(iii) Clearly specify the time

Gv)

vy)

(vit

©

period that these relative
weights are supposed to
represent. The weights
should be chosen to
represent the time period
associated with the base
price (i.e., the base period);

) The first step necessary for
the calculation of the
special index is to rebase all
of the original index data to
the contract’s base period.
This is done for each series
by dividing the indexes by
the index value for the base
period and then multiplying
the result by 100. (For this
and following steps, note
the detailed example at the
end of this report.)

Then derive values for the
composite index by multi-
plying relative weights by
the rebased index values for
each index series and
summing the results. (This
calculation must be done for
each quarter, or other time
period, needed for deter-
mining the current adjust-
ment.)

) Using the composite index
created in step (v), calculate
the current adjustment in
standard fashion, that is, by
using the procedure
described in (a) above.

(See example clause II for
an illustration of this
procedure.)

Limits for price adjustment.
Escalation clauses sometimes
contain a floor, a ceiling, or
both, to limit the total price
adjustment during the life of
the contract, If the upper or
lower limit is reached, the
parties may renegotiate prices
for the duration of the con-
tract. Some contracts specify
that no price adjustments are
to be made until a minimum

change in the selected index
has taken place. Contracts
may also provide that an
escalation is to apply in both
an upward and downward
direction, or in one direction
only.

Examples of Escalator
Clauses

Example clause I. Collective
bargaining agreements

Suppose a collective bargaining
agreement contains the following
language:

“For years two and three of this
contract, on July 1 of each year,
basic hourly wage rates for each step
and grade will be adjusted by the
percentage change in the Employ-
ment Cost Index for private industry
workers, wages and salaries, from
March of the prior year to March of
the current year. That is, the
increase to go into effect on July 1,
1994 will be the increase in the ECI
series between March 1993 and
March 1994, while the increase to go
into effect on July 1, 1995 will be the
increase in the ECI between March
1994 and March 1995.”

Assume that in June 1996 wage
rates for three occupations were as
follows:

Carpenters

Assume that the ECI private
industry wages and salaries index for
March 1995 is 125.0 and for March
1996 is 129.0. Then the adjustments
would be 129.0/125.0=1.032

$15.91

$15.42 * 1.082
745 * 1.032 = 7.69

14.00 * 1.032 = 14.45

7 Compensation and Working Conditions Spring 1997

Example clause Il. Long-term
sales or purchasing contracts
Suppose a manufacturer of
widgets enters into a long-term sales
contract with a customer. The buyer
and the seller agree to include an
escalation clause which will adjust
the selling price once a year to
account for changes in labor and
material costs. The following is an
example of the terms which might be
incorporated into such an escalation
clause.
A. The base selling price for a
lot of 10,000 type A widgets is
set at $768,450.00 as of
December 1989, to remain in
effect for 1 year. December
1989 is hereafter called the
reference base period.

B. The base selling price shall be
adjusted in accordance with
the percent changes of the
special index which is de-
scribed in (D) below. The
special index shall be derived
from the following index
series:

(i) The Employment Cost
Index for total compensa-
tion, durable goods
manufacturing, not
seasonally adjusted, as it
appears in the periodical
Monthly Labor Review as
published by the U.S.
Department of Labor,
Bureau of Labor Statistics;
this series shall be referred
to as the labor index;

(Gi) The Producer Price Index
for special industry
machinery and equip-
ment, commodity code 116,
not seasonally adjusted, as
it appears in the periodical
PPI Detailed Report as
published by the U.S.
Department of Labor,
Bureau of Labor Statistics;
this index shall be referred
to as the materials index;


2 For a description of how the EClis compiled,
see “The Emp! tt Cost Index,” BLS Hand-
book of Methods, BLS Bulletin 2414, 1992, chap-
ter8,

? Only workers in private houscholds and ag-
ricultural establishments are excluded,

* To obtain ECI data, contact the Inquiries and

—ENDNOTES—

Correspondence Office at any BLS Regional Of-
fice, of call the Division of Compensation Data
Analysis and Planning at (202) 606-6199.

“See G. Donald Wood, “Estimation Proce-
ures for the Employment Cost Index,” Monthly
Labor Review, May 1982, pp. 40-42.

5 Standard errors for published ECI series may

‘be found in Employment Cost Indexes and Ley-
els, 1975-95, BLS Bulletin 2466, 1995, pp. 137-
143,

§ See Albert E. Schwenk, “ECI Rebased to
June 1989,” Monthly Labor Review, April 1990,
pp. 38-39.

Compensation and Working Conditions Spring 1997 10

———1


(See section VII (c), below.)

