Inflation impacts the cost of nearly all your supplier agreements. Look closely at your IT agreements (especially your Cloud agreements). Even though the cost of technology goes down over time, and technology advancements make processes less manual, less error prone, less expensive, and more automated, many of your agreements still have antiquated clauses allowing your suppliers to *increase* your costs on an annual basis by an amount equal to the Consumer Price Index (CPI) amount, and generally include an accelerator above that amount; something like CPI + 3%, which would provide a contractual right of your supplier to increase your costs by the CPI rate (say 4%), plus a 3% additional amount, for a total of 7% in this example.
This likely has no relation to the cost to support you, it’s simply a contractual vehicle to extract more value. If your agreements have these “CPI+” terms, you should seek to remedy and limit these provisions today. We recommend acting now, before the IT supplier ecosystem jumps on the inflation bandwagon, exploiting our current economic conditions and leveraging these contractual loopholes to increase your costs.
Our Federated Market Intelligence (FMI) is demonstrating most procurement organizations are experiencing situations where suppliers are already proactively increasing costs on direct and indirect goods and services, undermining cost containment goals. There is upward cost pressure across the board in most industries, and in most geographies. Despite their best efforts, many organizations have been forced to agree to “CPI+” terms in their IT supplier agreements and this could unfortunately result in surprises in budgeting and unplanned increases in costs if not addressed.
In other economies, Latin America particularly, there have been periods of significant inflation, and even worse, currency devaluation in combination with inflation. Many businesses in these geographies have been stung hard in the past by similar conditions. When dealing with clients in those areas, we see a pronounced sensitivity in seeking protective terms to avoid significant surprise cost increases, including which currency is used in a contract. In North America in particular, and in the EU more generally, we have seen less sensitivity to the CPI+ clauses as the economies have been more stable and predictable, and inflation has been negligible. Because of this, most suppliers have chosen not to enact these provisions even where they could for political and other reasons.
Why does North America have less sensitivity to this issue? It has been several decades since the North American economies have been challenged by the “I-word” (sustained inflation). The US Dollar has been solid. The interest rates and inflation historically low. That is changing. The annual inflation rate for the United States is 5.0% for the 12 months ended May 2021 after rising 4.2% previously, according to U.S. Labor Department data published June 10.
No doubt, IT and procurement have always been sensitive to escalating contract costs, especially on renewal agreements, but at the same time, willing to accept some baked-in terms from suppliers for what has been assumed to be a very minor CPI index exposure.
Buying Perpetual versus Cloud:
Interestingly, with the growth of Cloud computing use over perpetual licensing, most organizations have felt it is fair and sustainable with suppliers to allow a form of “CPI+” in their agreements. The advantage of perpetual was that the only variability to support/maintenance. However, with Cloud, you own nothing and are then more subject to supplier changes.
What is a Fair Inflationary Index?
Everyone loves caps. However, in Cloud deals, these caps are more difficult to achieve. The observation of NET(net) is that most of the focus for Clients has been primarily on the “+” of the “CPI+” term as one of the important points to negotiate. Most companies did not foresee that the CPI basis may be where the real risk lives – after all, we have not seen any material inflation for quite some time. So, you must ask yourself this question: What happens if CPI or some equivalent metric is what really changes?
Three Considerations and Actions:
- First, it just makes sense seek an absolute increase cap, so you eliminate variability of “CPI” which is uncontrollable. Most companies want and ask for this cap, but it can be a hard-won concession. An absolute cap can be a “trade” in a deal if you prioritize. If you do not have it today, it is worth a renewed focused now to obtain before suppliers entrench as they experience inflation impacts.
- Second, it is important to understand which “index” is used as your basis. Right now, it is NET(net)’s projection that a simple consumer price index (CPI) will be one of the worst options. While CPI may work for Consumer-Packaged Goods (CPG) companies, as their business model is directly related to consumer markets, and they can quickly pass on price increases it is not an appropriate index for healthcare industry (note many large healthcare organizations use a different metric than CPI today). What about banking or heavy capital goods manufacturing with ‘out-year’ contracts for delivery at a committed cost? Our recommendation is that (absent real caps), you seek a relative “index” to your specific industry, that is linked to your business metrics, growth, and your own economics of pricing the goods/services that you sell.
- Third, inflation and currency interact. Now this is a complex topic, but worth consideration, especially for global clients, or clients who have significant “offshore” spend. What issues result if you have denominated your agreements in Pounds or Euros, and there is a big swing in the Dollar? If you have a global and centralized agreement, say with Microsoft, how does that impact your business units outside of the USA? Are they effectively getting good/services cheaper because the Dollar is down relative to the Euro? Should you advantage yourself to buying in different domiciles or multiple domiciles? What about internal cost allocations for a US Dollar based agreement to your German subsidiary? What about that giant BPO deal you just put in place in China or India, does the supplier achieve great advantage in being paid in Dollars, or will they seek to re-adjust your pricing as “…the Dollar did not buy what it used to…” relative to the local currency?
For once, IT suppliers are a little behind the curve versus other direct and indirect categories with increases based on inflation expectations. This extended opportunity increases the window of time you must work with your finance teams to determine the impact of inflation on your IT costs, develop strategies to eliminate or at least limit risk and consider contracting clauses now that provide for these future protections before your IT Suppliers are unwilling to concede on these points.
It is also important to know from a broad market intelligence perspective what are the “optimal” terms that your IT Suppliers are willing to provide, and where there is a hard no that you cannot overcome. This is of course only one of the dozens of financial clauses in your contracts that can erode value over time. NET(net) always recommends a detailed review of all financial provisions in your contracts including price holds, maintenance freezes, future discounts, and a variety of other terms – to ensure your agreements are market optimized to ensure maximum future proofing and financial protections. If you would like us to assess the opportunity to help you improve your IT contracts, please contact us today.
Founded in 2002, NET(net) is the world’s leading IT Investment Optimization firm, helping clients find, get and keep more economic and strategic value. With over 2,500 clients around the world in nearly all industries and geographies, and with the experience of over 25,000 field engagements with over 250 technology suppliers in XaaS, Cloud, Hardware, Software, Services, Healthcare, Outsourcing, Infrastructure, Telecommunications, and other areas of IT spend, resulting in incremental client captured value in excess of $250 billion since 2002. NET(net) has the expertise you need, the experience you want, and the performance you demand. Contact us today at firstname.lastname@example.org, visit us online at www.netnetweb.com, or call us at +1-866-2-NET-net to see if we can help you capture more value in your IT investments, agreements, and relationships.
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