Banana prices significantly increased in 2011, affecting the consumer price index (CPI) which tracks prices of goods and services purchased by households. However, CPI may not accurately reflect price changes for business supply contracts as it includes consumer goods unlike the producer price index (PPI) which tracks prices at the producer level. Creating a customized PPI using relevant industry price changes provides a better mechanism than CPI for adjusting business contracts over long periods.

1. What does the price of bananas have to do with your
supply contract?
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2. CPI vs. PPI
www.pricinginsight.com.au
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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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Pricing Insight is a firm of strategy advisors who are experts at
building world class pricing and commercial strategies, structures and
operations for ASX, Fortune 500 and private equity companies.
www.pricinginsight.com.au
+61 2 9091 0226