INFLATION AND ESCALATION BEST 

PRACTICES FOR COST ANALYSIS

OFFICE OF THE SECRETARY OF DEFENSE

COST ASSESSMENT AND PROGRAM 

EVALUATION

APRIL 2016
1. Background

Reliable cost analysis is critical to defense management. The rates at which the prices of 

defense goods are expected to change are often important determinants of system cost. Wellresearched forecasts of price growth help the Department to make sound acquisition trade-offs 

and adequately budget for weapon systems.

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Section 2334(a)(3) of Title 10, United States Code, requires the Director, Cost Assessment 

and Program Evaluation (DCAPE) to “periodically assess and update the cost indexes used by 

the Department to ensure that such indexes have a sound basis and meet the Department’s needs 

for realistic cost estimation.” DCAPE has published this guide to help analysts meet these 

objectives. Developed in collaboration with cost estimators and economists in OSD and the 

Military Departments, it provides best practices for incorporating price change into cost analysis. 

It includes: 

 Standard terminology to distinguish between inflation and escalation

 Minimum standards for documenting and labeling indices used in an analysis

 Use of realistic escalation rates to estimate investment and sustainment costs

 Selection of long-term assumptions about fuel prices and other rates to maximize the 

realism and stability of the estimate

 Selection of indices for converting then year estimates to a base year

Cost estimates should demonstrate understanding of price growth concepts and use accurate, 

relevant data. Therefore, the cost community should foster the data and methods necessary to 

measure escalation affecting weapons systems, and encourage analysts to assess all escalation 

rates bearing on their analyses.

This guide will be supplemented by an in-depth handbook to help analysts implement the 

best practices. 

2. Standard Terminology

Cost estimates should distinguish between inflation and changes in specific prices by 

adopting the following terms. An expanded glossary, including examples, appears in the 

Appendix.

a. “Inflation” refers to growth in the general, economy-wide, average price level and 

reflects a decrease in the value of the dollar. 

b. A change in a specific price, or in the prices of a particular set of goods and services, is 

not inflation. Inflation is only one component of a price change. The term “escalation” 

may be used for price changes below the level of the economy as a whole. Equivalent 

 

1 DoD Instruction 5000.73, “Cost Analysis Guidance and Procedures,” states, “It is DoD policy... 

that analysis be conducted to provide accurate information and realistic estimates of cost for DoD 

acquisition programs.” 
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terms include “price escalation,” “specific price change,” “specific price escalation,” or 

simply, “price change.” Examples of escalation include military and civilian pay raises, 

changes in contractor wrap rates, and changes in the unit cost of a particular weapon 

system. Escalation does not refer to price changes attributable solely to the mix of items 

being measured or significant changes in quality. Escalation can be positive or negative. 

c. “Constant year (CY) dollars,” also called “constant dollars,” have been normalized for 

inflation, not escalation, using an economy-wide index such as the Gross Domestic 

Product Implicit Price Deflator (GDP Deflator). Constant year dollars measure what 

goods and services economy-wide would have cost in a base year by adjusting for the 

decrease in the value of the dollar. This term will not be used to refer to costs normalized 

for specific price change.

d. “Real price change” (RPC) is price change measured in constant year dollars. Positive 

real price change indicates that the item has become more expensive relative to other 

goods and services in the economy, while negative real price change indicates that the 

item has become less expensive relative to other goods and services in the economy.

e. The term “constant price” (CP) may be used to refer to costs normalized with an 

escalation index. A constant price indicates what a narrowly defined basket of goods 

would have cost in a base year. Examples of constant prices include contractor labor 

rates divided by a labor rate index, aircraft unit costs divided by an aircraft index, and 

fuel costs divided by a fuel price index. Constant prices exclude both inflation and real 

price change.

Table 1 provides examples of correct and incorrect usage of the terms “inflation” and 

“escalation.”

