Annual increases in 3rd party agreements. Stop giving money away!

16th April 2019

You may be thinking of establishing or indeed already have in place an outsourced service agreement for some or all of your IT services and included in the agreement is the use of RPI (Retail Price Index) or other indices giving a year-on-year increase. You’d traditionally think that an annual price lift to reflect the RPI differences is normal and correct. If so, you may be inadvertently giving a profit increase to the supplier where the reverse action could be more appropriate.

IT infrastructure outsourced service agreements are often made upon very specific service and hardware specifications stating for example that a server will be supplied with a set processor, 128GB of Ram and 20TB of storage. Any increases to that specification would thus be a change to that agreement and subject to appropriate charges. That seems fair enough, but there is an issue with that model as it has a fundamental flaw. The flaw relates to the fact that whilst Moore Law can be argued to be no longer accurate, like-for-like computing costs still tend to fall on an annual basis. Thus same-specification additions or replacements will be available at a lower, declining price to suppliers. If, however, there is an RPI aligned price increase in your infrastructure fees then your supplier can purchase the equipment at a lower cost, yet they provide it back at a greater margin. This represents a one-sided position in favour of the supplier unless they share the savings or increase the specification in line with the agreed costs. Who wants to be paying the same price in five years’ time for old technology?

We should also take into consideration the impact of resource costs upon the cost to deliver an outsourced service. There are two trends that we must be mindful of when considering how the service is to be priced and delivered. If for example, you are operating with a team of 20 resources to deliver the service, then individuals can expect to see some form of extra compensation be it a bonus or a salary increase and as such an RPI model would seem correct. If, however, 10 of those roles were sent to an offshore location then the suppliers resource delivery cost would reduce. Do you have the option to renegotiate the fee if a service delivery adjustment such as this is made? It’s rare to have such an inclusion in an agreement as the supplier will argue that it’s their business and their profit margin. But if your costs are going up whilst theirs are going down, you have a potential conflict of interest that you should again be interested in knowing about.

The second consideration for resource costing is where a significant number of contractors or other external developers are used. Over the past few years there’s been a trend of driving rate cuts downwards by as much as 10% rather than giving rate increases. Whilst not all suppliers do this, some do with a degree of regularity and as such, you should be aware of this move. Again, your pricing may increase with RPI for example, whilst your suppliers are going down and their margin increasing.

Suppliers as I mentioned, will argue their right to change their operating model, and there is some validity in that argument. However, agreements are established based upon an understanding of the cost to supply the service at the point of assignment.

A trend I see with increasing regularity is where the supplier during the tendering process, highlights one operating model and prices to do this intends to change their operating model once the business has been secured. Knowing this in advance enabled the supplier to make a lower, unrepresentative proposal offer when compared to another supplier, for example, to commit to a specific model. It hardly represents a margin increasing comparison between suppliers. Do you ever go back and compare the old RFP’s once such changes are made by the chosen supplier? If you knew this information in advance, would they have won the tender in the first place? It’s a difficult dilemma.

Avoiding unwarranted price increases seems insignificant at first but substantive changes to a suppliers operating model can have detrimental impacts upon future service delivery quality as well as the medium to long term relationship due to trust issues.

It’s not difficult to avoid inappropriate increases if a few simple steps are taken. The first is to avoid the inclusion of index-based pricing in the first place. The second is to look at how hardware and infrastructure price changes are included in any agreement. Remember however to be fair to the selected supplier. If a certain set of hardware is purchased in order that the supplier can deliver the service, they must be able to write that investment down over an agreed period and as such declining pricing is not necessarily fair. However, note that once purchased, the infrastructure price is set and not subject to RPI and as such any associated annual price increase is reflected as a margin increase. If you add new hardware to your service agreement, make sure that the current market price and/ or specification is used in the cost model and reflected accordingly.

In your contract negotiations, make sure to include an option to discuss the pricing if there is a shift in the supplier’s delivery model format. If the supplier later wishes to switch to a lower cost location, that’s fine, make sure you have a clause that allows you to renegotiate the resourcing element. The same goes when suppliers are making pay and/ or rate cuts. After all, you’re also carrying the Business as Usual risk there as well.

It’s important and cannot be understated that all outsourced agreements should always be assigned with the best interests of both parties in mind. The best relationships are undertaken on a win-win basis and with a degree of flexibility and understanding on both parts. Allow your supplier to make a profit, it’s not unreasonable. But, (there’s always a but) outsourcing is undertaken as a commercial, profit-making venture by suppliers, they’re not a charity and the temptation to use seemingly innocuous techniques to increase their margins is an ever-present threat when the less scrupulous suppliers come out to play.

Forewarned, as they say, is forearmed. Good luck in your agreement negotiations and reviews and play nicely now.