In economics, the value of money itself changes over time as does the costs and prices of all sorts of goods and services. There are a number of ways that businesses can track these changes, with the end goal being the ability to judge a company’s growth over time as independently as possible. Changes in inflation, pricing, interest rates and the markets can all impact the raw numbers from year to year. When tracking economic health, price indices allow a better understanding of financial changes over time.
What Is PPI?
The producer price index formula is a representative index that captures the change in price over a time period from the viewpoint of the producer. It is a measure of the increase or decrease in the cost of production of goods in general, but it is expressed as an index over a wide number of markets from one point of time to another. This can include increases in raw materials cost, in operation of equipment, in labor and wages cost and in many other areas.
The United States publishes PPI information through the Bureau of Labor Statistics, and there are a number of such indices calculated by the BLS. For example, the BLS has created a number of industry classifications that look at the PPI as an amalgam of businesses within an industry. This allows for the separation of the PPI for plastics production as opposed to the PPI for agriculture.
There are also indices calculated based on classification of the commodity produced as well as indices divided based on classification of the end user. These indices have been tracked for many years. While individual businesses may recalculate PPI formulas over specific periods of time, the BLS reset all indices to 100 in 1982, and published values are based on that index unless otherwise noted.
PPI vs. CPI
Whereas PPI looks at cost from the production side, the customer price index evaluates price from the side of the consumer. On a generalized scale, the CPI can be looked at somewhat as a measure of the cost of living and the changes in that cost over periods of time. The CPI includes imports in its calculation, as they are available to customers in the United States. It is, however, an index based on urban U.S. residents.
It also includes things like taxes that are paid on the consumer’s end as well as any markups from intermediates like logistics, agents or retailers. The CPI is mainly used to calculate changes in the cost of living so that businesses can adjust accordingly.
The PPI, on the other hand, looks only at goods produced in the U.S. and looks at a wide range of purchase pipelines, not just urban. The PPI also does not include sales or taxes, as it focuses on the cost of production itself, and it does not include any of the price changes that might be due to intermediate retailers or salespeople. The PPI is mainly used to estimate a company’s real growth by allowing the business to break out which price changes are due to the PPI and which are due to company growth investments.
Producer Price Index Calculator
In order to calculate the PPI, economists in the BLS compare the prices received for some bundle of goods and services at present with the prices received for the same bundle at a previous point. Again, the PPI can be a measure of the nation’s general economy, or it can be narrowed down to a collective of businesses in the same industry.
The PPI is calculated as a weighted average, meaning that within an industry, each component good and service in that industry will be included in the PPI as a relative amount based on what proportion of the industry that product represents. This makes it a measure of quantity sold as well as the price.
To break that down, imagine a very simplified coffee industry consisting of three main goods: coffee, sweeteners and creams. The PPI for this industry would be the weighted result of the changes in quantity and price of each of these components over a time period. For example, assuming that coffee is the major good in this industry, a change in the price received for coffee sales will have more impact on the PPI than the other two goods. However, if the relative amount of cream sold changes significantly during this time period, the PPI will reflect that as well.
Changes in Producer Price Index Charts
When the PPI is increasing, this means that the input costs for businesses are increasing, and this can be due to raw materials, utility costs, production costs or inflation. An increasing PPI means that eventually, these costs will be passed down to the end consumers. This can affect the demand of certain goods and services, which will then have an impact on the company’s bottom line and on shareholder dividends. PPI increases are usually signs of oncoming inflation in the economy, which decreases the value of cash a customer may have on hand.
When the PPI decreases, inflation has slowed, and while slowing down is sometimes necessary, it can often lead to an economic slowdown for the whole country. In these cases, banks often adjust their interest rates in order to make more cash available to the industry in an attempt to keep growth moving forward. The consumer may see lower costs for goods and services but also has to be careful that an overall slowdown is not on its way. Economic slowdowns cause changes in customer spending as well as in interest rates throughout the nation.
Using PPI Numbers
Bodies like the Federal Reserve watch the PPI as a financial indicator. This allows them to adjust financial programs and policies, like the federal interest rate, based on the current market status and their projections of future performance. The PPI is also used to correct and compare financial information over a period of time, similar to adjustments for inflation.
Companies often develop long-term contracts with suppliers of raw materials to ensure they will have those materials on hand. In order to make sure pricing stays fair, these contracts often include adjustments of the contract price based on a certain PPI. For example, a material that costs $1 during the first year of the contract may cost $1.10 three years later if the PPI has increased at this rate.
For consumers and investors, the trends in the production price index can be used to predict future trends. This can warn investors about inflation, allowing them to change their portfolios as needed, and it can also warn of an economic slowdown, which changes the way consumers spend and save money. It can also help a company predict future price changes that may be necessary based on either inflation or additional incoming costs that need to be passed on to the end consumer. Being able to understand the production price index as one item in a toolbox will help people at all levels better understand the state of the economy and their own state within that.
- Bureau of Labor Statistics: Producer Price Indexes: Frequently Asked Questions (FAQs)
- Bureau of Labor Statistics: Price Adjustment Guide for Contracting Parties
- Study.com: Producer Price Index: Definition & Formula
- Bureau of Labor Statistics: Comparing the Producer Price Index for Personal Consumption with the U.S. All Items CPI for All Urban Consumers