A Time to Reconsider Price Indexation

The economic climate dictates that, it is time for procurement departments to re-examine their approach to the use of price indexation formulae. Our informal research shows that in the UK there is an extensive use of the Retail Price Index (RPI) and Consumer Price Index (CPI). These are produced by the Office for National Statistics. 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 and hence 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 authentic means whereas the RPI only uses authentic means.

The first official RPI was produced in January 1956 whereas the CPI was launched in 1996 and was first known as the HICP (Harmonised Index of Consumer Prices).

There is the RPIX that is the RPI excluding mortgage interest payments and the RPIY that is the RPI excluding mortgage interest payments and indirect taxes.

The discerning buyer may consider, why use either RPI or CPI 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 Office for National Statistics promotes the view that RPI and CPI have, among other things, the use of “indexing rates in private contracts”. We 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. BEAMA (British Electrotechnical and Allied Manufacturers Association) produce a Standard Contract Price Adjustment Clause and Formulae for Electrical Machinery and Mechanical Plant and other product formulae e.g. for Turbo Generating and Allied Plant. Here are nuances to the BEAMA formulae in that they introduce a “Fixed Element” (5%) and Labour and Materials weighted each at 47.5%. A sample calculation can be found on the BEAMA website www.beama.org.uk/en/services/statistics-cpa/contract-price-adjustment.

We were very pleased 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 3 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 question to be considered is:

“who checks the implications of contractors being awarded RPI (or other indexation) but who have not given the workers a wage increase for the past two years?”

The answer is, we suspect, very few organisations (if any!).

Here is a 7-point checklist you may wish to consider.

1. Do we include indexation in our contracts?
2. Why?
3. Have we reviewed any alternatives?
4. What impact does indexation have on Value for Money?
5. Do we have a forward strategy to deal with our approach to indexation?
6. Can we find an index (or indices) that accurately reflect the cost drivers of a specific purchase?
7. If we have indexation, who negotiates the fixed and variable elements?

*** For our guide The What and Why and When And How and Where and Who of  Price Indexation, please contact Steve Ashcroft or call 01744 20698 to request your free .pdf copy ***

If you’ve found our insight on price indexation useful and would like to learn more about how we might be able to help you with managing contract risk please contact me on 01744 20698 and we can have an informal chat to discuss your areas of interest.

When you call, we’ll have a conversation to learn more about your needs and challenges, your objectives and priorities – and to see whether what we do seems to be enough of a fit to move forward.

If there’s a fit, we’ll set up a meeting, either by telephone or in person to do a more in-depth “discovery session” to really understand what you need and whether we can help.

Drop me a note to set up an initial phone discussion. I fully recognise that contacting consultants can sometimes seem like a daunting prospect – but try us, we don’t bite! Alternatively you can call me on 01744 20698.

Thanks

Steve

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About Brian Farrington

Brian Farrington is one of the world’s longest established procurement and supply chain consultancy and executive training specialists. 33 of the current FTSE100 have retained our services, as well as leading organisations in the UK, North America, southern Africa and Asia. Established in 1978, we have proven expertise and experience in strategic procurement and risk management.

Brian Farrington solutions and services are formed through consultancy, training & development, coaching – all underpinned by proprietary technology. Our four core areas of procurement risk management capability are:

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For more details about procurement risk management and Procurisk®, Stephen Ashcroft can be reached at 01744 20698 and email

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