A fixed element, a weight per index and a base date: three drafting choices that decide what an indexation clause pays.
A price adjustment formula splits the base price into a fixed element and one weighted element per cost index, then moves each weighted element by its index ratio: P1 = P0 × (a + b × M1/M0 + c × L1/L0). On an illustrative part at 85.00 with a 15 per cent fixed element, steel at 55 per cent and labour at 30, a steel index up 11.49 per cent and labour up 4.81 per cent move the price to 91.60, up 7.76 per cent, or 791,529 a year on 120,000 units.
Worked in full in Contract Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An indexation clause protects both sides from cost movements neither controls. It is also a pricing mechanism that runs unattended for years once signed, and its value is decided almost entirely by three numbers chosen at the drafting stage: the size of the fixed element, the weights, and which index stands for which cost. Each one can be priced before signature, and each one is easier to negotiate than the base price.
| Input | Value |
|---|---|
| Base price P0 | 85.00 |
| Fixed, non-adjustable element a | 0.15 |
| Steel weight b | 0.55 |
| Labour weight c | 0.30 |
| Steel index at base date M0, and at review M1 | 212.4 / 236.8 |
| Labour index at base date L0, and at review L1 | 118.6 / 124.3 |
| Annual volume, units | 120,000 |
| Supplier's actual cost shares of price: steel, labour | 45% / 25% |
The weights must add to one: 0.15 + 0.55 + 0.30. The fixed element represents what should not move with the indices: the supplier's margin, depreciation, and the overhead already in its price. Index values are illustrative; in a real clause each one is a named published series, with a stated publication month and a fallback if it is discontinued or rebased.
Step 1: the index ratios. Steel 236.8 ÷ 212.4 = 1.1149, up 11.49 per cent. Labour 124.3 ÷ 118.6 = 1.0481, up 4.81 per cent.
Step 2: weight each ratio. Fixed 0.1500. Steel 0.55 × 1.1149 = 0.6132. Labour 0.30 × 1.0481 = 0.3144. The factor is the sum, 1.0776.
P1 = P0 × (a + b × M1/M0 + c × L1/L0)
= 85.00 × (0.1500 + 0.6132 + 0.3144) = 85.00 × 1.0776 = 91.60
In Excel, with P0 in B1, the weights in B2:B4 and the four index values in B5:B8: =B1*(B2+B3*B6/B5+B4*B8/B7). Always divide by the base-date index, never by the index at the previous review.
Step 3: where the 6.60 comes from. Steel contributes 85.00 × 0.55 × 11.49% = 5.37 a unit, labour 85.00 × 0.30 × 4.81% = 1.23. Across 120,000 units the buyer pays 791,529 more a year.
The formula says the supplier's costs rose 6.60 a unit. Its own cost structure says otherwise. If steel is really 45 per cent of the price and labour 25 per cent, its costs rose 85.00 × (45% × 11.49% + 25% × 4.81%) = 5.42. The other 1.18 a unit, 141,686 a year and 17.9 per cent of the adjustment, is not cost recovery. It is margin, earned because the steel weight in the clause is ten points above the steel in the part.
The weights are the clause. Ask for the supplier's cost breakdown at tender, or build a should-cost from the bill of materials, and set the weights to match. A weight that is too high pays the supplier on every index rise and repays the buyer, symmetrically, only if the index falls.
| Steel index | b = 0.45 (a = 0.25) | b = 0.55 (a = 0.15) | b = 0.65 (a = 0.05) |
|---|---|---|---|
| −10% | 82.40 | 81.55 | 80.70 |
| Unchanged | 86.23 | 86.23 | 86.23 |
| +10% | 90.05 | 90.90 | 91.75 |
| +20% | 93.88 | 95.58 | 97.28 |
Each ten points of weight moves the price by 0.85 for every 10 per cent the index moves. Over a three-year term in which steel rises by a fifth, the difference between a weight of 0.45 and 0.65 is 3.40 a unit, which can be a large part of the gap between two competitive bids.
The other drafting choices can be priced the same way. Removing the fixed element altogether, with steel and labour rescaled to 0.647 and 0.353, moves the price to 92.76, 9.13 per cent up and 931,211 a year. A cap of 3 per cent on any one adjustment would hold the price at 87.55 and save 485,529 a year. A 2 per cent threshold, below which nothing moves, does nothing here because the movement is 7.76 per cent; drafted instead as a dead band, passing on only the excess over 2 per cent, it would give 89.90 and save 204,000.
The common mistake is chaining: applying the formula to the last adjusted price instead of the base price. Suppose at the next review steel stands at 240.0 and labour at 127.0. Correctly, P2 = 85.00 × (0.15 + 0.55 × 240.0/212.4 + 0.30 × 127.0/118.6) = 92.88. Applied to the 91.60 already adjusted, with ratios still struck from the base date, it gives 100.09: the first period's movement is paid twice, 7.21 a unit and 864,917 a year. The clause should state in terms that P0 and the base-date indices never change for the life of the agreement, and the first invoice after each review should be checked against that.
The book prices indexation as one of eight clauses that differ between two real bids, and the free workbook for this case on the Contract Management companion page prints the full quarterly price table for both. When an indexed bid overtakes a dearer firm one is worked in when an indexed price overtakes a dearer firm bid.
The share of the price that does not move with any index, usually standing for margin, depreciation and overhead. In the worked case it is 0.15. Removing it, with the other weights rescaled, raises the adjusted price from 91.60 to 92.76 and costs the buyer 931,211 a year instead of 791,529, because the supplier's margin then inflates with steel.
From the supplier's actual cost structure, ideally a disclosed breakdown or a should-cost model. If steel is really 45 per cent of a price of 85.00 but the clause weights it at 0.55, an 11.49 per cent steel rise pays 6.60 a unit against a true cost increase of 5.42, an overpayment of 141,686 a year on 120,000 units.
The base index, applied to the base price, at every review. Applying base-date ratios to an already adjusted price pays earlier movements twice: at the second review the correct price here is 92.88, the chained one 100.09, an overcharge of 7.21 a unit. The clause should fix P0 and the base-date indices for the whole term.
This article is one calculation from Contract Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: business operations: cost, contracts, pricing and supply chain → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.