VI. Define the mechanics of
price adjustment

(a)Simple percentage method.
One method of price adjust-
ment is to have the base price
changed by the same percent-
age as that calculated for the
selected Employment Cost
Index series. To illustrate,
suppose that the contract
escalation clause refers to the
private industry white-collar
compensation cost index.

Also suppose that the private
industry white-collar compen-
sation cost index was 110.0
when the base price or wage
rate was set. A year later
when the first adjustment is
made, the figure is 115.5 This
represents an increase of 5.0
percent in the private industry
white-collar compensation cost
index, calculated as follows:

Index at time of calculation ........ 115.5

Divided by index at time base price
was set... 110.0

Equals . 1.050

This means that the base price or
wage rate should be increased by 5.0
percent. To proceed:

Base wage rate $11.00
Multiplied by 1,050
Equals adjusted wage ......... $11.55

In later years this procedure
would be applied again by taking the
current index value and dividing it
by the index value at the time the
base price was set, and then proceed-
ing just as described above. (See
example clause I, below, for an
illustration of this procedure.)

(b)Escalation of a portion of
the base price. In long-term
sales and purchasing contracts
a procedure sometimes em-
ployed changes the base price

so that only part of it is
escalated by a selected Em-
ployment Cost Index, while
the balance remains fixed.
This may be done by changing
the base price by a certain
dollar amount for each 1
percent movement in the
selected index.

To illustrate, suppose that
an item has a base price of
$1,000, of which $700 is to be
escalated by the index while
the other $300 remains
unchanged. To determine the
“certain dollar amount” that is
needed for citation in the
contract, simply divide the
designated variable portion of
the base price ($700) by 100,
which in this case would yield
$7. The escalation clause is
written so that it provides that
the base price of $1,000 shall
change $7 for each 1-percent
movement in the index.

Using this approach, the
base price would rise to
$1,035.00 for a 5.0-percent
tise in the ECI, as shown:

Base price
Plus 5.0 times $7

Equals adjusted price ..... $1,035.00

(c) Index points, Relatively few
escalation clauses which rely
on ECI data adjust contract
Prices on the basis of changes
in index points. (In the earlier
example, the index-point
change would be 5.5.) When
wages are adjusted by a
percentage on the basis of a
change in index points, the
value of an index point will
fall in percentage terms as the
index level rises, and vice
versa. For example, a 1-point
increase in an index from
105.5 to 106.5 represents an
advance of 0.9 percent, but a
1-point increase from 205.5 to
206.5 represents an upward
movement of only 0.5 percent.

Conversely, a 0.9-percent
increase in an index of
205.5 would raise the index
1.8 points, to 207.3.

Another disadvantage of
adjusting wages by index
points is that the procedure is
vulnerable to changes in the
index base period. For ex-
ample, index point values
for an index with June
1989=100 as the base will
differ from those for an index
with June 1981=100 as the
base.

(d)Composite indexes. Some
contracts describe construction
of a composite index based on
several EC] series, or the ECI
and other measures such as the
Producer Price Index. The
advantage of a composite
index is that it may more
accurately identify the
appropriate change from a
base period since it will refer
to several of the costs involved
in producing the product or
service in question. However,
a composite index entails more
calculations at the time of
adjustment than the simpler
procedures described earlier.
Composite indexes constructed
by the contracting parties are
not official BLS data.

One procedure for specify-
ing a composite index is illus-
trated by the following steps:

(i) Choose the indexes that will
represent the different costs
involved in producing the
item (such as blue-collar
Jabor, white-collar labor, or
whatever is appropriate);

Gi) Choose the appropriate
weights for these indexes,
in accordance with the
proportion of the production
budget which may be
devoted to these various
categories. The list of
chosen weights should sum
to 100 percent;

Compensation and Working Conditions Spring 1997 6

———j



and period for each of the three
ii) The Producer Price BLS index series specified
Index for 2 diesel fuel, in (B) above shall be
commodity code 057303, rebased to the reference
not seasonally adjusted, as base period December 1989;
it appears in the periodical, this shall be done by
PPI Detailed Report as dividing the current value
published by the U.S. of each index by its value
Department of Labor, for the reference base
Bureau of Labor Statistics; period, and then multiply-
this index shall be referred ing the result by 100.
to as the fuels index. (ii) The rebased labor index
shall be assigned a relative
C. The selling price shall be weight of forty (40) percent;
adjusted on February 20 of the rebased materials index
each subsequent year, based shall be assigned a relative
upon the percent changes. weight of forty (40) percent;
(whether up or down) in the the rebased fuels index shall
special index specified below, be assigned a relative
between the reference base weight of twenty (20)
period December 1989 and percent; these relative
December of the most recent weights represent the base
year. Ail calculations for the period of December 1989.
special index shall be based (iii) Multiply the rebased
upon the most recent official current value for each of the
data released by BLS of the three indexes by its relative
Producer Price Index and weight.
Employment Cost Index, as of (iv) The sum of these three
February 20 each year. figures shall be the value of
the special index for the

D. The special index shall be
derived in the following
manner:

(i) _ The values for the current

wy)

current time period.
Multiply the current value
of the special index by the
original base price, and

then divide by 100; this
final figure shall be the
adjusted price for the
current time period.

