Two questions -- both tongue twisters -- demand answers:
- What part does inflation play when we are trying to mitigate a risk relating to higher costs resulting from the cost of living that constantly increases?
- And when negotiating a services contract, can we assume that inflation is the only culprit we need to calculate?
We cannot! And truthfully, estimating the increasing cost of living accurately involves much more than calculating an inflation rate to quote in any contract. That’s what this article surrounds.
The increasing cost of living – a huge challenge
Providing contract coverage for the increasing cost of living in most countries is one of the hottest topics on the table during negotiations between sellers and buyers -- especially today when the market reflects high inflation rates globally. This trend becomes particularly relevant when labor cost is the main driver during negotiations involving long-term services agreements like outsourcing contracts.
This means that if we fail to appropriately negotiate a strategy for periodically updating the contract rates, we could eventually kill the profitability of the deal for the seller. Updating the contract rates will retain a good profitability level for the seller depending upon how the cost of living evolves.
But keep in mind as well, if the seller fully transfers the cost of living according to the actual increase of inflation or salaries, the costs might quite dramatically increase for the buyer to get the services versus the initial estimates that were made before the contract was signed. It’s problematic.
Inflation rate – one of many increasing cost challenges!
To speed up negotiations, many contract negotiators have focused on the increase in the inflation rate as the only criteria for updating the contract rates. But this does not necessarily represent -- for all parties -- the most appropriate strategy for covering the cost increases resulting from the actual cost of living increases. (Other indices may be more relevant according to the local regulations or the main drivers used when the seller’s headcount costs are calculated.)
In several countries, local regulators have imposed increases in the statutory minimum wages which have been significantly above the actual increases in inflation. Similarly, in some countries, collective bargaining agreement negotiations have triggered cost increases that live way above the actual inflation increases. These fluctuations in the worldwide economy precipitate constant changes in the cost of living.
The statutory minimum wage is especially relevant in countries and industries where this minimum wage is the main source used to calculate the cost of the headcount. In such cases, it might be worth your time to consider using a contractual process (possibly automation) that defines a periodic update of the contractual rates. The update would be set according to whichever statutory increase in the minimum wage becomes effective in the applicable country.
Increasing wages resulting from collective bargaining agreement negotiations is considered by many countries to be more useful than local regulations. This approach may be more realistic, because it is specific to each industry, and it would apply to the entire headcount engaged to provide the services.
A buyer -- when negotiating a strategy for enabling a periodic update of the contract rates to cover the impact of the cost of living -- will normally push to get fixed rates during the entire contract term or will delay the first-rate update until an initial number of years have passed after the effective date of the agreement.
From the seller’s perspective, one alternative option may be acceptable if the contract does not specifically include a provision that enables a periodic update of rates to cover the impact of the cost of living. This works well, providing that the estimate of additional costs resulting from the cost-of-living increase is clearly stated in the seller’s internal financial business case or profit and loss (P&L) showing the forecasted revenue and costs for a future contract.
If, however -- the profit of the agreement is so tight that accommodating this extra cost in the P&L could make the contract to become wasteful -- then a second option might be to negotiate with the client a clear provision in the agreement which would contractually enable the rate increase. (This could however damage the reputation of the seller, because the buyer may perceive that the seller is transferring the entire cost of living risk to the buyer.)
Therefore, a third option may be more flexible
Use a mixed strategy that allows you to periodically update prices up to a certain cap at a percentage below any of the fluctuations in the worldwide economy stated above i.e., inflation, wage increases, and cost increases per the collective bargaining agreement.
This option would cover part of the impact of the cost of living, while the seller would cover the remaining impact up to the cost of living increase. This alternative would assure the buyer that the contractual rates will not increase above a certain amount, and it would also be a valid formula for the seller who would cover the risk relating to the actual increase.
This increase would be calculated by providing the following cost mix:
- First, calculate a lower-than-actual cost of living price increase in the agreement.
- Second, calculate the remaining amount to enter the financial business case for the contract.
Understand the triggers of cost increases
Regardless of the approach agreed between buyers and sellers to cover the impact of the cost-of-living increase, it is very important to first understand the main triggers that increase costs resulting from the cost of living -- such as inflation, minimum wage increases, collective bargaining agreement. etc., and second, enable open dialogue between the buyer and the seller so that each party understands the other party’s risks and interests. This way the parties can negotiate a formula -- in good faith -- that substantially mitigates the risk resulting from the cost-of-living increase.
Yes, it’s a conundrum!
To restate again, the cost-of-living changes constantly because of fluctuations in worldwide economy like inflation, minimum wage increases, and collective bargaining agreements. But this conflicts with many legally binding contracts that do not allow the service provider (seller) to make any price increases apart from the contract provisions during the contract term. Therefore, the entire risk and related costs usually become the seller’s responsibility unless stated otherwise in the contract.
So, can you use mixed strategies to resolve the conflict legally? Yes, and again, you have several options. You can periodically update rates subject to a certain cap if you so stipulate in the contract or enable an initial rate update after a reasonable time has elapsed after the effective date of the contract. Then, you may adjust the rates to put the parties’ minds at ease regarding any risks related to contract coverage for the cost-of-living increases.
ABOUT THE AUTHOR
Alvaro de Leon has more than twenty years’ experience in Commercial and Contract Management, in pre- and post-signature phases and both on the sell side and on the buy side. He has been working in Lucent Technologies, Accenture and more recently Transcom, where today he leads the contract management team responsible to support the sales and procurement teams in the negotiation and setup of contracts with clients and suppliers. The contract management team’s main goal is to find an appropriate balance between the requirements from clients and vendors, and the company’s standards, searching for creative solutions during the setup phase of the contract, as well as risk management.
Transcom provides digitally-enhanced customer experience (CX) services to some of the world’s most ambitious brands. Transcom’s over 30,000 employees work in 80 contact centers and work-at-home networks across 25 countries, creating brilliant experiences in customer care, sales, content moderation, and back-office services.