Cost of Living Adjustment Considerations in Service Contracts in the Face of Rising Inflation – Tech & Sourcing @ Morgan Lewis
In outsourcing, technology and business transactions, cost of living adjustment (COLA) mechanisms linked to price indices are coming under increasing scrutiny with the pressures current global inflationary trends.
Over the past 20 to 30 years, Western price indices have been relatively low, compared to the price indices of high-growth countries, such as India. However, this is currently not the case. The Consumer Price Index (CPI) in the United States rose to 8.5% in July 2022, while the CPI in the United Kingdom rose to double digits (10.1%) in August 2022, its highest level in 40 years. At the same time, India’s CPI was around 7%.
It remains to be seen whether these high percentages are a spike, linked in particular to short-term energy price increases, or a longer-term problem caused, among other things, by recent monetary policy in the West.
Whether it is a short-term or long-term phenomenon, existing COLA mechanisms in major agreements and the negotiation of COLA mechanisms in new agreements have become a focal point for suppliers and customers. As costs rise, customers will often seek ways to control costs throughout their supply chain, while suppliers will no doubt seek to pass on some elements of cost increases to customers.
COLA provisions take various forms and refer to various indices. How a contract links fees to COLA is under negotiation and subject to several variables, including (1) the applicable contract period (if any); (2) what fees are subject to a COLA adjustment (eg, related to the territory of provision/nature of the service concerned or the cost of inputs); (3) the applicable index or indices; and (4) the calculation of the COLA itself (which may be subject to a cap or a discount factor).
Whether a COLA mechanism is appropriate is also under discussion, with input costs for technology and outsourcing arrangements still subject to an overall long-term reduction, driven by the reduction in technology cost. Additionally, many outsourcing and technology providers have operations and facilities spread across the globe, particularly in India which, as highlighted above, is not subject to this sudden rise in inflation that the western world today.
If you have any questions or would like to discuss how to implement a COLA mechanism in your next contract, please do not hesitate to contact your Morgan Lewis team.