October 2024
Time to ditch CPI as a price variation mechanism?
October 10, 2024 Filed in: Procurement
Time to ditch CPI for B2B price variation formulae?
The Consumer Price Index (CPI) is widely used for contract price variation in business to business contracts. Paul Rogers argues that CPI is no longer fit for purpose as a proxy measure of business input costs.
One of my procurement mentors was a retired army Major. I think it’s fair to say he ‘marched to the beat of a different drum’. It was the 1990s, and he told me that he still had a black-and-white television at home. “Why’s that Philip?” I asked him. “Black and white televisions are at the mature phase of their product life cycle. Reliable, defect free, and…” he leant towards me as if sharing a state secret and whispered “…considerably cheaper than colour televisions!”
I think there is a phrase in French for things that you wish you had said at the time, but only thought up later. (L’esprit d’escalier’; the ‘spirit of the stairs’) I wish I had pointed out to Philip that life is polychromatic and he was only cheating himself by clinging to something that belonged in a museum. Alas, Philip has long since passed to the great Officer’s Mess in the sky. But the attraction to the familiar long after it has ceased to be relevant is not confined to the cathode-ray tube.
Generals always fight the last war
The Consumer Price Index is widely used in contract price adjustment formulae to adjust contract prices. The attraction is that it is easily accessible, can be tracked by both parties, and is now updated monthly. This means that there is less ‘lag’ between the end of a period and the publication of the CPI index.
But what happened in March 2022? (OK, apart from Russia invading Ukraine.) In Phase 2 any linkage between CPI and PPI was broken. Whether it was post-COVID supply chain disruption, or international geopolitical events doesn’t really matter, does it? In Phase 2 contracts varied on the basis of CPI alone rewarded suppliers with a bonus. Look at the result for the first half of 2023. If we believe that PPI tracks actual ’factory gate’ pricing, then if contract pricing was varied 100% by CPI, suppliers got an unearned bonus from their clients of 2%. Clients 0 Suppliers 1.
Changing of the Guard in 2024
Phase 3 is different again. 12 months of relentless political focus on CPI paid dividends as the CPI fell by half. But hang on! What’s happening to PPI? PPI is higher than CPI in Phase 3. Clients 1 Suppliers 1? I don’t think the ‘swings and roundabouts’ argument is very strong.
The observable evidence is that using CPI alone as a price variation mechanism results in contract price changes that may be unrelated to the actual cost experience of our suppliers.
The clue is in the name
CPI reflects average price changes across a broad range of consumer goods and services. This means that it may not accurately capture the specific cost pressures faced by businesses in different industries. For example, contract prices for construction projects may be heavily influenced by fluctuations in the prices of raw materials like steel and concrete, which may not be fully reflected in the CPI. As a result, using the CPI to adjust contract prices may not adequately account for the unique cost structures and inflationary pressures faced by businesses in various sectors. Here is the contents of the basket of goods and services that is used to calculate CPI;
• Food and non-alcoholic beverages
• Alcohol and tobacco
• Clothing and footwear
• Housing
• Furnishings, household equipment, and services
• Health
• Transport
• Communication
• Recreation and culture
• Education
• Insurance and financial service
An obvious question to ask procurement practitioners is this; what has this got to do with the input costs of your suppliers?
The shopping basked is specifically designed to represent the typical purchases of metropolitan households over a year. I have heard the argument that it does represent the experience of our supplier’s staff in their day-to-day purchasing. But what has that got to do with our supplier’s costs?
CPI is designed to measure changes in consumer prices at the retail level, not price variations experienced by businesses at the wholesale or producer level. Businesses may face cost pressures from changes in input costs, supply chain disruptions, or shifts in global market conditions. This can -and has- lead to mismatches between suppliers actual cost increases and contract price adjustments. This will affect the profitability and viability of contracts leading to winners and losers.
Porter’s Sixth Force
I understand that if Michael Porter had the chance to update his ’Five Forces’ model, he would add in government regulation. In their note to the September quarters’ CPI result, the Australian Bureau of Statistics (ABS) mention that “Electricity prices fell 17.3 per cent in the September quarter and 15.8 per cent in the past 12 months.” A great result, welcomed by all consumers. The ABS then lists a variety of government interventions that have reduced the cost of electricity, before mentioning, almost as a footnote, “Excluding the rebates, electricity prices would have risen by 0.7 per cent in the September 2024 quarter.”
My point is that CPI has become such a topic of public debate, especially now that it is published monthly, that governments influence the CPI to serve their political interests.
This diminishes the utility of CPI as proxy measure for actual business costs.
The ‘best of the best’?
Are your suppliers ‘average’? Do you go through complex and sophisticated procurement processes to select suppliers who perform in an average way? No, you don’t. So why use a proxy measure for inflation which assumes that suppliers experience cost inflation the same as the average consumer in the supermarket? It is time to ditch CPI as a proxy measure of business to business inflation.
Here are two alternatives:
• Construct a cost model with your suppliers which identifies cost drivers influencing at least 80% of the final price. This is likely to include wages, materials and overheads. Agree with your suppliers the Wage Price Index (WPI) that is most relevant for wages, and the PPI that is most relevant for materials. Perhaps agree a composite index based on WPI and PPI for overheads;
• Construct a cost model with your suppliers which identifies cost drivers influencing at least 80% of the final price. Get them to track and validate actual cost changes in respect of wages, materials and overheads.
Remember that digitalisation is driving significant productivity improvements in every organisation on the planet including your suppliers. We should build the expectation amongst our suppliers that they will moderate any unavoidable cost increases through offsetting productivity improvements, which they should demonstrate in black and white.
