Chart 2 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 U.S. Consumer Price Index-for Urban Americans unadjusted for seasonal variations (CPI-U).

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

Selecting the Appropriate Index

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 (U.S.A., U.K., 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. However, it is important to note that these measures can sometimes be volatile. Reliance on the wrong index may cost a purchaser of outsourcing services millions of dollars during a contract’s lifespan. Having said that, a company should seek guidance from a trusted source in addition to evaluating sound statistical data.

Using a government index from the country in which the outsourcing client receives the services is generally recognized as a best practice In negotiations on behalf of U.S.-based clients.

The index used can have a notable impact on contract costs. Chart 3 compares major cost-of-living and employment cost indices for the U.S.A. and Europe.

For U.S.-headquartered companies, it is generally advisable to use the CPI-U, as compiled by the U.S. 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 U.S. population; thus, it is a good gauge of the living cost of the U.S. workforce.

Another measure, the Employment Cost Index (ECI) — also compiled by the BLS — assesses labor costs experienced by employers in all sectors, including Information Technology (IT) and professional workers. Focusing on changes in wages and benefits, it is generally a more volatile index than the CPI. It might be logical to use this index if exactly the same employees were providing exactly the same services every year, for example, if an organization is relatively stationary. However, 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.

The chart below illustrates the dramatic difference that is shown on annual costs during a seven-year contract because of using one of these price-increase measures instead of the other. In this example, the total cost difference during the seven-year life of a $50 million (annual) contract using the ECI versus the U.S. CPI-U is $23.3 million, which is a substantial savings.

Data for European Union (EU) countries possess a different set of challenges. Economists are combining cost-of-living and employment statistics compiled by individual country governments into increasingly sophisticated composite data for the expanding group of European nations although huge regional differences still remain.