Why do I feel 2% lighter?
Growing up in the 80’s, I can remember bouncing in and out of the house between commands of “go play outside” and trying to master the ever developing industry of home based consumer video games. All the while, I was continually losing track of the small bits of change that my pockets were paying to the couch Gods. You can think of inflation as the wood veneered, gold piped allowance eating couch silently chipping away at your hard earned bottom line.
The fast paced transactional data processing industry is driven by long standing and low frequency reviewed contracts and reasonably so. Generally in the transactional industry, once a contract is reviewed, being able to revisit contract pricing can be almost as significant of an undertaking as the original sale and in some cases may even require a full RFP process. Many of our transactional brethren back into contract review and renewals through a process of “We are charging what?!” all the while costs of materials, labor and equipment have only escalated not to mention that pesky drop in purchasing power due to inflation from when the contract was originally drafted.
The average inflation over the last 5 years is roughly 2 percent. To oversimplify it a bit, you can think of that as almost a two percent loss in purchasing power every year for five years. Think of that new customer that you landed back in 2010. Let’s say the contract brings in $100,000 in new revenue in 2010 dollars. It would take you approximately $109,057.35 in 2015 dollars to have the same purchasing power. Now, to compound that, let’s say that, for the most part, you give a minimum of a 2% cost of living wage increase to employees. Essentially losing 2% off of the contract in a given year and paying out a 2% cost of living increase to employees is a 4% spread on simply inflation and “default” raises alone…in one year!
It is because of this that it is good practice to build an automated inflation escalator into your new business agreements. Depending on your business model, it may be tied to PPI, CPI or general Inflation, but it helps to insulate you from rising macroeconomic costs while your agreement sits in the contract sauna waiting for review losing 2% of its value every year.
Calculation performed at http://www.usinflationcalculator.com/.
Rates retrieved from http://www.usinflationcalculator.com/inflation/historical-inflation-rates/
More information on how inflation is calculated can be found on: http://www.investopedia.com/university/inflation/inflation2.asp