Index linking or commodity price indexing should be used in contracts where a large proportion of the pricing is driven by a particular component. If index linking is going to be looked at within a contract, the cost breakdown of the goods or services needs to be understood. Note that this mechanism can also be used to mitigate risk in currency fluctuation.
Some examples of where this could be used are: purchasing raw materials such as steel, purchasing manufactured goods such as plastic pots or transport services where the obvious index to be used could be fuel. As examples, metal indexes could be from London Metal Exchange, plastic indexes from ICIS and fuel indexes from the Road Haulage Association.
Index linking does create a management overhead and so care needs to be taken depending on the contract, it could lead to monthly/quarterly/six-monthly or even annual review. Typically the contract price is adjusted when the average index over the preceding period, varies by more than +/-10%.
During the review there are two ways you can look at the price adjustment. If for example you are looking at the purchase of plastics pots and you know the weight of raw materials that goes into each pot, then the movement in the price will directly correlate to the increase or decrease in the material cost. If you do not know the specific quantities of the index-linked item such as with fuel in transport, then the adjustment must be linked back to the price paid at the beginning of the contract as it will be based on percentage variations.
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