Price adjustments can have a significant impact on the bottom line. So when outsourcing, forgetting about inflation is not an option, especially during contract negotiations. Unless, of course, you’re comfortable with the assumption of this risk.
Inflation affects service providers (especially those in high growth emerging markets),
the contract structure, and therefore the firms that are outsourcing. That’s
why contract negotiators must be aware of the role of inflation in service
delivery and the adjustment principles that can be used to account for price
fluctuations.
A service provider generally experiences inflation due to an upward cost-wage
spiral, where wages respond to high business growth rates and costs of
inflation sensitive items, creating positive feedback. To manage the
inflationary impact on their cost structure, service providers try to replace
more experienced employees with recent graduates, utilize cost structures in
low-cost sourcing destinations, and distribute the average wage hike.
So
when setting up inflation adjustments in a sourcing contract, the principal
options available to contract negotiators include:
No adjustment for inflation – This option does
not explicitly allow for adjustment for inflation over the term of the
contract, regardless of the countries that deliver services.
Adjustment based on inflation index – To combat
uncertainty and the associated risk, the price adjustment can be linked to an
inflation index. Choice of an appropriate index is imperative.
Adjustment based on open book – The client agrees
to adjustments based on the actual cost impact of inflation on the service
provider delivery cost. But this option makes significant administrative
demands on both parties and hence generally not popular.
The selection of an inflation adjustment option
results from negotiations and depends on the circumstances in every situation,
as was discussed in “Dynamics of Price Adjustments in a
Globalized Sourcing World”. Companies outsourcing and their service
provider partners need a mutually beneficial agreement at the outset.
Otherwise, the inflation spiral may turn into a coiled problem. What are your
experiences and thoughts on handling such price adjustments in outsourcing
contracts?
Dinesh is a highly experienced and well-respected advisor in the outsourcing industry with more than 23 years of experience in management consulting and outsourcing. He works with enterprises to craft sourcing strategies, structure and negotiate complex sourcing transactions and design and implement sourcing governance organizations. Prior to joining ISG, Dinesh worked with Infosys and Accenture, where he led large transition programs and consulted on IT strategy and implementations, business process-reengineering and operational improvement programs. He is a published thought leader and a regular speaker at industry conferences. Dinesh manages the ISG India Business.
