Onerous Contracts: Spot, Avoid & Protect Your Business
You know, in my two decades navigating the choppy waters of corporate finance, I’ve seen more than my fair share of contracts. Most are great, some are just fine, but then there are the real headaches – the ones that just keep taking, with little to nothing coming back. We in the biz call them “onerous contracts,” and trust me, they’re exactly what they sound like: a burden.
I remember this one time, a mid-sized manufacturing client signed what seemed like a brilliant deal for a long-term supply of a key raw material. The price was fixed, seemed fair at the time and guaranteed volume. Fast forward eighteen months and global commodity prices tanked. Suddenly, they were locked into paying double the market rate for something they could get for a song elsewhere. Plus, their end-product demand dipped. That “brilliant deal” quickly became an onerous contract, draining cash and stifling their competitiveness. It’s a classic tale, isn’t it?
So, what are we talking about here? At its core, an onerous contract is a contract where the unavoidable costs of meeting the obligations under it exceed the economic benefits expected to be received. Think of it this way: you’re paying more to uphold your end of the bargain than you’ll ever get back and you can’t wiggle out of it without incurring even more significant penalties. It’s a losing game you’re legally bound to play.
Now, it’s important to note that the term “onerous contract” itself isn’t explicitly detailed in the latest financial reports I’m seeing, like the Audioboom Group PLC’s unaudited half-year results or the HMRC service agreement. But the principles behind them – managing costs, assessing economic benefits and understanding contractual obligations – are absolutely everywhere in finance, forming the backbone of sound business decisions.
Identifying an onerous contract isn’t always like hitting a brick wall; sometimes it’s a slow, creeping erosion. But there are usually some red flags if you know where to look.
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Skyrocketing Costs: Are the expenses associated with fulfilling the contract escalating beyond original forecasts? Maybe raw material prices have surged or labor costs have gone up unexpectedly. For instance, the “Agreement Scottish Income Tax operation by HMRC” highlights that the Scottish Government “will reimburse HMRC for net additional costs wholly and necessarily incurred as a result of the implementation and administration of the Income Tax powers” [footnote 2] (gov.scot, “Service Level Agreement”). This agreement clearly recognizes that costs can be “additional” and need specific frameworks for reimbursement, underlining how critical cost management is in any long-term arrangement to prevent it from becoming a burden.
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Dwindling Revenue or Benefits: Is the income you expected from the contract falling or are the strategic benefits simply not materializing? Perhaps market demand for your product has dropped or a key client scaled back their orders.
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Operational Inefficiencies: Is the contract forcing you into an inefficient production process or service delivery model that’s eating into your margins? Sometimes, the terms of a contract can prevent you from adapting to new, more efficient ways of working.
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Negative Gross Margin: The most obvious sign, right? If your gross profit from the contract flips into a loss, you’ve got a problem. Just look at the flip side: Audioboom Group PLC, according to the RNS news from Halifax, saw their H1 gross profit for the six months ended June 30, 2025, hit US$7.4 million, up 30% on H1 2024, representing a gross margin of 21% (investments.halifax.co.uk, “Rns news - Halifax”). That’s what healthy contracts look like – positive, growing margins. An onerous contract is doing the exact opposite.
Why do these deals, which seemed so promising on paper, suddenly turn into financial vampires? It’s rarely a single villain; more often, it’s a confluence of factors.
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Market Swings: This is a big one. Think about that manufacturing client I mentioned. Unforeseen drops in commodity prices, shifts in consumer demand or even the emergence of new, cheaper competitors can make your once-profitable contract a liability.
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Regulatory Earthquakes: New laws, unexpected taxes or stricter environmental regulations can suddenly increase your compliance costs or operational expenses under a contract. Remember how the HMRC agreement details “rechargeable costs” for operating Scottish Income Tax (gov.scot, “Service Level Agreement”)? Even with such provisions, new regulations could introduce unforeseen “additional costs” that might not be fully recoverable, turning a portion of the contractual obligation onerous.
