TPI has published an excellent, brief report on "Avoiding the High Costs of Cost-of-Living Adjustments in Outsourcing Contracts: A Litmus Test of Sourcing Done Right." Written by Chris Kalnik, chief knowledge officer, the article addresses that part of an outsourcing contract typically called "price-inflation clauses" or "economic cost adjustments."
As a client, you want to be prepared to negotiate several aspects of these "automatic" price increases.
First, what portion of the "market basket" will be subject to inflation or deflation? For example, whereas labor costs typically go up, server costs decline. Therefore, the inflation ratio should be softened by the discounting factors of other aspects of the contract. In a $50 million annual contract, he writes, that could have a financial total impact of $12.5 million over seven years.
Second, what country cost indices will be applied for cost-of-living calculations? Kalnik strong recommends that the choice of country be decided by where the services are being delivered to, not from. He also suggests that in the US, the Consumer Price Index is a better gauge overall of cost of living than the Employment Cost Index. You could well save $23.3 million on that seven-year, $50 million contract using the former index rather than the latter.
Finally, if inflation or deflation are inevitable, what should the contract include to allow for economic cost adjustments? Rather than basing the increases on an average rate of inflation, TPI suggests negotiating "a retrospective adjustment formula based on actual inflation or deflation."
This is a worthwhile six-page document to read. Not only will it better equip you to understand those price inflation sections of your contract, but it may persuade you that the savings your organization enjoys will more than make up for the expense of hiring an advisor such as TPI.
