Engineering Economic Analysis

Price Change with Indexes 453

Composite Versus Commodity Indexes

'Cost indexes, in general, come in two types: commodity-specificindexes and composite

indexes. Each type of index is useful to the engineeringeconomist.Commodity-specificin-

dexes measure the historical change in price for specificitems-such as green beans or iron

ore. Common commodities that are trackedby price indexesand used in engineering eco-

nomic analysis includeutility commodities,labor costs,andpurchase prices.Commodity.

indexes, like our letter cost index, are useful whenan economicanalysis includes individual

cost items that are tracked by such indexes.For example,if we need to estimate the direct-

labor cost portion of a constructionproject,wecoulduse an indexthat tracks the inflation, or

escalation, of this particular cost over time.The U.S. Departmentsof Commerce and Labor

track many cost quantities through the Departmentof Economic Analysis and Bureau of

Labor Statistics. For our example constructionproject,we would reference the appropriate

labor index and investigate how this cost item had behavedin the past. This should give us

valuable information about how to estimatethis cost in the future.

Congratulations! Yoursisterjust had a baby girl namedVeronica.Whenyou hear this happy news,

you fondly remember the fine pony you had as a young child, and you decide you would like to

give your new niece a pony .forher fifth birthday. You wouldlike to know how much you must

put into your passbook savings account (earning 4% interestper year) today to purchase a pony

and saddlp for Veronica 5 years from now. But you have no idea how much a pony and saddle

might cost in 5 years.

SOlUTI9N

Divide the;problem into the following steps:

Step 1 trse commodity indexes to measure past pqce changesfor both ponies and saddles.

Step 2 dan several dealers to get prices on the current co~tsof ponies and saddles.

Step 3 Use theaverageprice increasevaluesfor each commodity(ponyand saddle) to estimate

~ttat the cost of each will be in 5 yearS...

Step 4 C1uculatehow much you would have to put into your bankaccoUnttoday to cover those

cc>stsin 5 years. ..

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Step 1

A trip to tl)elibrary.reveals that, indeed, there are price indexesfor the two items that you would

like to buy,j.n5 years: a pony and a saddle. From the indexesyou findthat in the last 10 years the

little pony;price index (LPP.I)has gone from 213 to 541, and the leathersaddle index (LSI) from

1046 to 1229. For each commodity you calculate theaveragerate ofprice increasefor the past

10 yea:t;s <1$:.'

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A.veragepricechang~ (LPPI) is 541= 213(1+i)1O

solviyg torifor ppQj.~s=9.8% per year

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