Negotiating Contracts In A Volatile Economic Environment
For firms delivering services on long-term contracts, rising inflation has hit like a sledgehammer. The inability to raise rates due to resource rate or fixed price commitments threatens to jeopardize profitability as wages escalate by as much as 15%.
Contracts signed before 2022 are in danger of becoming unprofitable, while competition for new business requires balancing price competition with intelligent contracting.
If a vendor loses money on long-term contracts, this is also dangerous for the client. Failure to charge profitable rates can cause vendors to either lose money or cut the number or quality of resources, both of which jeopardize the quality of service—and potentially the customer’s own business.
So, what can be done when the terms of a contract inhibit or prevent a vendor from operating profitably? This issue often arises within three different scenarios.
- Existing contracts which limit price changes/increases.
- The negotiation of new contracts.
In all three situations, it is critical to understand who has leverage that would enable or compel the other side to agree to one’s own terms.
There are five key factors within existing contracts that determine leverage and enable the vendor to justify price increases.
The Value Of Services
The more the services impact the client’s business, the more likely it is that the vendor can increase rates by indicating to the client that critical resources may be lost if the vendor cannot afford to pay for them. This argument improves if additional value to what is contracted can be negotiated and delivered as a result of making the contract change.
Regardless of the value of the services, if vendor performance is poor, the vendor loses leverage. Still, improving performance is often better than starting over.
Understanding the current contract terms is critical. If there is a cost-of-living adjustment (COLA) provision, how is it written? Does it allow for annual or more/less frequent adjustments? What index is used—and is it relevant to the resources most critically affected by inflationary pressures? If most of the resources of the services are in India, using a U.S. cost-of-living index probably will not accurately reflect necessary inflation-based increases. It’s also important to determine what happens if the vendor ceases service delivery; is there a limitation of liability? What are its limitations? In other words, can the vendor walk away and have its liability limited?
Does a client have viable alternatives? How long would they take to be implemented? The better the client’s alternatives, the more leverage the client has, particularly if the alternatives can be implemented quickly and at a cost that is equal to or lower than the current costs.
Is there another business that the client can leverage against the vendor? Has the client raised their own prices to customers?
In order to overcome the potentially negative reaction to a price increase, the vendor should remind their client sponsors of the business benefits of their services and the risks associated with changes to those services that may be precipitated by increased labor and product costs.
In a newly negotiated agreement, it’s critical for the vendor that provisions be made for increases based on higher-than-normal inflation. While a certain amount of inflation can be factored into even a fixed-price contract, a vendor may be reluctant to factor in too much in a competitive bid environment. This makes it even more important to have COLA provisions that kick in under certain conditions, such as inflation rates above the level that is factored into any long-term price or rate commitments (e.g., >3% inflation).
COLA may be a misnomer, as many such provisions need to include factors other than the cost of living to be relevant. These include:
In other words, what do we apply COLA to: Is it all the rates on a rate list (sometimes called a rate card)? Is it fixed-priced projects or some other items?
Which index do we use?
The relevant index should be related to the country and type of labor at issue. For example, if most of the delivery is from call centers in India, we may want to use the non-farm labor wage survey, as published by Aon Plc Survey for India (“India Index”).
What does it apply to?
Parties must determine a way in which to split each of these proportionally.
- The portion of the fees attributable to India resources versus local resources.
- All of the vendor personnel and the fixed-price services.
- Onshore resources.
When does it begin?
Will the initial indicated index recalculation take place on the 1-year, 18-month or 2-year anniversary date following the commencement date?
How frequently is pricing recalculated?
Will it be annually, bi-annually, every second year or monthly? What will be the impact on compounding?
Some possibilities may include such language as:
- “…if less than 3% no COLA shall apply…”
- “…COLA is limited to 5%; COLA in excess of 5% shall be borne by supplier…”
- “…should the CPI Index be in excess of 5%, either party shall have the right to explore alternatives…”
Renewals are similar to an existing agreement situation, except that the vendor is not obligated to continue providing services under current contract terms. In that sense, the value of successful current delivery is even more important as a driver of leverage which the client should recognize. With renewals, as well as new contracts, a common-sense approach to applying COLA provisions to ensure relevance and effectiveness.
Preparing To Navigate Your Contract Negotiations
Whether you are negotiating an existing contract, a new contract or a renewal, it is imperative to address the situation early in order to understand your leverage points and your customer’s. Information—plus proactivity and the right negotiation techniques—can help your business remain profitable despite inflation or other unfavorable economic conditions.
Note: this article originally appeared in November, 2022 on Forbes.com. You can view the original post here.