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Technological Obsolescence: Let’s say you’re locked into using an older technology or process due to a long-term contract, but a new, disruptive technology emerges that makes your current setup incredibly expensive or inefficient by comparison. You’re stuck.
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Poor Initial Forecasting or Due Diligence: Sometimes, the problem was there from the start, just hidden. Overly optimistic revenue projections, underestimation of costs or a failure to properly assess market risks can set a contract up for failure before the ink is even dry. It’s why things like careful consideration of “different tax and economic consequences for the company and participants upon grant, vesting, purchase or later sale” are so crucial in agreements, as highlighted in the discussion around equity incentive plans for private companies (michiganitlaw.com, “Comparative Summary”). Every clause matters.
The moment a contract becomes onerous, it triggers some serious accounting implications. Companies are generally required to recognize a provision for the expected loss. What does that mean? It means taking a hit on your income statement now for future losses that are unavoidable.
Imagine a company like Audioboom, which just reported a US$1.8 million H1 adjusted EBITDA profit, up 500% on H1 2024, with H1 revenue of US$35.1 million for the six months ended June 30, 2025 (investments.halifax.co.uk, “Rns news - Halifax”). That’s fantastic news! But if they had an onerous contract, that profit would be directly reduced by the provision for future losses. It’s like having a weight tied to your ankle, dragging down your otherwise stellar performance. This provision represents the unavoidable cost that exceeds the expected benefits, even if the cash outflow hasn’t happened yet. It’s about presenting a true and fair view of a company’s financial health, even when it’s not pretty.
So, what do you do when you realize you’re stuck in an onerous contract? It’s not about throwing your hands up in despair. There are strategies, though none are a magic bullet.
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Early Identification: The absolute best defense is a good offense. Regularly review your contracts and their financial performance. Don’t wait until the losses are catastrophic. Set up warning indicators and act on them.
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Renegotiation: Can you go back to the table? Sometimes, if you can present a clear, mutually beneficial alternative, the other party might be open to renegotiating terms. Perhaps you can adjust volumes, extend timelines or even find a way to share risks more equitably. It requires a lot of finesse and often, some very direct conversations about the new reality.
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Operational Optimization: Can you somehow make your own operations more efficient to reduce the cost of fulfilling the contract, even if the terms remain fixed? This might involve adopting new technologies, streamlining processes or finding cheaper internal alternatives. It’s about squeezing every bit of efficiency out of a bad situation.
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Seek Legal Counsel on Termination: Is there an exit clause? What are the penalties for early termination? Sometimes, biting the bullet and paying a termination fee now might be less costly than continuing to hemorrhage money for years to come. This is where legal and financial expertise truly intersect. You need to weigh the immediate pain of a termination penalty against the long-term, unavoidable bleed of an onerous contract.
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Strategic Hedging: If the onerous nature is due to price fluctuations (like my manufacturing client), can you use financial instruments to hedge against future price movements? This isn’t always feasible for every business, but it’s a tool worth considering for those exposed to volatile commodity markets.
Contracts, by their very nature, are designed to protect both parties. But the world changes and a deal that made perfect sense a year ago might be a ticking financial bomb today. Businesses, particularly private companies navigating the complexities of their finances, need to continuously assess their contractual obligations, from service level agreements like the one HMRC has for Scottish Income Tax (gov.scot, “Service Level Agreement”) to equity incentive plans for employees (michiganitlaw.com, “Comparative Summary”). Each carries potential benefits, yes, but also risks and unavoidable costs.
The world of finance and business moves at warp speed and what’s a boon today could be a burden tomorrow. Onerous contracts are a harsh reminder that vigilance, proactive financial management and the willingness to face uncomfortable truths head-on are not just good practices – they’re absolutely essential for survival and long-term prosperity. Keep those eyes on your contracts, friends; your balance sheet will thank you.
References
What are the signs of an onerous contract?
Look for skyrocketing costs, dwindling revenue, operational inefficiencies and negative gross margins.
How can companies mitigate the risks of onerous contracts?
Conduct thorough due diligence, monitor market conditions and include flexible terms in contracts.