Table 1 Examples of Correct and Incorrect Terminology

What Happened

Examples of Correct 

Terminology

Examples of Incorrect 

Terminology

The price of medical procedures 

increased 3%

 Medical escalation

 Escalation

 Price change

 Specific price change

 Inflation

 Medical Inflation

The general price level in the 

U.S. increased 1.7%

 Inflation

 General price inflation

 Escalation

 Specific price change

Government civilian pay 

increased 1.5%, a smaller 

percentage in previous years

 Pay raise

 Escalation

 Wage growth

 Inflation

 Pay inflation

 Deescalation

The unit cost index for aircraft 

changed as a result of major 

capability improvements

 Unit cost increase  Escalation

 Price change

 Inflation

3. Documentation and Labeling

a. Cost estimates must document the inflation and escalation rates used to estimate each 

component of the program. Documentation must be accessible to decision makers, other 
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users of the estimate, and subsequent analysts. Citations of published indices must 

include the chosen index, base year, source(s), and date. References to analyst-developed 

indices must include a descriptive title, base year, source data, and date.

b. Estimates expressed in a base year using an escalation index, or a composite of inflation 

and escalation, must be labeled “constant price” to distinguish them from inflationadjusted estimates. The Appendix discusses options for labeling both constant year 

dollars and constant prices.

c. Ambiguous labels, such as “fiscal year dollars” and “base year dollars,” will be annotated 

to indicate the index used.

4. Use of Realistic Escalation Rates to Estimate Then Year (TY) Dollar Costs

a. Cost estimates will incorporate the escalation rates that best forecast funding 

requirements for the system being estimated, taking specific markets into account.

b. Cost analysts (and the organizations publishing estimates) are responsible for determining 

which escalation assumptions are appropriate and where they are applicable, for 

conducting analyses necessary to forecast escalation affecting system costs, and for 

developing the rationale for their approach. Analysts should not rely exclusively on 

DoD-published indices to measure escalation, as the indices for Research, Development, 

Testing, and Evaluation (RDT&E) and Procurement reflect inflation and generalized 

expenditure rates. They are not developed based on DoD’s pricing experience or industry 

trends.2 Although escalation in a given program may match the DoD index, this 

conclusion should be supported with analysis. Professional market forecasts, cost 

estimating models, government-published price indices, contractors’ forward pricing rate 

agreements, contractual economic adjustments, historical quality-adjusted unit costs, and 

historical wrap rates are among the preferred data and tools to measure and predict 

escalation. 

Example. The unit cost of a vehicle system is $20M in 2015 and the analyst is 

estimating what its cost will be in 2025. A military service’s published procurement 

index is growing at an annual average rate of 2%. If this index is an accurate 

measure of system escalation, in 2025 DoD would pay $24.4M (=$20M*1.0210) per 

unit. Based on a combination of market forecasts and contractor rate trends, 

however, the analyst estimates that unit costs will grow 3% per year. The systemrelevant escalation rate implies that DoD would instead pay $26.9M (=$20M*1.0310) 

in 2025. Thus, the correct approach yielded an estimate 10.2 percent higher than 

would be expected based on the published index.

 

2

DoD and service indices for RDT&E, Procurement, Military Construction and Family Housing, and Operations 

and Maintenance typically track the GDP Price Index forecast developed each year by the Office of Management 

and Budget. Thus, the raw indices for these appropriations are the same. Weighted indices differ because they 

include appropriation-specific outlay profiles. Changes in military pay, civilian pay, fuel, and medical costs are 

types of escalation; indices for these costs, and composite indices including them, are escalation, not inflation,

indices.
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c. Long-term forecasts. Long-term assumptions about inflation and escalation of fuel 

prices, military pay raises, civilian pay raises, and other prices will be chosen to 

maximize the realism and stability of the cost estimate. The OSD (Comptroller) annual 

President’s Budget Inflation Guidance typically addresses DoD’s Future Years Defense 

Program (FYDP) only. There is no requirement to extrapolate price growth assumptions 

for the FYDP into out years beyond the scope of the guidance. This practice causes yearto-year changes in cost estimates based solely on FYDP values; estimates of programs 

with large sustainment costs, normally incurred over many decades, can be particularly 

unstable. The same principle applies to years beyond other government or commercial 

forecasts: out year assumptions should be chosen to maximize the realism and stability 

of the estimate.

i. OSD (CAPE) will oversee an advisory group charged with recommending postFYDP price escalation rates to use in cost analysis. Advisory group participants 

include representatives from OSD (Comptroller), OSD (AT&L), and the Military 

Departments, including organizations responsible for publishing services’ index 

tables. These recommendations may include, but are not limited to, inflation, fuel

prices, military and civilian labor costs, and medical costs. The scope of the 

advisory group’s recommendations will depend annually on direction from 

DCAPE, expected by October 1 of each year.

ii. The advisory group will convene no later than the first week in November each 

year. Components will identify participants by mid-October. The group will 

develop and circulate recommendations to coincide with the release of OSD 

(Comptroller) annual President’s Budget Inflation Guidance, during DecemberFebruary. 

iii. Recommendations will be based on analysis of published public and private 

forecasts. To avoid excess volatility in the annual post-FYDP rate 

recommendations, the advisory group will only recommend a change in the rates 

previously used if the analysis indicates a significant shift in long-term forecasts. 

