Inflation & Indexation

Since the banking and credit crises which gripped most of the world in 2006 – 2008, the general equilibrium that tended to exist between various economic indicators has been turned on their head and while generally the economic situation has improved we live in extremely odd times financially and commercially at a global level.

The economic crises initially led to years of stagnation in wage inflation, but with relatively high general consumer inflation, coupled with high commodity prices such as oil and oil derived products.

Large numbers of contracts will be multi-year where the value remaining to be delivered may be increased based on the method of indexation agreed at the start of the contract and if the rate of increase was calculated based on traditional inflation measures, such as the Retail Price Index (RPI) or the Consumer Price Index (CPI) any revaluations taking place around now based on the last 12 months data will be extremely painful for organisations.

Of course if you are delivering a new road you would firstly be asking yourself the question, “What does a loaf of bread, protein powder, sweet potato, streaming music over the internet, pasta, craft beer or mobile phone chargers got to do with the cost to a company delivering a new road?” In reality very little as the drivers here will be significantly different, such as aggregates, oil derived products, cement and labour. Yet some companies will allow the value of their contract to be raised by the CPI or RPI/ (See below a typical percentage make up of the ‘basket of goods’ that makes up the CPI annual calculation.)

14.1 Indexation
Over the last two years on a calendar year basis, the sum of £100 at the base date of 1 January 2014 will have escalated to £101.46 on January 2015 and more worryingly to only £101.49 in the last year. This is primarily as the last year saw 3 months with negative inflation or deflation. Yet in reality has this deflation filtered down at a business level? I think the general consensus would be ‘No.’

The table below shows the percentage change per year for both the CPI and Average Weekly Earnings (AWE) which will be used for an illustration significance of the correct Indexation Model later in this post.

14.2 Indexation
At the same time that both CPI and RPI have been almost stagnant, years of depressed wage inflation has resulted in average earning having lagged behind both CPI and RPI resulting in what the political classes like to call the “cost of living crises” which they blamed on each other. The truth of course is more complex, but if we have to apportion blame, they are both equally responsible and equally inept at having the will, desire or mechanisms to make any real difference and to change anything fundamentally.

Over the same period that CPI and RPI has been stagnant, the AWE index has moved significantly in the opposite direction. (See Table above) By using the same measure as previously of a notional £100 at 1 January 2014. In the first year there was almost parity as the increase was from £101.25 as measured at 1 January 2015. However this has moved significantly in the last 12 months this £101.25 would have escalated to £103.73 by January 2016. Therefore in effect there is under recovery of wage inflation.

Of course all these numbers are subjective really, as they are just random in reality. However the picture emerges if we add a real life situation to the equation for illustration purposes.

If we continue the analogy that the company is a road builder and we assume they have an internal design office which is a labour intensive activity. Their fees for the design of the new road will be £5 Million which will be earned on a straight line basis over 3 years or 36 months, commencing on 1 January 2014. This will see them earning £138,888.89 each period in the first year of the contract.

In line with the contract provisions at 1st January the balance of the sum due to be earned is escalated by the CPI. This is the sum of £3,333,333.33. As we have already established this is a labour intensive activity and the wage charge is 60% of the total fee which the balance being absorbed by fixed costs of 25% and the variable costs and overhead and profit is 15%, of which notionally 7.5% is profit is projected.

The calculations in the table below show how the Contract Sum and by consequence the Monthly Fee rises as a result of the CPI inflation rates of 2.57% effective on 1st January 2015 and then by 1.40% on 1st January 2016. These calculations are assuming that internal costs remain constant.14.3 Indexation

However as a result of a shortage of skilled labour and a general change in government policy towards road building the company has had to settle their yearly salary negotiations at significantly more than the increase they have received for inflation. This has resulted in the wage charge now absorbing 64% of the yearly fee and as the Fixed Costs absorb 25% meaning that the difference between the yearly indexation uplift will have to be absorbed by the Variable Costs. Unless there is scope to reduce some of the company’s other variable costs this is going to impact on the profitability of the project.

The table below shows the impact of a single inflationary factor on the potential profit of the project. This is on a single factor only, you can only imagine the impact if materials and resources are used. There was a period in the early and mid part of the last decade where oil derived products were increasing in cost by 10% a year and inflation was 2%, this 8% variance would have to be funded from cuts elsewhere.

14.4 Indexation
Now of course this is entirely subjective and in reality companies cost capture and overhead apportionment is more robust and complex than the simple example shown, but this does not detract from the issue that a company needs to ensure, particularly in multi-year contracts that they are being suitably rewarded for inflationary pressure.

You could even make an inflationary increase clause and a suitable mechanism part of any contract, even if it is not multi-year as neither party can foresee any complications that could result on the contract being significantly extended.

In the next post we will look at an Indexation Model to show how the various indices can be used to make past events predict future trends and allow a company un Indexation Model that is bound into the contract to offer the best protection they can get, in a completely uncertain area.

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