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CPI and PPI explained


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What does the price of bananas have to do with your supply contract?

Many businesses use CPI in their contracts when PPI may be a more accurate index to measure the price fluctuations in a more relevant market, saving you millions.

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CPI and PPI explained

  1. 1. What does the price of bananas have to do with yoursupply contract? 1
  2. 2. CPI vs. PPI 2
  3. 3. TABLE OF CONTENTS Title Page How bananas can affect your supply contract 4 Definition of CPI and PPI 7 CPI – How to calculate the index 10 PPI – How to calculate the index 12 PPI in contracts 16 Creating a bespoke PPI for your supply contracts 17© Pricing Insight 2012 3
  4. 4. How bananas can affect your supply contract Is CPI the right index for your contracts? As a commonly purchased item, 2011 CPI bananas will always be included in the CPI basket of goods. The recent escalation in banana prices had a significant effect on the food component of the 2011 CPI (+27% for fruit prices in Q2 contributed to +0.4% in Q2 CPI). CPI is often referred to in trade agreements as a pricing adjustment mechanism, however the CPI basket usually has little to do with goods/services in supply contracts. If the prices in your trade agreement are subject to changes in CPI, you may be paying for price increases that do not actually affect your business.© Pricing Insight 2012 4
  5. 5. Using CPI instead of PPI Choosing the wrong index can have a significant effect on margin Effect of using CPI instead of PPI in a $10M pa contract over the last 5 and 10 years $6.00 -$5.43M $5.00 $4.00 Loss (in millions) $3.00 $2.00 -$1.21M $1.00 $- over the last 5 years over the last 10 years After 10 years, you could be missing out on up to 20% of your company’s potential profitability© Pricing Insight 2012 5
  6. 6. CPI vs. PPI Annual % change of PPI and CPI and the corresponding effect on $100 over 10 years Annual % change Effect on $100 over 10 years CPI PPI CPI PPI 7.00% $150.00 $145.00 6.00% $140.00 5% 5.00% $135.00 $130.00 4.00% $125.00 3.00% $120.00 2.00% $115.00 $110.00 1.00% $105.00 0.00% $100.00 Businesses that use CPI as the price mechanism to protect against inflation have experienced up to 500 basis points of margin erosion ever year for the last five years© Pricing Insight 2012 6
  7. 7. Definition Def_ No 1. Def_ No 2. CONSUMER PRICE PRODUCER PRICE INDEX – INDEX – CPI measures the cost of PPI is an output index – it measures price fixed basket of consumer good and services changes at the level of the manufacturers of a of a constant quality product (in this it differs from consumer price indices which measure the prices from the point of view of A CPI measures the change in prices paid buyers). by households for goods and services for consumption purposes (households must The PPI is a family of indexes that measures the acquire, use or pay for it) average change over the year in selling prices received by domestic producers of goods and services© Pricing Insight 2012 7
  8. 8. Difference How does the Producer Price Index differ from the Consumer Price Index? The set of goods and services included in the CPI are those #1 purchased for consumption by Australian households  This set includes imports for all calculations TYPES OF GOODS The set of goods and services included in the PPI is the AND SERVICES entire marketed output of producers INCLUDED  This includes those items purchased by other producers or by consumers either directly from the service producer or indirectly from a retailer  Because the PPI target is the output of Australian producers, imports are excluded for some calculations #2 The price collected for an item included in the CPI is the out-of-pocket expenditure by a consumer for the item  Taxes are included because they are a part of the price the consumer pays TYPES OF PRICES COLLECTED The price collected for an item included in the PPIs is the revenue received by its producer  Taxes are not included because they aren’t a part of the revenue that the producer receives© Pricing Insight 2012 8
  9. 9. In a nutshell. CPI PRIMARY USE A primary use of the CPI is to adjust income and expenditure streams for changes in the cost of living. PPI PRIMARY USE A primary use of the PPI is to deflate revenue streams in order to measure real growth in output.© Pricing Insight 2012 9
  10. 10. CPI – Uses #1 #2 #3 MEASURES THE IDENTIFIES PRICE INDICATES CHANGES IN PURCHASING POWER OF INFLATION SPECIFIC TO STANDARD OF LIVING MONEY THE HOUSEHOLD SECTOR CPI compares how the price of When used alongside data on CPI measures inflation specific household goods and services household expenditure, CPI can to household consumers as have changed since the base indicate changes in the opposed to that of the nation’s period, and how much of today’s consumption of all goods and economy, using the current rate income is needed to purchase the services. It is assumed that of change of goods and same basket of goods. higher standards of living are services. associated with higher levels of household consumption.© Pricing Insight 2012 10
  11. 11. CPI – How to calculate the index For example: Highest level, containing all groups, sub-groups and All groups expenditure class All groups Groups of like Food & non-alcoholic goods or services Group beverages Sub-group Fruit & Vegetables Expenditure class Bananas Basic building blocks of the CPI, each Elementary aggregate Cavendish bananas containing several prices for a particular Price $2.99/kg good/service The set of goods and services included in a CPI is known as its “item coverage” or “CPI Basket”. The basket will vary depending on the principal purpose of the index.© Pricing Insight 2012 11
