and the costs caused by leaving early, and decides the exit. The free workbook for this case prices the exit cost of a signed agreement against the notice the rejected bid offered, with every clause of the contract alongside.
Its value sits in the notice period and the costs it makes payable. On the illustrative contract each month of notice costs 56,000 of premium over market, so 12 months of notice instead of 6 cost 336,000 on exit. Price the clause at signature, as part of the bid comparison, when the notice is still negotiable.
When the premium avoided after the notice ends exceeds the costs caused only by leaving early. With a 14.00 price gap, 4,000 units a month and 300,000 of termination-specific costs, exit pays once more than 5.4 months would remain after the notice, so 17.4 months on 12 months' notice. Switching costs paid at expiry anyway do not count.
Only if staying means never changing supplier. If the business would switch at expiry anyway, new tooling and qualification are paid either way and only move in time. Charging the illustrative 385,000 of switching costs to the exit cuts its net benefit from 708,000 to 323,000 and can make a losing contract look worth finishing.
This article is one calculation from Contract Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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