Many buyers of outsourced services are approaching the contract negotiation process without a full understanding of the issues that negatively impact their bottom lines, according to a new white paper by TPI. As a result, companies which fail to implement appropriate price-inflation mechanisms in outsourcing contract negotiations risk losing millions of dollars during the lifetime of a typical five to seven-year contract.
TPI said buyers of outsourcing services negotiating contracts seldom fully grasp the long-term effect that the price-inflation clauses they negotiate can have on their outsourcing pocketbook. If buyers agree upon an inappropriate price-increase mechanism, they may find themselves paying millions of dollars in costs that escalate and compound during a typical 5-year to 7-year contract duration.
Determine the Appropriate Portion of the Market Basket Impacted
TPI said buyers should first and foremost determine what portion of an outsourcing market basket might be subject to inflation or deflation. In a typical Information Technology Outsourcing (ITO) contract, the cost of IT hardware, such as servers, is likely to actually decline during a contract's term, in accordance with Moore's Law.
Although the cost of maintaining facilities is likely to increase, the facility costs themselves may remain constant. Clients are usually reluctant to inflate the service provider’s overhead and profit. Average labor costs typically rise; however, many outsourcing providers experience employee turnover that is high enough to significantly reduce labor cost increases, as newly hired workers replace longer-tenured (more highly compensated) workers. Business Process Outsourcing (BPO) transactions tend to be much more labor-based than ITO contracts.
Hardware/software components are included only if the hosting of the system is also provided, such as an HR system along with the HR functions.
Given the diverse elements in an outsourcing service provider’s cost structure, an important issue in many outsourcing negotiations is the relative role of labor costs versus various nonlabor costs in economic cost-adjustment formulas. Service providers may understandably bargain for annual price increases based solely on a major cost-of-living and/or employment cost index in the client's country. A more appropriate price inflator, however, is one that reflects not only realistic inflation rates for labor but also those for hardware, facilities and other factors.
This discounting factor to allow for non-labor price changes — the ‘sensitivity ratio’ or "share ratio” — typically decreases economic cost adjustments in contracts to about 60 percent to 70 percent (or higher in BPO transactions) of what those costs would be if they were based on labor costs alone.
Figure 1 shows an example of how the “share ratio” might account for inflation sensitivity in a contract.
Fig. 1: Determining Inflation Sensitivity (Share Ratio) {Source TPI}
Figure 2, Chart 2, which follows, shows the impact of a typical negotiated “sensitivity ratio” of 65 percent compounded during a 7-year contract (1998-2005), compared to the impact of 100 percent of the annual U.S. CPI-U.
Fig. 2: Effect of Sensitivity Ratio (Share Ratio) on Annual Contract Cost {Starting value = 50 million}
In this case, using a sensitivity ratio of 65 percent for a US million (annual) contract would have made a total cost difference of USD 12.5 million during the 7-year contract period.
Select the Appropriate Index
According to TPI a second critical consideration that impacts negotiated economic cost adjustments is selection of the appropriate cost-of-living indices on which to base price-inflation and/or price-deflation formulas. Clients should pay the expected cost increase/decrease in the country where services are to be delivered, not the country from which they are provided.
Governments in the countries of major purchasers of outsourcing services (United States, United Kingdom, Japan, etc.) compile and publish highly sophisticated indices of cost-of-living and employment costs.
Additional statistical measures are available from research firms and employer organizations. These measures can sometimes be more volatile, however, and reliance on the wrong index can cost a purchaser of outsourcing services millions of dollars during a contract’s lifespan.
Fig. 3: Cost of Living and Employment Cost Comparison, US and Europe, 1995-2005
Figure 3 compares major cost-of-living and employment cost indices for the United States and Europe. It suggests that the index used can have a notable impact on contract costs.
Workforce turnover and retirements tend to offset the impact of steadily rising salaries and benefits in the work force, and these diminishing factors are not well represented in the ECI.
Figure 4 indicates the dramatic difference using one of these price-increase measures instead of the other can have on annual costs during a 7-year contract. In this example, the total cost difference during the 7-year life of a USD 50 million (annual) contract using the ECI versus the U.S. CPI-U is USD 23.3 million.
Fig. 4: Effect of Inflation – Adjustment Index on Annual Contract Cost (Starting Value =USD 50 million)
TPI recommends using a government index from the country in which the outsourcing client receives the services.
Selecting the right index is especially important in offshore transactions. TPI’s advice is that whereas the service provider assumes the costs and the benefits of choosing a source — such as India — that has had higher inflation than the United States or Europe, the client should bear costs and realize benefits of the location where it receives the services. For this reason, the provider might deliver services from multiple sources to reduce the overall impact of inflation on its labor costs. In India, the inflationary wage pressures are partially offset by the “turnover effect,” where younger, less expensive workers tend to replace those who leave. Turnover provides some downward pressure on the typical wage increases even after allowing for the cost of training the newer, probably younger, workers.
Build a Conservative but Flexible Approach into the Contract
TPI said instead of basing any service provider's cost increases on an estimated average rate of inflation during each contract year, it is recommend that the service provider determine what its costs will be without inflation and then negotiate a retrospective adjustment formula based on actual inflation or deflation. We often use the Base Case — the client’s existing and projected costs for the “in-scope” functions — as the basis for determining what costs will be affected by inflation/deflation.
The Base Case determines the amount of employee-related costs — such as compensation and training — as well as other inflation-sensitive costs and non-inflationsensitive costs. This tends to provide a reasonably consistent measure that both the service provider and the client can accept.
Figure 5 illustrates the differences between a presumed annual inflation rate of 3% and actual inflation rate (as measured by the U.S. CPI-U) in a 7-year, USD 50 million (annual) contract. In this example, the total cost difference during the 7-year life would have been USD 20.7 million.
Fig. 5: Contract Cost Inflated by a Fixed Rate Versus by CPI-U with 70% Sensitivity Ratio
Conclusion
TPI said to avoid paying more than is reasonable because of economic change adjustments in outsourcing contracts, corporate buyers of services must negotiate with the following factors in mind:
- Future changes in the “market basket” of all costs, not just labor
- The appropriate index to use in calculating inflation
- The need for negotiated and agreed-upon formulas that will reflect the corporation’s actual future cost increases or decreases
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