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Companies are losing millions of dollars on their outsourced services contracts because they are not implementing appropriate stipulations that account for future pricing factors impacting their outsourcing arrangements. Economic factors such as inflation can have a substantial effect on a company's bottom line during the lifetime of a typical five to seven year outsourcing contract as the cost of labor, cost of living, hardware, facilities and other factors increase over time.

Companies are overlooking these issues because they are approaching the contract-negotiation process unaware of the issues they will face, and are not taking a long-term perspective by adding adjustment mechanisms in their contracts.

Most consumers understand how the rising cost of living can challenge their budgets, but 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 contract duration. Recognizing the problems associated with these price-inflation clauses (often known as "economic cost adjustments") and how to remedy them can help buyers who are moving through the negotiation process.

To help avoid financial drain, buyers should follow three important guidelines when approaching outsourcing contracts from a long-term perspective:

• Determine the appropriate portion of the outsourcing "market basket" subject to inflation/deflation

• Select the appropriate index

• Build a conservative, flexible approach into the contract.

Corporate buyers can often benefit from expert advice and guidance to negotiate with service providers to obtain contracts that accurately reflect future labor and nonlabor costs during a contract period. It is important to look at crucial future pricing factors affecting a purchaser of outsourced services.

Inflation or Deflation Impact
The first issue that must be determined is 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. Clients are generally reluctant to inflate the service provider's overheads and profits. Average labor costs typically rise; however, many outsourcing providers experience employee turnover that is high enough to significantly reduce labor cost increases. 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.

Relative labor costs versus various non-labor costs is an important issue in economic cost-adjustment formulas for service providers. 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 nonlabor price changes-the "sensitivity ratio" or "share ratio"-typically decreases economic cost adjustments in contracts to approximately 60%–70% (or higher in BPO transactions) of what those costs would be if they were based on labor costs alone (shown below).

The sensitivity ratio on annual contract cost shows the impact of a typically negotiated "sensitivity ratio" of 65% compounded during a seven-year contract (1998–2005), compared to the impact of 100% of the annual US Consumer Price Index-for Urban Americans unadjusted for seasonal variations (CPI-U).

In this case, using a sensitivity ratio of 65% for a $50 mn (annual) contract would have made a total cost difference of $12.5 mn during the seven-year contract period. When compared to contracts without this provision, it is feasible to negotiate a favorable sensitivity ratio that can save 0.3%–1% per year (compounded).

Determining Inflation Sensitivity		Effect of Inflation-Adjustment Index

Appropriate Index Selection
A second critical consideration that impacts negotiated economic cost adjustments is selection of the appropriate cost-of-living indices on which the price-inflation and/or price-deflation formulas are based. Clients should pay the expected cost differences for the services delivered. Governments in the countries of major purchasers of outsourcing services (US, UK, Japan, etc) compile and publish highly sophisticated indices of cost-of-living and employment costs. A company can also utilize additional statistical measures that are available from research firms and employer organizations to make decisions that are more informed. Reliance on the wrong index may cost heavlily on a purchaser of outsourcing services during a contract's lifespan for which seeking guidance from a trusted source is essential.

For US-headquartered companies, it is generally advisable to use the CPI-U, as compiled by the US Department of Labor's Bureau of Labor Statistics (BLS). This index reflects costs for a broad-based market basket of goods purchased by most of the US population.