CPI being abused in price negotiations

By Kevin Phillips

South Africans pay a lot of attention to the inflation rate: whether it’s up, down or stable, which direction it’s headed in and what it means for our wage and salary negotiations.

But in some cases, the official inflation rate is being abused by large companies to squeeze their suppliers — putting the long-term health of many small businesses at risk.

The problem is that when we say “inflation” we actually mean the Consumer Price Index (CPI). This is measured every month by Statistics South Africa (Stats SA), based on changes in the prices of goods and services bought by the average consumer. The “basket” tracked by Stats SA has 12 categories: food and non-alcoholic beverages, alcohol and tobacco, clothing and footwear, housing and utilities, household contents, health, transport, communication, recreation and culture, education, restaurants and hotels, and a “miscellaneous” category that includes insurance and financial services.

The basket is “weighted” to reflect the relative importance of different spending categories in the average household budget. For example, our current CPI weights expenditure on food and non-alcoholic beverages at 15,68% of the total, meaning the typical household spends just over 15% of its income on this category. This weighting used to be higher at 22,09%, but the CPI was revised in 2009 to adapt them to changes in spending patterns.

By all accounts the CPI is a reasonably accurate reflection of the actual price changes experienced by the average household. The problem comes in when people try to use it to determine what businesses should be charging for their goods and services.

Businesses don’t buy a lot of food, or clothing or shoes. They don’t pay doctors’ bills or school fees or taxi fares, all of which go to determining the official inflation rate.

So what do businesses buy? Let’s take the example of a typical small business like a plumber, a beauty salon, a software developer or a graphic design company. These are all service businesses, and for most of them the single biggest cost they face — about 60 to 70% of the total — is salaries.

Salaries, though, have gone up by much more than the official CPI inflation rate in the past year. Last October the government reached a wage settlement with public-sector unions that granted a salary increase of 7,5% — more than double the inflation rate of 3,4% in the previous 12 months. And where the public service goes, others will expect to follow — so there is pressure on all employers to grant wage increases at least above 5%.

What about the other major costs that businesses face? Electricity went up by 27% in 2008, 31% in 2009, 35% in 2010 and it will go by 35% again this year and next year. Travel costs are at the mercy of fuel prices, which have gone up dramatically and aren’t coming down any time soon. Most rental agreements have 10% annual increases built in. The only thing that’s stayed relatively stable is telecommunications costs.

For most businesses, salaries, electricity, communications, travel and rent accounts for about 90% of their total costs. All but one of these costs have gone up by more than double the inflation rate in the past year.

It gets worse. The CPI does include the cost of utilities, so the Eskom price increases will at least feature; but the relative importance of those costs to households and businesses is very different. Businesses spend far more of their income on electricity and communications than do households — but the weighting of the CPI basket reflects only the spending priorities of households.

So, the CPI is a great measure of what’s happening to households; but a terrible measure of what’s happening to businesses. Yet when it comes time to negotiate supply contracts with big clients, many of them point to the inflation rate. “Inflation only averaged 4,3% last year, so you shouldn’t increase your prices by more than that.”

How many of the CEOs of those companies accepted salary increases of 4,3%? Certainly if I was to offer my staff that, they’d be very unhappy; I might lose people I’d very much like to keep.

So those who want their suppliers to limit their price increases to the inflation rate are either ignorant of what the CPI really measures, or they’re abusing it as a bullying tactic. Small businesses are facing increases in their basic costs of way more than inflation — and if they can’t increase their prices to compensate, they won’t survive for very long.

Kevin is an entrepreneur who has built a successful business and so has a solid understanding of the challenges and questions business owners face. He has degrees in commerce and accounting.