Selecting the Proper Indexes

The cost estimator will not have to construct an index to adjust for inflation but will select one. Often, the index is directed by higher authority, such as OMB. In this way, all programs can be compared and aggregated since they are all using the same economic assumptions. This does not mean that the projected inflation rates are correct—in fact, inflation rates are difficult to forecast—but, program comparisons will not be skewed by different assumptions about inflation. When the index is not directed, a few general guidelines can help the cost estimator select the correct index. Because all indexes measure the overall rise in prices for a particular market basket of goods, the objective in making a choice is to select the one whose market basket most closely matches the program to be estimated. The key is to use common sense and professional judgment. For example, the consumer price index would be a poor indicator of inflation for a new fighter aircraft because the market baskets obviously do not match. Although the market basket for the selected index may never exactly match the components in the program’s cost estimate, the closer the match, the better the estimate.

Weighted indexes are used to convert constant, base-year dollars to budget year dollars and vice versa. Raw indexes are used to change the economic base of constant dollars from one base year to another. Contract prices are stated in budget year dollars, and weighted indexes are appropriate for converting them to base-year dollars. Published historical cost data are frequently, but not always, normalized to a common base year, and raw indexes are appropriate for changing the base year to match that of the program being estimated. It is important that the cost estimator determine what year dollars cost data are expressed in so that adjustments for inflation can be performed properly.

Schedule risk can affect the magnitude of inflation in a cost estimate. The amount of the estimate due to inflation is often estimated by applying a monthly inflation rate (computed so that compounding monthly values equates to the forecasted annual rate) to dollars forecasted to be spent in each month. If the schedule is delayed, a dollar that would have been inflated by 30 months might now be inflated for 36 months. Even if the cost estimate in today’s dollars is an accurate estimate, a schedule slip would affect the amount of the inflation adjustment.

In addition, the question of inflating the amount of contingency arises. Some cost estimating systems calculate the contingency on base-year dollars but do not adjust the contingency for inflation, perhaps because they do not have a way to determine when the contingency will be spent. However, some assumption should be made regarding the phasing of contingency because it represents additional money needed to complete the statement of work, and it will be affected by inflation just as is any other funding.