E. If December ECI data are not
available for any year, the ECI
for the immediately preceding
September shall be used as the
basis for adjustment of the
labor index. If December PPI
data are not available for any
year, the PPI data for the
immediately preceding
November, October, or
September, whichever is the
most recent month which has
published data, shall be used
as the basis for adjustment of
the materials and fuels
indexes. If no ECI or PPI data
have been published for these
months, then the contracting
parties shall agree upon
substitute series by February
20.

With these terms in effect, table 1
shows some hypothetical data and
calculations which might have been
made on February 20, 1991 to
determine the new selling price for a
lot of 10,000 type A widgets as of
December 1, 1990.

Table 1. Exampie of caicuiation procedures

Labor Materials Fuels Composite
Base price = $ 768,450 ...... - - - -
Current period series values (Dec. 1990) 107.2 133.4 91.0 -
Divide ah base period values (Dec. 1989) 102.2 128.6 68.5 .
ease 1.049 1.037 1.328 -
Mungo 100 to yield converted series 104.9 103.7 132.8
Multiply by assigned weight (labor 40%,
materials 40%, fuels 20%) ..... 41.96 4448 26.56 -
Add the three figures to get the current
value (Dec. 1990) for special index..... - - - 110.0
Multiply by original base price ($768,450) - - - $84,529,500
Divide by 100 to yield the adjusted price ..... : - - $645,295

Compensation and Working Conditions Spring 1997 8


Albert E. Schwenk

Albert E, Schwenk is an economist in the Divi-
sion of Compensation Data Analysis and Plan-
ning, Bureau of Labor Statistics. Telephone (202)
606-6203.

Escalation in Employer
Costs for Employee
Compensation: A Guide
for Contracting Parties

Like its forerunners, the Consumer Price Index and the

Producer Price Index, the ECI is increasingly being used

by business organizations as an escalator to adjust long-
term sales and purchasing contracts, and to adjust wage
rates in collective bargaining agreements.

Te Employment Cost Index
(ECD) is particularly well
suited as a vehicle to adjust
long-term sales and purchasing
contracts to reflect changing labor
costs, and to adjust wage rates in
collective bargaining agreements to
keep pace with what is paid by other
employers, for two reasons.’ First, it
is comprehensive. It includes not
only wages and salaries but also
employer costs for employee ben-
efits, and covers nearly all employees
in the civilian (non-Federal)
economy.’ Second, it measures the
“pure” change in labor costs, that is,
it is not affected by changes in
relative employment of industries
and occupations with different wage
and compensation levels. The
advantages of a fixed weight index,
such as the ECI, compared with a
measure of average earnings are
illustrated in an example presented
in the appendix.

3 Compensation and Working Conditions Spring 1997

The BLS Role in Escalation

The role of the Bureau of
Labor Statistics is to provide
requested data and to explain
their underlying methodology
and limitations. The Bureau
does not encourage or discour-
age the use of price adjust-
ments in purchase, sales, or
labor contracts. Nor does the
Bureau directly assist in
writing contracts or provide
advice on disputes arising
from contract interpretation.
Because index methodology.
and publication conventions
could be crucial in developing
escalation clauses, this report
is intended to alert users to
potential problems arising in
these areas.’



Appendix. An lilustration of the Effects of Fixed Weights

The following example illustrates the effects of using fixed rather than current weights. Consider the case
of an employer with two types of workers, electricians and janitors. In March 1994, the firm employed 10
electricians at $10 per hour and 10 janitors at $5 per hour. Both the average hourly wage and the wage rate
are $7.50, calculated as follows:

NUMBER X WAGE RATE = AGGREGATE
Electricians 10 X $10.00 $100.00
Janitors 10 X__5.00 50.00
20 $150.00

Average wage rate: $150.00 / 20 = $7.50

In March 1996, both groups were given a 10-percent wage increase, but only five janitors were employed.
The average wage (without fixed weights) increased to $9.17:

Electricians 10 X $11.00 $110.00

Janitors 5X 5.50 = 27.50
15 $137.50

Average wage rate: $137.50 / 15 = $9.17
Average wage change: $9.17 / $7.50 = 1.223, or a 22.3-percent increase

The increase in the average wage reflects the 10-percent increase in the wage rates and the relative decrease
in the number of workers in the low-wage occupation of janitor.

