Avoiding and Mitigating Inflation Risk

As outsourcing service delivery models become increasingly global, customers frequently face challenges in accounting for inflation and foreign exchange risks in their financial business cases and in negotiating contract terms with their outsourcing service providers that fairly allocate these risks. For example, in a global transaction where the customer is paying for the services in US Dollars, the way in which the parties allocate foreign exchange risk can result in millions of dollars of benefit to one party or the other.

Likewise, economic adjustments based on rising inflation can have a major impact on a customer's overall costs during the term of an outsourcing contract. Service providers will typically propose an annual price increase that is pegged to a standard cost of living benchmark, such as a public consumer price index (CPI), because these indices are typically used as macroeconomic indicators of inflation. We challenge the premise that cost of living adjustments are always appropriate, but, where appropriate, the parties may agree to include them to account for rising production costs in a particular market.

This begs the question - which inflationary index is the most appropriate and what can consumers do to protect themselves?

Which Index?
We compiled data for a few popular offshoring locations and found that the changes in CPI of these countries can fluctuate significantly. A representative sample of this data is included in the table below:

Canada, US, UK

Offshore

Certainty and stability are important for analyzing any long term business case, which is why the CPI figures published by the US Department of Labor have historically been the most favorable from the perspective of US-based outsourcing customers. Inflation in the United States has been modest (3% or less over the past five years) and typically lacks wild swings sometimes seen in other indices. Furthermore, US CPI is considered extremely accurate and transparent, as the Department of Labor publishes scores of historical data along with tools to help read and interpret the data. The same could be said for customers based in Canada. As in the US, inflation in Canada has been historically modest, evidenced by the figures compiled and published by Statistics Canada. For those customers based in the UK, inflation has proved to be little more volatile (especially during the recent global recession), but the indices published by the UK Office for National Statistics are considered similarly accurate and transparent.

The lesson here is clear - if a service provider insists on pegging rates to a CPI, customers based in the US, Canada, and UK will generally be best served by using the index published by their home countries assuming recent inflation trends continue.

Offshore CPI? Not So Fast.
Service providers will often insist on tying rate increases to CPIs in offshore locations, which may increase faster than their actual production costs. Before agreeing to use an offshore CPI, customers should pay attention to the service provider's historical rates for the resources provided in countries in which services will be provided. Even in countries with soaring inflation (e.g., India), most service providers are able to keep their rates flat since they have internal mechanisms to control costs while sustaining their profit margins. For example, service providers often control the labor pool by hiring junior (and lower paid) employees and remove senior (and more highly paid) employees from a customer's account in order to keep labor costs low. Furthermore, other production costs have decreased markedly over the past decade (e.g., telecom costs), which has helped service providers manage their costs despite rapid inflation. Therefore, if a service provider attempts to tie its prices to an offshore CPI, but its historical rates for services in that country have remained flat in recent years; the customer would have a strong argument that using the offshore CPI as a benchmark is inappropriate.

Mitigating Offshore CPI Risk
Under certain circumstances, however, the contracting parties may agree to peg rates to the CPI of offshore locations in which services are to be delivered. For example, if a service provider agrees to flat or declining rates over a long-term deal and intends to deliver services primarily from offshore locations, the service provider may have a stronger argument for pegging portions of its pricing to inflation at the corresponding offshore service delivery locations. If the customer ultimately agrees to allow pricing to be tied to an offshore index, any such inflationary adjustments should be capped. Furthermore, any such agreed upon offshore index should be made available to the public at no cost (i.e., not a private "boutique" index) because (i) a customer should never be charged to gain access to a tool that is so important to its business case, and (ii) a non-public index could be influenced by the agendas of its paid subscribers.

As evidenced by the table above, allowing labor rates to be pegged to an offshore CPI on an uncapped basis can be a risky business proposition. For example, Brazil, which has become an increasingly popular offshoring location, has experienced wild swings in CPI over the last five years, which could wreak havoc on a customer's pricing assumptions and overall business case. Not to mention that the administrative overhead in tracking offshore indices can be extremely burdensome, particularly if the pricing related to each of the service provider's delivery locations is pegged to a different index.

In order to avoid such large swings and manage the risk profile more effectively, a customer should only agree to use an offshore index if pricing adjustments based on that index are subject to a cap. Of course, the figure for such a cap would be subject to negotiation, but industry standard would likely land around 3% per year. With a reasonable cap in place, both the risks associated with and the time negotiating inflation-based pricing adjustments should be greatly diminished.