Inflation Adjustment Clause Definition
This is a finance-related clause in a contract. It adjusts the relevant payments based upon annual or periodic inflation.
A Little More on Inflation Adjustment Clause
An inflation clause is generally used to adjust prices or payments due. Simple calculations follow an inflation index; whole complex methods follow the combination of several indexes and prices. Generally, the baseline date must be set to start measuring the variability at the commencement of the contract.
The more complex is the formula, often, the more accurate are the results. The level of complexity of the method is a matter of cost-benefit analysis.
This tool is essential in the negotiation process from buyers and suppliers point of view. From the buyer side of view, it is imperative to enable the buyer to determine and negotiate the correct adjustment clauses, because the price is derived through the adjustment will affect the cost and the profits of the company. While on the seller’s point of view, it is imperative so the supplier can determine the suitable evolution prices and it impacts the profits of the business.
Below are a few examples of products and services at a different level of complexity:
Cm = Monthly coefficient
LABORm = Value of the variable LABOR in the month of the adjustment
LABOR0 = Baseline value of the variable LABOR at the beginning of the contract
COOPERm = Value of the variable COOPER in the month of the adjustment
COOPER0 = Baseline value of the variable COOPER at the beginning of the contract
IPIMm = Value of the variable IPIM in the month of the adjustment
IPIM0 = Baseline value of the variable IPIM at the beginning of the contract
And finally, to get the Adjusted Price:
Pm = P0 x Cm
Pm = Adjusted price
P0 = Baseline price of the contract
Cm = Monthly coefficient
Not everything is about the formula.
Some of the essential factors to be negotiated in the contracts are explained below:
Begin by defining the starting point of any adjustments. This will be the baseline measure. The coefficient will then be adjusted for every payment or pricing period. Suppliers generally request adjustments monthly, while buyers prefer longer term adjustments (quarterly or yearly).
The whole formula will generally be subject to adjusted at any time. This is a common practice in long term contracts.
The conditions for adjustment differs in economies suffering fluctuations, particularly in long-term contracts. In any event, both parties must agree to any revision.
The Trigger clause is the provision indicating when an inflation adjustment must take place. It is usually set to take effect when there is some unforeseen variance in the variables.
References for Inflation Adjustment Clause
Academic Research on Inflation Adjustment Clause
- Inflation-Proof Rent Adjustment Clause for Commercial Leases (with Forms), An, Payne, J. M. (1983). Inflation-Proof Rent Adjustment Clause for Commercial Leases (with Forms), An. Prac. Law., 29, 35. This paper shows the reaction of stock prices to the new information about inflation. According to the daily returns to the Standard and Poor’s composite portfolio from 1953-78, it seems that the stock market reacts negatively to the pronouncement of unexpected inflation in the Consumer Price Index (C.P.I.), although the reaction is small. The stock market responded at the time of the announcement of the C.P.I., approximately 30 days after the Bureau of Labor Statistics collected the price data.
The adjustment of stock prices to information about inflation, Schwert, G. W. (1981). The adjustment of stock prices to information about inflation. The Journal of Finance, 36(1), 15-29. This article analyzes the reaction of stock prices to recent information on inflation. According to daily returns on the Standard and Poor’s composite portfolio from 1953–78, the stock market reacted negatively to the pronouncement of unprecedented increase in the Consumer Price Index (C.P.I.), although there was a slight reaction. It is important to note that the stock market seems to react at the time of the announcement of the C.P.I., approximately one month after the Bureau of Labor Statistics collects the price data.
Inflation and tax evasion: An empirical analysis, Crane, S. E., & Nourzad, F. (1986). The Review of Economics and Statistics, 217-223. This paper contains an analysis of the effect of inflation on aggregate tax evasion in the United States over the period 1947-1981. It was discovered that tax evasion in both absolute and relative terms is positively related to the inflation rate. Further, the results indicate that aggregate evasion has risen in both absolute and relative terms with increases in the marginal tax rate, but has fallen with increases in the detection probability, the penalty rate, and the wage share of income.
