IT Services Contracts: Beware of Cumulative Price Increases

Inflation is a natural part of a healthy economy, and it is in the best interest of all parties that prices for goods and services increase slightly every year.  However, software and IT Services vendors have leveraged this “known” economic impact in their favor and often present attractive proposals which seem like a steal upon signing, but turn into a weight around your IT or sourcing department’s neck by the end of the term.

Over the last 5 years, U.S. inflation (or CPI) has increased by an average of just under 2% per year.  Software and services contracts commonly span for 5+ years, and vendors naturally want to insulate themselves from losing this value every year.  Simultaneously, it is important for you, the customer, to establish some level of price predictability for the initial term and beyond.  The primary ways we have seen vendors position options for financial predictability are:

1. Lock prices for the initial term, with no yearly increases. Any renewals thereafter will have a yearly 3% increase applied to the base cost.
2. Lock prices for the initial term, with no yearly increases. The first year following the lock period will have the 3% increase applied “cumulatively” and all following years will apply the 3% increase at the beginning of each fiscal year.
3. Link pricing to a yearly CPI index and raise prices in accordance with the findings at the beginning of each new fiscal year.
4. Establish a standard percentage for prices to increase every year (commonly 3% for U.S. and 5% for the rest-of-world).

Scenario’s 1 and 3 are the best of these options for any long-term/ongoing contract.  These price lock or price cap mechanisms are typical and fair for all parties involved.  I’d like to dive a bit deeper into scenario’s 2 and 4.

Cumulative Price Increases Can Come Back to Bite You

Let’s begin with scenario 2, where prices are locked throughout the initial term and the 3% increase is applied cumulatively following the lock period.  Locked pricing for the initial term is a very common bargaining chip IT vendors will put on the table, but in this situation, that value is never truly realized by the customer if you choose to renew.  Cumulative price increases mean that although your costs will stay the same per year during the first 5 years of the deal, the vendor is keeping track of how much the cost SHOULD have increased during that time and will charge you after you renew.

To illustrate this example, we’ll create a fictional $20M software subscription purchase with a 5-year term ($4M annually).  When year 6 comes around and your business is reliant on that software, every single price increase will now be applied all at once to your new annual invoice.  At 3% annually, you will pay $4.6M in Year 6 for the same products and the cost will continue to increase by 3% YoY thereafter.  Under scenario 2, unless you exit the deal after your initial term, the vendor will recoup even more than the savings that the initial price lock granted your business.

In a negotiation, don’t be too quick to compromise on another request just to lock down the price predictability that comes with locked rates for the initial term.  Try to ensure that you are actually getting what you think you are from your vendor and that they are not just clawing that value back at a later date.  The trickiest part of avoiding scenario 2 is reading the contract language proposed by the vendor.  Often, they will sneak the word “cumulative” or “aggregate” into their responses about CPI increases without calling much attention to the major effect it will have on your cost profile.

CPI increases are directly attributable when dealing with resource rates, as salaries are continually increasing, and again that is a good thing for everyone.  When dealing with software vendors, however, their margins are much greater, and price locks for your initial subscription term with NON-cumulative increases should be considered table stakes for any deal.

Locked Price Increases Can Add Up Too

Now let’s discuss scenario 4 with the same example of a $4M annual software subscription purchase with a 5-year term.  In this scenario, the IT services vendor establishes a standard percentage for yearly price increases (such as 3%).  Though this is a common scenario, you can see in the table below that it is in fact the costliest in the long run.

As you can see, a slight difference in “fee lock” or “increase cap” wording can mean millions in lost value to your enterprise.  The ultimate goal of any negotiation is to optimize your financials, but also to create a level of ongoing cost predictability.

If positioned correctly in the negotiation, there is a fifth option where both the initial term AND the full renewal term are price locked, with agreed upon annual increases thereafter.  IT vendors will never position this fifth option themselves as they prefer to renegotiate after the initial term in order to re-establish higher list rates once your business is dependent on their service.  Avoiding this second negotiation is critical to establishing cost predictability for your enterprise.

Don’t let software or IT Services vendors claw back value you worked hard to negotiate. Our expert advisors are to help you address price locks and increase caps early and often. Contact us today for how we can help.