But when fixed employment weights are used (that is, the number of janitors remains fixed at 10), the
average change in wage rates is calculated, not the change in the average wage.

NUMBER X WAGE RATE = AGGREGATE

Electricians 10_X_$11.00_= $110.00
Janitors 10 X 5.50 = 55.00
20 $165.00

Average wage rate: $165.00 / 20 = $8.25
Wage-rate change: $8.25 / $7.50 = 1.10, or a 10-percent increase.

In this case, the increase is 10 percent, the size of the wage-rate increase which was granted to both
occupations.

9° Compensation and Working Conditions Spring 1997


This report provides guidance on
the development of escalation
clauses in contracts which are to be
tied to ECI data. It is patterned after
Escalation and Producer Price
Indexes: A Guide for Contracting
Parties, BLS report 807, and it
comprises three sections. First, an
overview of the Employment Cost
Index system describes the major
categories of indexes published each
quarter. Then guidelines for
assisting in the development of
escalation clauses are outlined.
Finally, practical examples of
provisions that might be incorpo-
rated into a contract are presented,
based upon the guidelines discussed,
along with an example of the price
adjustment calculations that would
be needed to implement these
provisions.

Structure of the ECI

The Employment Cost Index is a
fixed-employment-weighted index
which tracks changes in labor costs
(wages, salaries, and employer costs
for employee benefits), free from the
influence of employment shifts
among occupations and industries.
It covers nearly all occupations and
industries in both private industry
and State and local governments.
Approximately 120 series covering
specific industry, occupation, area
size, and union status categories are
produced quarterly. Indexes are
published for wages and total
compensation for the various series,
and for benefit costs for a few of the
series. The reference period for the
indexes is the week including the
12th of the months of March, June,
September, and December. The
index typically is published the last
Tuesday of the month following the
reference month. Seasonally adjusted
data are available for a number of
series, although it is recommended
that only unadjusted data be used in
escalation agreements. The unad-
justed data are final as published and
are not subject to revision.

The industry series are based on
the 1987 Standard Industrial

Classification (SIC), as defined by
the U.S. Office of Management and
Budget. The occupational series are
based on the 1990 Census of
Population classification system.
The series on bargaining status,
region, and area size are based on
employment counts from the ECI
sample, rather than external employ-
ment counts obtained from adminis-
trative records and a very large
occupational employment survey.‘

How to Escalate

Escalator clauses should be
written with great care to avoid
serious problems when contract
adjustments are implemented. The
information in this report is based
upon BLS staff experience in
handling issues that have been
brought to their attention in connec-
tion with actual escalation clauses.
The issues have been translated into
several steps that should be followed
to use escalation successfully.

|. Establish the costs to be
escalated

Clearly specify the labor cost
component in the contract to be
escalated. This may be either wages
and salaries, benefit costs, or total
compensation. Indicate the specific
occupations covered, the month or
year of the base labor costs, and how
long the contract will be in effect.

Il. Select an appropriate index
by industry, occupation, or
other characteristic

The ECI provides a variety of
series by industry, occupation,
bargaining status, region, and area
size. The series selected should
Teflect the characteristics of the
group of workers whose labor costs
are being escalated. Recognize,
however, that there generally is a
tradeoff between how specifically the
group of workers covered is defined
and the precision of the ECI as a
measure of change. That is, in
general, the more narrowly defined a

series is the larger the sampling
error associated with any estimate of
change is likely to be.*

A determination will also have to
be made whether the escalator
relates to wages and salaries only, or
to total compensation.

Tf a contract represents different
types of labor it may be best to
choose multiple series to fit each
individual category. Examples
would be to escalate engineering
salaries by the index for private
industry workers, professional
specialty and technical occupations;
and to escalate production worker
salaries by either the index for
private industry workers, manufac-
turing, blue-collar occupations, or
the index for private industry
workers, manufacturing, durable
goods.

Contracting parties may prefer to
escalate on the basis of several data
series, including some from other
government statistical programs, to
reflect changes in a variety of inputs.
In some contracts, for example, costs
of labor are escalated with the ECI
while costs of materials and supplies
are escalated with one or more
producer price indexes. In such
cases, the escalation clause should
specify the percentage weights given
to each index in calculating the total
escalation amount.

