Escalation clauses are often used to facilitate the creation of long-term contracts, and the consumer price index (CPI) is one of the most frequently used measurements for applying an escalation clause.
Sellers are hesitant to lock in a price on a long-term contract for fear of losing the benefit of possible market appreciation in the value of their goods or services that may occur over time due to inflation or other economic factors. However, it is often convenient for buyers to be able to secure long-term agreements, either to insure a steady supply or to be able to budget for long-term expenditures. A solution that is usually agreeable to both parties involves including an escalation clause that periodically adjusts the contract price in accord with an agreed-upon indicator of market price changes. The CPI is such an indicator; it is widely accepted as providing a reasonably accurate reflection of price changes due to inflation.
Escalation clauses are applied to contracts for rental property, labor, insurance, court-ordered support payments, and a myriad of contracts for goods and services. One well-known economic area where the CPI is used for escalation is government benefits provided to eligible individuals. For example, the CPI provides the basis for annual cost of living increases for recipients of Social Security benefits. The CPI is not a direct cost-of-living indicator; it is merely a price survey of a broad basket of consumer staples, but it is still utilized to estimate cost of living changes.
Implementing the CPI in a Market Escalation Contract
When implementing an escalation clause modifier such as the CPI, the contract must precisely define how periodic adjustments are made to the contract.
The figure that the adjustment is applied to must be clearly defined. For example, in a rental contract the adjustment may be made solely to the base rent amount or it may be applied to a larger figure that includes other secondary items such as utilities or maintenance services.
The particular variation of the CPI to be employed is specified. The government computes variations of the CPI for different areas of the country in addition to the standard overall CPI calculation designated as CPI-U, which purports to show the average CPI for urban workers in all U.S. cities.
The contract necessarily states how often adjustments are to be made or considered. Escalation adjustments most commonly occur on an annual basis, but they may be applied more or less frequently according to whatever agreement the parties to the contract reach. When using the CPI as an escalation modifier, the different variations of the CPI are not all provided with equal frequency. Indexes for some of the U.S. metropolitan areas are only published by the Bureau of Labor Statistics semi-annually, and therefore are not appropriate for contract situations in which the parties wish to make inflation-related price adjustments every month.
The specific formula for adjustment is also stated in the contract. Commonly, the price adjustment made is a percentage equal to the percent change of the CPI, but a contract may stipulate using a multiplier that results in a greater or lesser adjustment than the change in the CPI number. Some contracts additionally stipulate a maximum total price increase or guarantee a periodic minimum increase.