Guide to price index for commodity prices

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A price index, also known as price indice, is the normalized average of the prices of certain goods or services in relation to their prices in a base-year. In other words: it’s a way to measure inflation. It is a scale which to measure changes in the levels of prices between different time periods as well as geographical locations to give insights into the market and assist companies in their sourcing strategies.

Using the price index data and information can serve as the foundation for advanced sourcing strategies. Sourcing approaches that leverages price index data allows a company to:

  1. Form the foundation which to perform statistical regression models, predictive models and forecasting on.
  2. Gain a better understanding of the interplay between raw materials and impact on commodity prices.
  3. Use the price indexes as a contracting tool, both for price escalation and de-escalation clauses.
  4. Embed with business intelligence, ERP and procurement systems to be able to perform more robust spend analytics.
  5. Use in a fact-based negotiation tactic with suppliers, especially when creating new contracts.

Categories of commodity price indexes

Commodity price indexes can be broadly grouped into two different categories.

Soft commodities

Soft commodities refers to products that have been grown and cared for, such as agricultural produce, livestock and related primary products. These include but is not limited to:

Grains: Corn, rice, wheat.
Softs: Coffee, sugar, milk.
Livestock & meat: Hogs, live cattle, pork bellies.

Hard commodities

Hard commodities refers to all natural resources such as metal ores, oil reserves, etc. These include but is not limited to:

Energy: Coal, ethanol, gasoline, natural gas, propane.
Base metals: Lead, zinc, nickel.
Precious metals: Gold, silver, platinum.
Plastics: Polyethylene, polypropylene, Polyvinyl chloride.
Chemicals: Ammonia, sulfuric acid, ethanol.

Can you create your own commodity price index?

Yes, but creating a commodity price index is a complex and time consuming process that includes three difficult challenges: data gathering, weighting and bias adjustment.

Data gathering

The main challenge of creating a commodity price index is to gather a sample of prices that’s representative of the various price quotations for each of the commodities to be studied. The sampling process is in most cases always necessary. The larger and more complex the universe of prices to be covered by the commodity price index, the more complex the sampling pattern will have to be.

Weighting

Weighting refers to combining the commodity price relatives in such a way that the price movement of the whole commodity group from one time period to another is accurately described. This usually begins by averaging the price relatives for different commodities from different reporters. This gives rise to another problem where the commodities need to be given different weights because not all commodities are of equal importance for the company.

Bias adjustment

The final challenge is the problem of continuous quality change and the tendency to ignore changes in quality when calculating a price index. The quality of goods are continuously changing to such a degree that it’s doubtful that anyone living in an industrialized economy is buying products that are identical in physical and technical characteristics to those that their grandfather used to buy. Therefore, a bias either upward (if the quality of the goods is improving) or downwards (if the quality of the goods is deteriorating) can emerge. For example: technological improvements sometimes decrease the cost of technological goods (like TVs or computers) by making them more efficient. There is no fully satisfactory way to handle this problem of quality changes.

What’s the alternative?

Using Prognos. We would not recommend creating your own price indexes to identify commodity price developments as this will require more time and effort than it’s worth. Instead, with Prognos, you can get access to thousands of indices on commodity prices as well as other price indexes for components, manufacturing costs, tax & transport, wages and currencies. The data is gathered from multiple sources all over the world to give you up to date data in one place.

We give you access to objective commodity prices data you need in order to get the most out of your suppliers, with data tailored to your specific situation and needs.

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Jacob Mannheimer, New Customer Contacts | Prognos MKA AB
Jacob Mannheimer

CEO, New Customer Contacts

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