When did you last read the inflation clause in your outsourcing contract? If the answer is anything other than yesterday, read it again because there are clear winners and losers in a time of deflation. Over the 12-month period ending in March 2009, U.S. consumer prices fell 0.4 percent — the first 12-month decline since a similar drop for the year ending in August 1955.

There are three possibilities for your outsourcing contract:

1. It is silent with respect to inflation
2. It has a unilateral inflation clause
3. It has a bilateral inflation clause

Scenarios where buyers lose

For contracts that are silent with respect to inflation, buyers lose and service providers win. Why? Because a service provider that must bear the cost of inflation will make an inflation assumption and add that expected inflation to its price for services. If the service provider built three percent annual inflation into its price, and inflation is anything below three percent, the service provider reaps excess profit.

Many contracts contain a unilateral inflation clause. These clauses allow the service provider to adjust prices upward for some or all of the increase in U.S. inflation as measured by CPI-U (the consumer price index for all urban consumers published by the U.S. Bureau of Labor Statistics).

Once again, buyers lose and service providers win. Why? Because the contract only adjusts for increases in inflation. During a time of deflation, prices remain flat and the buyers of services do not see the benefits of deflation.

I recently heard someone quip that “flat is the new up.” If you are a service provider and your contract pricing does not decline to adjust for deflation, the greater the deflation, the greater the win because each dollar of revenue is worth more as deflation increases the purchasing power of those dollars.

Why buyers want a bilateral inflation clause

Smart buyers have service contracts with bilateral inflation clauses. Here the prices adjust up or down based upon changes in the inflation index. These contracts, when properly constructed, theoretically produce no winners or losers.

In a well-designed contract, the prices adjust up or down by a percentage of the change in the inflation index, and the percentage is set to represent the service provider’s cost structure split between fixed and variable costs. The inflation clause in the contract attempts to adjust prices to reflect the change in the service provider’s costs, recognizing that fixed costs are fixed and that the adjustment therefore only needs to address the variable portion of the costs.

In practice, when a bilateral inflation clause is in use, the service providers will probably be losers and the buyers winners during times of deflation. Why? Because the United States has not seen deflation for a half century and many service providers never thought that it would happen on their watch; so they built their cost and pricing models with the assumption that deflation would never happen and trigger a price decrease. Therefore, the triggered price reduction in many cases results in buyers underpaying for services, which causes an erosion of service provider margins.

The best way to handle inflation

Outsourcing agreements work best when there are no winners or losers. Win/lose deals often degrade into lose/lose deals. Bilateral inflation price adjustment clauses are arguably the fairest and therefore the best way to avoid creating winners and losers. The bad news is that most contracts are not written with bilateral inflation price adjustment clauses.

The good news is that history tells us that the current period of deflation is likely to be brief. We had two brief periods of deflation in the past century, the first mid-1949 to mid-1950, and the second mid-1954 to mid-1955. (See exhibit 1) Both periods of brief deflation coincided with recessions. Prolonged periods of deflation are associated with depressions as happened in the 1930s and 1890s. Hopefully the current economic situation will prove to be a recession (brief period of deflation) and not a depression (prolonged period of deflation).

Everest’s advice: If you are a buyer of services and don’t have a bilateral inflation agreement, talk to your service provider. Your contract may not explicitly provide you the right to a price reduction in a time of deflation, but it can’t hurt to have a discussion of the intent of the price adjustment mechanisms that are in the contract. Be sure to also reread your entire contract; you may have other contract provisions such as “significant changes in the business environment” provisions that you can call into play.