  12. 12. PPI – Uses #1 #2 #3 INDICATES ECONOMIC FOCUSES ON ACTUAL ADJUSTS CONTRACTUAL DIRECTION DOMESTIC OUTPUT PRICING AGREEMENTS Because PPI’s are established at PPI’s are calculated PPI data is often included in the producer level, they can often independent of imports and purchase agreements as a rise be a precursor for impending price government taxes, and as such and fall provision. As contracts changes for businesses and are often used in economic typically have extended periods consumers. This is often helpful in series for price changes when of payment, including the PPI predicting future inflationary other indexes aren’t appropriate. will minimise the risk of input pressures in the economy. pricing exposure for either party.© Pricing Insight 2012 12
  13. 13. PPI – How to calculate the index For example: Highest level, containing all industries, industry All industries All industries divisions and elementary aggregates Industry Service industries Industry sub-division Transport, postal and warehousing Basic building blocks Rail transport freight; of the PPI, each Elementary aggregate Bulk cargo containing several Heavy duty ore prices for a particular Price Containerised freight good/service PPI’s are calculated based on prices specific to each industry and industry sub-divisions, allowing a more accurate reflection of relevant changes.© Pricing Insight 2012 13
  14. 14. Different types of PPIs Various national PPIs are calculated based on factors such as stage of production and company industry Choosing the right index can have a dramatic effect on margin in the long term© Pricing Insight 2012 14
  15. 15. Input and output PPIs The process of manufacturing paint is a good example of how outputs and inputs flow through each stage of production PPIs are calculated based on: 1. Input and outputs prices of different industries; and 2. The stage of production (SOP) in which these industries operate SOP SOP indexes are E.g. paint manufacturing used to understand how changes in input Basic material Value adding Final product goods are passed through to the price of SOP Stage 1 - Preliminary Stage 2 - Intermediate Stage 3 - Finished goods final goods. Industry Manufacturing Manufacturing Construction Output Industry outputs refer to the goods produced specific to each industry and Sub- industry sub-division. division Input Industry inputs refer to the raw materials used specific to each industry and industry Elementary - Titanium oxide - Protective coatings - Sydney Harbour sub-division. aggregate - Red iron oxide - Interior wall paint Bridge The outputs of a primary good (chemicals) can be used as an input in the production of an intermediary good (paint), and this output can be used as an input into a finished good (bridge construction).© Pricing Insight 2012 15
  16. 16. PPI in contracts Including the PPI in contract agreements What is a rise A rise and fall clause modifies the rates paid to the contractor in circumstances where there are price fluctuations for certain inputs to the good or service (e.g. petrol, electricity or labour). These clauses are and fall clause? typically based on economic indices such as CPI or PPI. Why are they Where projects are heavily geared to market pricing (i.e. freight) it is necessary for parties to include provisions against price exposure. As contracts typically bind parties over significant periods of time, included in the price paid for the goods or services throughout the contract need to be constantly updated to reflect the current prices. contracts? While CPI & PPI both measure price change a fixed set of goods, CPI’s basket of goods is less Why is CPI an relevant to commodity pricing in Australia. Its inclusion of imports and taxes further dilute its relevance to your supply contract as they typically do not represent revenue to the producer. inappropriate PPI measures real output growth which is tailored to industry. Having your supply contracts geared to a bespoke index (i.e. for freight; petrol & labour) is the most suitable method for accommodating price index? fluctuations.© Pricing Insight 2012 16
  17. 17. Create a bespoke PPI for your supply contracts Identify which commodities are relevant to your business and use the corresponding change in price to calculate a bespoke PPI Dec Qtr Mar Qtr Change 2011 2012 Commercial fishing 1.16 1.09 -0.07 Meat and meat product mfg 3.47 3.45 -0.02 Dairy product mfg 3.92 3.90 -0.02 List the PPI that are relevant to your Fruit and vegetable processing 2.34 2.35 0.01 business Flour mill and cereal food mfg 1.04 1.04 0.00 Bakery product mfg 1. 2.42 2.41 -0.01 Beverage and malt mfg 5.57 5.66 0.09 2. Textile product mfg 0.64 0.60 -0.04 3. Printing and services to printing 0.38 0.38 0.00 4. Rubber product mfg 0.12 0.13 0.01 Plastic product mfg 1.11 1.11 0.00 5. Sheet metal product mfg 0.32 0.31 -0.01 6. Electronic equipment mfg 0.34 0.34 0.00 7. Industrial machinery and equipment mfg 2.08 2.07 -0.01 8. Electricity, gas and water supply 12.75 13.00 0.25 Building construction 61.55 61.39 -0.16 9. Road freight transport 2.08 2.10 0.02 10. Rail transport 0.59 0.61 0.02 Computer services 3.85 3.92 0.07 Legal and accounting services 0.83 0.83 0.00 Motor vehicle and part mfg 0.87 0.85 -0.02 Not all of these inputs/outputs may be relevant to your business, so a unique index should be applied which is based on price changes specific to your business. Through regression analysis of your historical data, it is possible to identify the most relevant indexes for your specific supply contracts.© Pricing Insight 2012 17
  18. 18. Pricing Insight is a firm of strategy advisors who are experts atbuilding world class pricing and commercial strategies, structures andoperations for ASX, Fortune 500 and private equity 2 9091 0226