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 United States’ CPI-U is considered the standard index. Similar indices exist in major European and Asian countries, which are suitable for these clients. The use of government-provided indices is recommended, since they are typically more reliable than indices compiled by private companies, because their future availability and consistency may be less certain.

It is very important to select the right index in offshore transactions. Whereas the service provider assumes the costs and the benefits of choosing a source, such as India, that has had higher inflation than the U.S.A. or Europe (recently, approximately two or three times higher), 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.

Building a Conservative but Flexible Approach into the Contract

Assuming that inflation or deflation can and must be accounted for in a reasonable way based on both the right sensitivity ratios and the right index, what process should an outsourcing contract include to comfortably allow for economic cost adjustments? Instead of basing any service provider’s cost increases on an estimated average rate of inflation during each contract year, it is recommended 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. The Base Case is often utilized — 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 noninflation-sensitive costs. This process usually provides a reasonably consistent measure that both the service provider and the client can accept.

The differences between a presumed annual inflation rate of three percent and actual inflation rate (as measured by the U.S. CPI-U) in a seven-year, $50 million (annual) contract is shownbelow (See Chart 5). In this example, the total cost difference during the seven-year life would have been $20.3 million.

Clearly, to avoid paying more than is reasonable due to economic change adjustments in outsourcing contracts, corporate buyers of services must negotiate their contracts with certain factors in mind:

Companies need to take notice of the issues surrounding the contract-negotiation process. Thus, they can identify problems before they occur and avoid potential financial drains. The power of economic factors, such as inflation, have a demonstrated effect on a company’s bottom line during the lifetime of a typical five to seven year outsourcing contract as the cost of labor, their cost of living, hardware, facilities and other factors increase over time. For this reason, it is important for both clients and service providers to arrive at an effective and long-term joint resolution of these issues, so that their negotiated contracts exhibit the “staying power” to stand the test of time.

Christopher Kalnik is a recognized industry leader in developing innovative pricing mechanisms and analyzing complex financial transactions. As a TPI partner, Chris serves as TPI’s Chief Knowledge Officer and is ultimately responsible for the approval of TPI’s tools and methodologies.