Although the ECI covers nearly
all workers in private industry and
State and local governments, there
are some gaps in the published
series. For example, no index for
mining is provided. Sometimes
indexes must be chosen as proxies to
estimate labor cost movements.

Ill. Clearly identify the selected
Index

The escalation clause must cite
the particular index and series by its
complete title, e.g., “Employment
Cost Index for Total Compensation
(not seasonally adjusted), private
industry workers, service-producing
industries, white-collar occupations
excluding sales.” Also, specific
sources for obtaining the index must

Compensation and Working Conditions Spring 1997 4

TT


be selected. Official BLS sources for
the ECT are:

* “Employment Cost Index”
quarterly news release

* Compensation and Working
Conditions

* Monthly Labor Review

© Employment Cost Indexes and
Levels (annual bulletin)

* ECT historical data listing

* The World Wide Web, at
http://stats.bIs.gov/ecthome.htm.

Each source will have a different
cost, publication schedule, and
number of indexes printed, The
“Employment Cost Index” quarterly
news release includes all indexes, is
free, and is mailed shortly after the
quarterly data are released. To be
placed on the news release mailing
list, call (202) 606-6199. Compen-
sation and Working Conditions
includes each quarterly news release
shortly after it is published, a
complete historical listing of ECI
data in the March issue each year,
and analytical articles examining
ECI and other compensation data.

A subscription to Compensation and
Working Conditions is $12 per year
(as of 1997). A subscription to the
Monthly Labor Review (MLR) costs
$29 for 1 year, but the MLR may not
include all currently available series
and usually will not be available
until about 3 months following the
reference month. Employment Cost
Indexes and Levels, published
toward the end of each year, provides
complete historical data through
June of that year, and costs $7.50.
The latter three publications are
available from the Superintendent of
Documents, U.S, Government
Printing Office, Washington, DC
20402. The ECT historical data
listing is available free upon request,
but because it is a computer printout,

it may not be regarded as “official”
by some parties. The World Wide
Web site contains the news release
and complete historical data at the
instant the data are published, but
for some users there may be a
requirement that the data be in paper
form.

Cite the index and series by its
full name rather than a table number
or page number because documents
are reformatted and table and page
numbers occasionally change,
whereas series titles very seldom
change. BLS sources are preferable
to secondary sources such as other
government publications or private
firms. If contracting parties agree to
accept updated index values on the
telephone from BLS staff members,
the escalation clause should specify
appropriate procedures and whether
subsequent verification from a
published source is necessary.

Note that periodically the industry
and occupational classification
systems change. This may alter
what is published.

IV. Specify whether seasonally
adjusted indexes or unad-
Justed indexes are to be used

In general, seasonally adjusted
indexes are not appropriate in
escalation agreements. Because
price adjustment clauses usually are
intended to capture actual price
changes, contracting parties nor-
mally would not want to remove
seasonal labor cost movements from
their adjustment calculations.

V. State the frequency of
escalation

The contracting parties should
specify whether labor cost adjust-
ments are to be made at fixed
intervals, such as quarterly, semian-
nually, or annually, or only at the
end of the contract. Also, specify if
there are to be restrictions on the
size of increases, such as a threshold
change before adjustment takes place
(for example, the change must
exceed 2 percent before any wage
adjustment is made), or a cap on the

5 Compensation and Working Conditions Spring 1997

amount of change at each readjust-
ment period or over the life of the
contract (for example, the largest
wage increase is 3 percent regardless
of how much the ECI increases).
(See section VII(e), below.)

Note that ECI indexes relate to
the payroll periods including the
12th of the months of March, June,
September, and December. Avoid
wording such as “the index for
wages and salaries, private industry
workers as of September 30,” since
several different and equally plau-
sible interpretations are possible for
such language. It could mean the
index that was available on Septem-
ber 30, which would be the June
figure; it could mean the September
index; or it could mean the Decem-
ber index, since that index would be
based in part on compensation
changes that occurred before
September 30. A clearer statement
would be “the Employment Cost
Index for wages and salaries for
private industry workers, for the
month of September.”

Vi. Provide for missing or
discontinued data

The ECI seldom discontinues a
series, but because it might happen,
escalation clauses should provide
procedures to be used when required
data are missing.

VII. Avoid locking indexes
used for escalation into any
particular reference period
Periodically, the ECI will change
its index base. When indexes were
first published for the survey, the
index base was June 1981=100. In
March 1990, the base changed to
June 1989=100.5 The index base to
be used should be the one in effect at
the time the adjustment is to be
made, which may not be the one in
effect when the contract was written.
The selection of the base matters
especially when the escalator is
expressed as a fixed dollar change
for each change in index points,
because the formula must be modi-
fied if the index base is changed.