Finding the price index that is right for you

7 February 2013
Stephen Ashcroft - January 2013The economic climate dictates it is time for procurement departments to re-examine their approach to the use of price indexation formulae. Personal experience indicates in the UK there is an extensive use of the Retail Prices Index (RPI) and Consumer Price Index (CPI). These are produced by the Office for National Statistics (ONS). The main differences between the RPI and CPI relate to:
  • Commodity coverage. The CPI excludes owner-occupiers housing costs and hence the RPI has wider commodity coverage than the CPI.
  • Population base. The RPI excludes very high and low income households, so the CPI has a wider population coverage than the RPI.
  • Formulae used to combine prices at the first stage of aggregation – the CPI uses a combination of geometric means and arithmetic means whereas the RPI only uses arithmetic means.
The first official RPI was produced in January 1956 whereas the CPI was launched in 1996, and was initially known as the Harmonised Index of Consumer Prices (HICP). There is also the RPIX, which is the RPI excluding mortgage interest payments, and the RPIY, which is the RPI excluding mortgage interest payments and indirect taxes. The discerning buyer may question why either RPI or CPI as should be used as indexation formulae in an ‘industrial context’. The RPI and CPI both measure the average change in a fixed basket of goods and services over time. They are based on a comprehensive price collection that combines the price movements of around 180,000 price quotes collected each month, for a range of over 650 representative good and services. The ONS promotes the view that RPI and CPI are, among other things, used as “indexing rates in private contracts”. But I challenge the logic of such an approach. The indices are too general, lacking precision when applied to specific cost drivers.

The choice of indexation requires careful consideration of what is being purchased. For instance, The British Electrotechnical and Allied Manufacturers Association produces a ‘Standard Contract Price Adjustment Clause and Formulae for Electrical Machinery and Mechanical Plant’ for a range of machinery. There are nuances to the BEAMA formulae in that they introduce a ‘Fixed Element” (5 per cent), and ‘Labour and Materials’ weighted at 47.5 per cent each. A sample calculation can be found on the BEAMA website.

I was also recently interested to see a UK Council take a somewhat unusual stance: “In line with the Council’s reduced funding provision, the contract is being offered on a fixed price basis for three years and then linked to an appropriate basket of indices to reflect the labour and equipment used in its provision rather than RPIX or CPI. This should provide a level of price certainty in the short to medium term and also link future increases to actual cost model in delivery of the service”. A further question to consider is “who checks the implications of contractors being awarded RPI (or other indexation) that have not given their workers a wage increase for the past two years?”. The answer is, I suspect, very few organisations (if any!). Here is a checklist you may wish to build upon.
  • Do we include indexation in our contracts?
  • Why?
  • Have we reviewed any alternatives?
  • What impact does indexation have on value for money?
  • Do we have a forward strategy to deal with our approach to indexation?
  • Can we find an index (or indices) that accurately reflect the cost drivers of a specific purchase?
  • If we have indexation, who negotiates the fixed and variable elements?
Stephen Ashcroft is a procurement coach at Brian Farrington. He welcomes comments and LinkedIn connections
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