Soaring Inflation Demands Careful Review of COLA Provisions in Technology & Services Agreements

Many long-term technology and services agreements have COLA mechanisms allowing for automatic increases in contract charges on an annual basis because of inflation. Indeed, COLA provisions that may have garnered little or no attention just a year ago merit scrutiny in our current environment to contain the risk of soaring price increases that dramatically impact operating budgets and, potentially, the fiscal health of an enterprise.  

In reviewing COLA provisions in technology and services agreements, customers may want to focus on the following issues:

Targeted COLA – The Scope of Pricing Adjustment

Look closely at the particular charges and fees that are eligible for escalation under the COLA provision and beware of COLA provisions that apply to “all” charges in a contract.

• Some charges are not sensitive to (and should not be subject to) inflation.
• In some cases, or in contracts with only a limited number of charges that are primarily for services tied to labor, it may be reasonable for most, if not all, of the service provider’s charges to be subject to a COLA increase. But in agreements with several charging mechanisms (rates, unit charges, fixed fees, variable fees, etc.), scrutiny should be paid to the charges (or components of charges) that should (and should not) be subject to increase.
• For example, personnel fees, and hourly fees for services provided, frequently are affected by inflation, and certain equipment and material charges may be affected by inflation (as the cost of producing such materials can increase). But certain surcharges, fixed fees and software charges (especially those that do not have a labor or personnel component affecting the fee) may not be sensitive to inflation and should not necessarily be increased.
• Also, consider if only a portion of a charge should be subject to a COLA increase. For example, a charge that includes both software and labor elements might be increased only for the labor component, resulting in only 25% to 75% of the charge being adjusted, based on the corresponding breakdown of labor versus other costs.

Picking the Right Inflation Index

Most countries publish multiple inflation indices, each gauged to address different costs-drivers of the economy, including the cost of goods, the cost of personnel/service or the cost of goods or personnel/service in particular industries (e.g., health care, manufacturing). Factors to consider include:

• In the United States, consider whether it might be appropriate to link contract prices to the rate of increase in the Consumer Price Index (CPI), the Consumer Price Index for All Urban Consumers (CPI-U) or the Employment Cost Index (ECI).
• A particular inflation index may be appropriate for one agreement (or one industry) but not another.
• Additionally, certain inflation indices run historically higher (or lower) than others.
• Consider both the appropriate inflation index and the historical volatility (or stability) of that index over time.

COLA Plus? Not in Today’s Market

Examine whether a proposed COLA increase will simply reflect the increase in inflation or something more than that (such as the change in COLA “plus 2%”). In a low-inflation market, service providers may seek a “bump-up” from the standard COLA increase to compensate for increased costs that are not otherwise recovered by COLA. Savvy customers may find a reasonable “bump-up” acceptable, in such a low-inflation market, to incentivize optimal performance (and to avoid a service provider cutting corners to preserve their margins). However, with inflation hovering around a 40-year high, an additional increase (on top of the standard COLA change) should be off the table.

Today’s Imperative: Capping COLA

For contracts entered into in today’s environment, customers will be well served to negotiate a reasonable cap on COLA increases. The success of this effort (and the level of the cap) will depend, at least in part, on the customer’s leverage.

In this economy, a customer may be wary of absorbing high inflation increases across its entire third-party supplier base. Contracts with no limits on COLA (and with no opportunity for the customer to say “no”) create a substantial risk. While customers have different business drivers, risk tolerances, hedging mechanisms and leverage postures, consider the following when approaching the COLA elements of a pricing model:

• If a customer is signing a long-term agreement, it should obtain contractual assurance that any pricing increases due to inflation will be calculated as “the lesser of” (i) the increase in inflation and (ii) a certain maximum percentage increase (i.e., a negotiated “cap”).
• Beware of inflation provisions that reflect the opposite approach, under which there is a floor with no upper limit. For instance, avoid COLA formulations based on “the greater of” (i) a certain base percentage increase (for example, 3%) and (ii) the increase in inflation. In a high-inflation market, where actual inflation is far-in-excess of the floor, this means that there is no maximum protection for the customer.
• If a service provider is unwilling to agree to a cap on COLA increases, customers might explore whether there are alternative contractual measures to mitigate the risk of price escalation.
• For example, some service providers may be amenable to “building in” COLA to certain charges (which may increase the rates paid by the customer but will provide a greater measure of protection against excessive inflationary risks).
• Also, customers may be able to secure a contract termination right if the application of COLA results in a price increase above an agreed level. Customers may have (and will continue to pursue) other “creative” mechanisms to control inflationary risks, some of which may require highly tailored contractual provisions, such as an “Extraordinary Events” clause.

What is the “Base” Timeframe?

The baseline or beginning timeframe used to calculate COLA increases also requires careful consideration. For example, to calculate inflation increases from year to year, some COLA provisions compare the current year’s inflation index rate to the index rate when the contract was signed, while other COLA provisions may compare costs back to the then-previous year. In a period of rapid inflation (potentially changing from month to month), this can significantly affect possible pricing increases due to COLA.

Closing Thoughts

It is of paramount importance to scrutinize COLA and related terms in technology and services agreements given current hyper-inflationary pressures. While there are no easy, out-of-the-box remedies, the importance of an informed, reasoned and, at times, creative approach to containing COLA-driven price increases cannot be overstated. Customers also should dust off their existing agreements to assess the potential impacts of (and possible avenues for renegotiation of) unfavorable COLA provisions.