The size of change in the forecast necessary to trigger an update to the post-FYDP 

rate guidance will be agreed upon by members of the advisory group under the 

direction of DCAPE.

5. Converting Then Year Dollar Estimates to a Base Year

a. Figure 1 presents the graphical and algebraic relationships between then year dollars, 

constant year dollars, and constant prices. The relationships have been simplified by 

assuming that inflation and escalation rates are the same each year. The increase in 

constant year dollar costs relative to the base year (here, year 1) is real price change 

(RPC). The gap between RPC and the remaining escalation is inflation plus an 

interaction term, interpreted as inflation on RPC. 
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Figure 1. Converting Then Year Dollars to a Base Year

b. Constant dollar and constant price figures convey distinct information and have different 

uses in cost estimation. Constant year dollars eliminate the distortion3caused by the 

reduced value of the dollar over time but preserve real price change. Real price change 

signals increasing or decreasing claims against budgetary resources. In contrast, constant 

prices help measure changes in quantity or capability underlying a then year dollar cost.

Figure 2. Comparison of Constant Year Dollars and Constant Prices (Hypothetical Data)

Example. Figure 2 uses hypothetical data to illustrate the difference between 

constant year dollars and constant prices. Constant prices are calculated by 

normalizing the cost of each resource with a price index, e.g., fuel costs are 

normalized using a fuel price index and manpower costs normalized using a 

manpower price index. The constant price chart has a flat profile. The constant year 

 

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If the dollar can be viewed as a measuring stick for expressing the cost of all items, inflation “lengthens” the 

measuring stick. Constant year dollars remove the distortion caused by this change in the measuring stick.

Escalation% = e, Inflation% = i, RPC% = r, Time=t

e = i + r + i*r

TY(t)$ = CP$ * (1+e)t= CP$*((1+i)(1+r))t

CY(t)$ = TY(t)$/(1+i)t = CP$*(1+r)t

CP(t)$ = TY(t)$/((1+i)(1+r))t
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dollar chart shows that due to increases in the real price of fuel, the program is 

becoming more expensive to support. This information may affect decisions about 

the program, e.g., whether to seek fuel-efficient alternatives.

c. Cost estimates to support decision making should be presented in then year dollars or 

constant year dollars, not constant prices. Thus, when it is necessary to present a cost 

estimate in terms of a base year, the conversion from then year dollars to constant year 

dollars should be made with an inflation index, not an escalation index. This principle 

applies to both investment and sustainment costs. Lifecycle costs should be converted to 

a base year using (raw or weighted) inflation indices for all appropriations and phases of 

the program.

d. Constant prices indicate what a given product, service, or capability would cost in a base 

year. Potential applications include normalization of historical unit costs, buying power 

analysis, cost estimating relationships, and learning curves.

Example. An analyst is estimating the 2015 cost of a new aircraft system based on 

analogy to a similar system last procured in 1990 at a unit cost of $30M. The analyst 

determines that unit costs would have escalated at 2.8% annually between 1990 and 

2015, while inflation grew at 2%. Thus, the inflation index value for 1990, base year 

2015, is .609 and the escalation index is .501. Converting the 1990 unit cost to 2015 

constant dollars yields $49.2M (=$30M/.609). The constant price is $59.8M 

(=$30M/.501). The constant year dollar figure is incorrect because it only adjusts for 

inflation and neglects real price change during the past 25 years. The constant price 

figure is a more accurate measure of what the system would cost today. 
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APPENDIX: GLOSSARY

Base Year. A 12-month period used as a reference against which to measure price change. Both 

constant year dollars and constant prices are expressed in terms of a base year. 

Constant Price. A dollar value that has been adjusted to remove escalation. Constant price 

values are labeled CP$Year or CPYear, where Year is the base year (e.g., CP$12 if the base year 

is 2012). 