Or colour, as the case may be.
The Consumer Price Index (CPI) is widely used for contract price variation in business to business contracts. Paul Rogers argues that CPI is no longer fit for purpose as a proxy measure of business input costs.
One of my procurement mentors was a retired army Major. I think it’s fair to say he ‘marched to the beat of a different drum’. It was the 1990s, and he told me that he still had a black-and-white television at home. “Why’s that Philip?” I asked him. “Black and white televisions are at the mature phase of their product life cycle. Reliable, defect free, and…” he leant towards me as if sharing a state secret and whispered “…considerably cheaper than colour televisions!”
I think there is a phrase in French for things that you wish you had said at the time, but only thought up later. (L’esprit d’escalier’; the ‘spirit of the stairs’) I wish I had pointed out to Philip that life is polychromatic and he was only cheating himself by clinging to something that belonged in a museum. Alas, Philip has long since passed to the great Officer’s Mess in the sky. But the attraction to the familiar long after it has ceased to be relevant is not confined to the cathode-ray tube.
Generals always fight the last war
The Consumer Price Index is widely used in contract price adjustment formulae to adjust contract prices. The attraction is that it is easily accessible, can be tracked by both parties, and is now updated monthly. This means that there is less ‘lag’ between the end of a period and the publication of the CPI index.
But what happened in March 2022? (OK, apart from Russia invading Ukraine.) In Phase 2 any linkage between CPI and PPI was broken. Whether it was post-COVID supply chain disruption, or international geopolitical events doesn’t really matter, does it? In Phase 2 contracts varied on the basis of CPI alone rewarded suppliers with a bonus. Look at the result for the first half of 2023. If we believe that PPI tracks actual ’factory gate’ pricing, then if contract pricing was varied 100% by CPI, suppliers got an unearned bonus from their clients of 2%. Clients 0 Suppliers 1.
Changing of the Guard in 2024
Phase 3 is different again. 12 months of relentless political focus on CPI paid dividends as the CPI fell by half. But hang on! What’s happening to PPI? PPI is higher than CPI in Phase 3. Clients 1 Suppliers 1? I don’t think the ‘swings and roundabouts’ argument is very strong.
The observable evidence is that using CPI alone as a price variation mechanism results in contract price changes that may be unrelated to the actual cost experience of our suppliers.
The clue is in the name
CPI reflects average price changes across a broad range of consumer goods and services. This means that it may not accurately capture the specific cost pressures faced by businesses in different industries. For example, contract prices for construction projects may be heavily influenced by fluctuations in the prices of raw materials like steel and concrete, which may not be fully reflected in the CPI. As a result, using the CPI to adjust contract prices may not adequately account for the unique cost structures and inflationary pressures faced by businesses in various sectors. Here is the contents of the basket of goods and services that is used to calculate CPI;
• Food and non-alcoholic beverages
• Alcohol and tobacco
• Clothing and footwear
• Housing
• Furnishings, household equipment, and services
• Health
• Transport
• Communication
• Recreation and culture
• Education
• Insurance and financial service
An obvious question to ask procurement practitioners is this; what has this got to do with the input costs of your suppliers?
The shopping basked is specifically designed to represent the typical purchases of metropolitan households over a year. I have heard the argument that it does represent the experience of our supplier’s staff in their day-to-day purchasing. But what has that got to do with our supplier’s costs?
CPI is designed to measure changes in consumer prices at the retail level, not price variations experienced by businesses at the wholesale or producer level. Businesses may face cost pressures from changes in input costs, supply chain disruptions, or shifts in global market conditions. This can -and has- lead to mismatches between suppliers actual cost increases and contract price adjustments. This will affect the profitability and viability of contracts leading to winners and losers.
Porter’s Sixth Force
I understand that if Michael Porter had the chance to update his ’Five Forces’ model, he would add in government regulation. In their note to the September quarters’ CPI result, the Australian Bureau of Statistics (ABS) mention that “Electricity prices fell 17.3 per cent in the September quarter and 15.8 per cent in the past 12 months.” A great result, welcomed by all consumers. The ABS then lists a variety of government interventions that have reduced the cost of electricity, before mentioning, almost as a footnote, “Excluding the rebates, electricity prices would have risen by 0.7 per cent in the September 2024 quarter.”
My point is that CPI has become such a topic of public debate, especially now that it is published monthly, that governments influence the CPI to serve their political interests.
This diminishes the utility of CPI as proxy measure for actual business costs.
The ‘best of the best’?
Are your suppliers ‘average’? Do you go through complex and sophisticated procurement processes to select suppliers who perform in an average way? No, you don’t. So why use a proxy measure for inflation which assumes that suppliers experience cost inflation the same as the average consumer in the supermarket? It is time to ditch CPI as a proxy measure of business to business inflation.
Here are two alternatives:
• Construct a cost model with your suppliers which identifies cost drivers influencing at least 80% of the final price. This is likely to include wages, materials and overheads. Agree with your suppliers the Wage Price Index (WPI) that is most relevant for wages, and the PPI that is most relevant for materials. Perhaps agree a composite index based on WPI and PPI for overheads;
• Construct a cost model with your suppliers which identifies cost drivers influencing at least 80% of the final price. Get them to track and validate actual cost changes in respect of wages, materials and overheads.
Remember that digitalisation is driving significant productivity improvements in every organisation on the planet including your suppliers. We should build the expectation amongst our suppliers that they will moderate any unavoidable cost increases through offsetting productivity improvements, which they should demonstrate in black and white.
Or colour, as the case may be.