Companies are losing millions of dollars on their outsourced services contracts beca-use 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:

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 and how an expert advisor can help the negotiating parties resolve these issues successfully.

Determining the Appropriate Portion of the Market Basket Impacted

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. However, while the cost of maintaining facilities is likely to increase, the facility costs themselves may remain constant. 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, 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.

An important issue in many outsourcing negotiations is the relative role of labor costs versus various nonlabor costs in economic cost-adjustment formulas, given the diverse elements in an outsourcing service provider’s cost structure. 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 (See Chart 1).