Example. Suppose the nominal price of a gallon of fuel was $3.50 in 2015 and that the 

fuel index value for 2015, index base year 2008, was 1.250. In 2015, the CP$08 price of 

fuel would be $2.80 (=$3.50/1.250). 

Constant Year Dollar. A dollar value that has been adjusted to remove inflation so that its 

purchasing power is the same as that of a base year; also called a “constant dollar.” A cost in 

constant year dollars does not remove all price change, only that due to decreased purchasing 

power of the dollar. Constant year dollars are labeled CY$Year, where Year is the base year. 

Many variations exist, including “Constant Year Dollars, Base Year = Year”.

Example. Suppose the price of a gallon of fuel was $2.80 in 2008 and $3.50 in 2015, and 

that the inflation index value for 2015, index base year 2008, is 1.149. The 2015 price 

expressed in CY$08 is $3.05 (=$3.50/1.149).

Escalation. The change in the price of a specific good or service, or a specific basket of goods and 

services, over time. Escalation reflects not only inflation, but also the change in the real price of a

good or service. In percentage terms, 

Escalation % = Inflation % + Real Price Change% + Inflation% * Real Price Change%

Example: Suppose inflation is 2% per year and real price change is 1%. Overall price 

growth, or escalation, is 3.02% (=.02 + .01 + .02*.01). The final term represents inflation 

on real price change. 

Escalation Index. An index used to measure change in the price of specific good or service, or 

basket of goods and services, relative to a base year. Producer Price Indices for particular 

industries and the Employment Cost Index, both developed by the Bureau of Labor Statistics, are 

examples.

Inflation. A sustained rise in the general price level, or the proportionate rate of increase in the 

general price level per unit of time. The general price level is an economy-wide average. A

sustained decrease in the general price level is called deflation.

Inflation Index. An index used to measure the percentage change in the general price level 

relative to a base year. The Gross Domestic Product (GDP) Price Index and the similar GDP 

Implicit Price Deflator, published by the Bureau of Economic Analysis (BEA), capture the yearto-year change in the price level encompassing all goods and services produced in the U.S. 

Real Price Change. The change in price of a good or service net of inflation, i.e., price change 

measured in constant year dollars. Real price change can be positive or negative, and indicates 

that the product has become more (or less) expensive relative to other goods and services in the 

economy. Causes of real price change include market shifts, changes in the supplies of systemunique materials, contractors’ and government’s costs of doing business, economies or 

diseconomies of scale (i.e., rate effects), technological change, and learning.
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Example. Suppose the price of labor was $50.00 in 2008 and $60.00 in 2014, and that 

the inflation index value for 2014 (index base year 2008) is 1.150. The 2014 price of 

labor expressed in CY$08 would be $52.17 (=$60.00/1.150). Real price change is the 

difference in prices measured in CY$08, and is equal to $2.17 (=$52.17-$50.00) or 4.3% 

($2.17/$50.00). This suggests increased demand or decreased supply of labor.

Then Year (TY) Dollars. The dollars necessary to fund Total Obligation Authority (TOA) and 

Budget Authority (BA), taking into account the time-phasing of funds expended each year after they 

are appropriated. The cost of a system in then year dollars reflects escalation up to and during the 

year of the appropriation; and throughout the period during which dollars are expended from the 

Treasury. Then year dollars are converted to constant year dollars using a weighted inflation 

index and to a constant price using a weighted escalation index. 

Inflation example. The spendout rate for system X is expected to be 60% in year 1 and 

40% in year 2. The raw inflation index with base year 2015 is forecasted to be 1.35 in 

2030 and 1.38 in year 2031. The weighted inflation index applicable to system X is 

1.362 (=1/ (.6/1.35 + .4/1.38)). This is the amount of funding that would be required to 

buy the system using dollars appropriated in 2030, to cover inflation expected during the 

spendout period. If the TY$30 cost of the system is $1M, the CY$15 cost in 2030 is 

$0.73M (=$1M/1.362).

Escalation example. Suppose the raw price index for system X is expected to be 1.28 in 

2030 and 1.29 in 2031. The weighted index is 1.284 (=1/ (.6/1.28 + .4/1.29)). If the 

TY30 cost of the system is $1M, the CP$15 cost in 2030 is $0.84M (=$1M/1.184).