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?About the author
A management consultant with over 22 years of experience across consulting and sourcing industry encompassing sourcing advisor, senior executive with a leading service provider and a global consulting firm. He is a well published and recognized thought leader in the global sourcing industry. In his current role of Partner & India Head with ISG, he heads the India business and operations for ISG. He can be contacted at [email protected] or +91 98458 93787.
