The economic climate dictates that, it is time for people engaging and managing suppliers re-examine their approach to the use of price indexation formulae.

Surely there's a smarter way to deal with price?

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

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.

There 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 .

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!).

Surely there's a smarter way to deal with price:  The takeaway

Chances are some one in your team is about to make one (all!?) of the following mistakes. Here's a 7 point checklist of NOT what do in reviewing your approach to price variations.

1. Don't include indexation in your fixed price contracts

2. Have a raft of appendices with the contract, but not one with a worked example of how price indexation works

3. Refused to explore alternatives from RPI - "we've always done it this way"

4. Require something called Value for Money but not figured out how to link it to the indexation strategy

5. Do we have a forward strategy to deal with our approach to indexation?

6. Struggled to find an index (or indices) that accurately reflect the cost drivers of a specific purchase.

7. If we do have indexation, unconvincing in negotiating the granularity of the fixed and variable elements

These are the rookie procurement errors we’ve observed most often. What did we miss?

Steve

Steve Ashcroft, your first point of contact for advice and support on how to enhance procurement practices, can be reached on 01744 20698 or email

 

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Brian Farrington - one the world's longest established procurement consultancy and training specialists.