Business & Technology Sourcing Review - Issue 21, Winter 2014
As companies move to outsource their FM services globally, they are encountering more and more often the question of how to accommodate for inflation, especially with respect to its impact on FM suppliers savings commitments. The FM supplier will tell you that it’s inequitable to ask them to shoulder the risk and the burden for inflation in certain countries. They will ask that any savings commitments they make be automatically reduced to account for the amount of inflation experienced each year. While there’s no disputing the inequity in asking an FM supplier to shoulder the entire burden and risk in high inflation environments, it behooves the customer to take a closer look at the costs that are actually impacted by inflation in order to determine the most fair and equitable way to mitigate and allocate the associated risk and the burden.
Breakdown of Costs in an IFM Engagement
To cover the provision of hard services (i.e., work often capable of being performed by skilled labor) and soft services (i.e., work often capable of being performed by unskilled labor), there are the following cost categories: (A) the supplier’s internal overhead (back-office labor, goods and services costs), (B) the supplier’s labor, (C) third party services (subcontracted services), (D) goods, and (E) software and related IT services.
In order to determine how best to deal with inflationary impact on these costs, let us examine in more detail the level of control a supplier has over such costs.
The analysis below assumes a pass-through, gross maximum price (GMP) pricing model:
SUPPLIER’S INTERNAL OVERHEAD COSTS
These costs are typically included within the management fee charged by the supplier. The management fee is often tied to volume of business and is expressed as either a square foot cost or a percentage of overall spend, depending on the structure of the deal. We do not typically see suppliers asking for the management fee to be indexed to inflation. Any such request should be refused as the supplier has sole control over these costs and the customer has no visibility into such costs or any ability to mitigate or otherwise influence such costs.
SUPPLIER’S LABOR COSTS
Suppliers will raise wages as necessary to retain their workforce but will typically not match inflation unless required to do so (e.g., an inflation matching provision in a collective bargaining agreement). Absent such a requirement to raise wages to match inflation, suppliers are unlikely to completely offset inflation with wage increases for all of its employees. With respect to their skilled workforce, however, there will be more pressure on suppliers to raise wages, especially as customers will want continuity in such workforce in order to avoid disruption in service delivery in areas that could have a more material adverse impact on the customer. The customer should only be responsible for the actual increases in wages incurred by the supplier resulting from inflation and should not agree to a mechanism that assumes an increase that matches inflation for the supplier’s entire workforce.
THIRD PARTY SERVICE PROVIDER COSTS
Inflation may have some impact on the cost of third party services depending on the nature of the service (i.e., skilled vs. unskilled) but, as such contracts are often volume-based and nationwide or enterprise-wide, the supplier has significant leverage over these third party suppliers. They have the ability to move from one vendor to another, offering a significant amount of business in exchange for lower rates. The supplier will have to actively bid services and monitor the market for the best services at the lowest rates, but that is part of the value it should be bringing as part of its service offering. Thus, third party service costs may increase because of inflation, but suppliers should be actively working to mitigate those increases.
GOODS, MATERIALS AND PRODUCT COSTS
Costs for goods, especially when unique or tailored for the customer, will increase because of inflation. Similar to third party services, suppliers may be able to better mitigate the increased costs for commodity goods by actively searching the market for the lowest cost. Even with such mitigation measures, the supplier’s costs for goods may increase as a result of inflation but depending on the nature of such goods, such cost increases may not, in the aggregate, equal the rate of inflation.
SOFTWARE AND IT SERVICES COSTS
Typically software costs are priced on a long-term basis (i.e., the supplier agrees to a fixed license fee over a long-term period). Such licenses may be seat-based or otherwise volume-influenced, but those cost drivers are consumption-based and independent of inflation. IT service costs may increase due to higher labor costs, but any increases should be less than the actual rate of inflation for the reasons discussed above.
As we’ve discussed, inflation will increase the costs of a supplier, but such costs are not all impacted equally by inflation. The first thing suppliers should be required to do is to use best efforts to mitigate inflation. The parties should then determine the actual increase in costs directly attributable to inflation. The customer should then decide whether to offset such increased costs with cost savings resulting from measures like reducing head count or decreasing required service levels or whether it would rather increase the budget and reduce the supplier’s savings commitment to offset such increased costs. Regardless of which of those options the customer elects, for the reasons discussed above, automatic budget adjustments matching the rate of inflation should be avoided.
This article was originally published by Inside Counsel.
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