The impact of the automatic adjustment clause on fuel purchase and utilization practices in the US electric utility industry, Kaserman, D. L., & Tepel, R. C. (1982). Southern Economic Journal, 687-700. All electric utilities are subjected to fuel price adjustment mechanism. The difference between these formulas is purchasing power. This paper studied the impact of alternative treatment of purchasing power on the incentive of regulated firms that minimizes running cost through its purchasing power and own-generated power. According to the data gathered and empirical analysis, over 113 privately owned U.S electric utilities confirms the theoretical prediction.
The Impact of a Fuel Adjustment Clause on the Regulated Firm’s Value and Cost of Capital, Clarke, R. G. (1978). Journal of Financial and Quantitative Analysis, 13(4), 745-757. Recently, The running cost for power generating plant has increased immensely than what many utility executives and regulators anticipated. Amidst substantial regulatory lag in adjusting rates, stockholders have learned to absorb the differences between the unprecedented increase in fuel and other revenues. Many firms have permission to make use of automatic fuel adjustments clause ( FAC), so they can shorten the time required for the increment at fuel price to be reflected, to consumers. The FAC helps the firm to adjust the rate of electricity when the amount of fuel fluctuates. Recently over 45 states regulatory commissions have allowed some FAC.
- The interaction between indexation, contract duration and non-contingent wage adjustment, Christofides, L. N. (1990). Economica, 395-409. A model of the elasticity of indexation, contract duration, and non-contingent wage adjustment is estimated using Canadian wage agreements. The outcome suggested that the level of indexation and contract time length are interdependent and are affected by their past values, inflation uncertainty and the conditions of the labor market. The relationship between the CPI ad the industry products prices dramatically changes the degree of indexation. This model elaborates on the overall wage adjustment as well as more aggressive models designed solely for that purpose.
Cost-of-living adjustment: keeping up with inflation, Sheifer, V. J. (1979). Monthly Lab. Rev., 102, 14. This study reveals the price-indexation provisions of a sample of the Canadian collective bargaining agreements conducted between 1968 and 1975. According to these contracts agreement, escalated wage increases comprised about one-third of total wage increases and represented a significant source of erosion in the relative wages of skilled workers. The variation across all industries responds to the changes in price.
- Cost-of-living clauses in union contracts: determinants and effects, Hendricks, W. E., & Kahn, L. M. (1983). ILR Review, 36(3), 447-460. According to the hypothesis carried out between 1969 and 1981, the primary influencer of the incidence and the strength of cost of living adjustment (COLA) clauses in U.S manufacturing industries and the effect on the requirements of wage inflation. Over 2500 bargaining relationship out of 5570 union contracts samples were tested. The hypothesis results revealed that both union bargaining power and inflation uncertainty affects the probability that a COLA clause was adopted as well as the strength of the clause adopted. This negatively influences the incidence and strength of COLA clauses during the study as a result of a fluctuation in industry prices.
Inflation uncertainty and contract duration, Vroman, S. B. (1989). The Review of Economics and Statistics, 677-681. This study examines the major factor responsible for the time duration of U.S union contracts using a longitudinal contract database. A hypothesis supporting the claim that ; inflation uncertainty reduces contract duration, and higher contracting costs, as proxied by a strike variable and by the previous duration, guarantees an increased contract duration.
Furthermore, contract duration is believed to be higher for indexed contracts, and also to be pro-cyclical.
- Cost-of-living escalators in major union contracts, Card, D. (1983). Cost-of-living escalators in major union contracts. ILR Review, 37(1), 34-48. This paper analyses the price indexation according to the provided samples by the Canadian collective bargaining agreements that were conducted between 1968 and 1975. During the time of the contracts, wage increment was escalated. This led to an increase in over one-third of the total wages, which presented a big blow to the relative wages of skilled workers. The author also categorically stated that the indexation provisions are usefully symbolized by marginal elasticity of the contractual wage rate to increase in prices.
Drafting Contracts in an Inflationary Era, Hurst, T. R. (1975). U. Fla. L. Rev., 28, 879.