Inflation Adjustments in Outsourcing Contracts – Balance of Risk or Supplier Reward?

Typically, Suppliers ask for cost of living adjustments (COLAs) in IT outsourcing agreements to adjust prices periodically for inflation. We believe that the general assumption that a COLA is appropriate to “balance risk” in a three to five year IT deal should be challenged.

The Supplier community is highly sophisticated at managing a global workforce and associated delivery costs. They know their local labor markets (the source of most inflation) and, at least in the IT services domain, are adroit at managing labor cost and turnover. For example, for services delivered from India in particular, labor rate pricing has been flat over recent years in the face of sustained increases in labor costs. During this same time, Supplier margins have also been relatively constant. Why is that, and what are the implications for considering a COLA provision?

Suppliers have managed their non-labor costs extremely well though better expense management and economies of scale. In addition, by constantly moving into new labor markets, the large providers have been able to keep the cost of newer resources relatively flat. And they do all this while constantly cycling resources through their client accounts to replace the more experienced/expensive resources with less experienced/cheaper resources. Therefore, while the resource that was on the account last year may be more expensive this year, that resource has typically moved on and been replaced by a resource that cost the same as the prior one did last year – or even less if the resource is from a different geography.

This doesn’t mean there is no inflation risk. There certainly is. BPO providers seem to have been pinched by raising labor costs, high staff attrition and downward rate pressure. In IT services, the Supplier community has been more adroit at managing this risk in the medium term under fixed rate contracts. Under these circumstances, COLA may not be a “risk balancing” provision, but rather a gift to the Suppliers for doing what all companies have to do – manage their costs. It becomes a margin enhancing provision whereby the Supplier delivers the same solution and value as they did before the COLA, but now makes a larger margin.

In a competitive sourcing of a three to five year outsourcing term, we believe the Suppliers’ price competition should include the risk of inflation – and not by comparing COLA provisions between Suppliers, but by the Supplier taking inflation risk in the pricing. Suppliers choose where to deliver services from and how to construct their delivery solutions. Those that are effective at managing their delivery costs and confident they can within a foreseeable future, will have a competitive advantage on price. The Suppliers that want to rely on an index to manage their costs will not be competitive.

Beyond five years, there is something to be said for risk sharing on inflation in exchange for firm pricing beyond five years and a COLA provision may be entirely appropriate.