Whether you’re drawing up a business plan or signing a contract, don’t underestimate the impact of rising prices. Over time, inflation will reduce your purchasing power due to consistent rise in prices without the productivity to match. While you can’t prevent inflation, one potential strategy to guard against it is with an escalation clause. Here’s a closer look at the escalation meaning, and how to implement it into your business policy.
The meaning of escalation in business
It’s not uncommon for businesses to juggle multiple contracts at once. When these contracts are based on costs and revenues present at the time of signing, they won’t always take future inflation into account. When real-life inflation differs from what’s specified in a contract, this is referred to as price escalation.
The escalation meaning refers to a persistent rise in the price of goods, services, or commodities. The price rise is due not only to inflation, but also to things like supply and demand, technological advances, politics, and macroeconomic factors.
Escalation vs inflation
Both relate to a rise in prices, so what’s the difference between escalation and inflation? While inflation refers to a full basket of goods and services, price escalation refers to a specific good or service. A common example is the development of the Alaskan pipeline. Its initial cost estimation was 900 million USD in 1969, while its final estimate was 8 billion USD in 1977 – a rise of 900%. The escalation in price was due not only to inflation, but also to supply and demand, environment policies, and advances in technology. This demonstrates how estimates can widely diverge over a period of only several years.
What is an escalation clause?
To better ensure that the prices included in contracts match reality, businesses can include an escalation clause. For example, an employment contract will often include an escalation clause stipulating that the employee’s salary will be periodically adjusted for inflation. A production contract will include an escalation clause allowing for the increased costs of supplies over time, also adjusted for inflation.
Essentially, escalation clauses are provisions accounting for these increases in prices or wages over time. This allows businesses to enter longer term contracts while mitigating the risk of future market changes. These don’t always have to be related to inflation alone. In the shipping industry, contracts will often include price escalation clauses accounting for the volatility of oil prices.
Along with escalation clauses, you can also use de-escalation clauses to account for predicted falls in price such as supply depreciation.
How to create an escalation procedure
If you wish to account for price escalation when drawing up contracts or financial planning, the first step is to figure out escalation rate. There’s no single formula to use when calculating escalation rate, as it will depend on industry and economic conditions. While some investors will equate anticipated inflation with escalation on a like-for-like basis, others will follow the movement of commodity prices instead.
On the other hand, some businesses prefer to avoid escalation clauses altogether. Although they can be used to protect workers in terms of future purchasing power, some economists argue that they can contribute to inflation. As wages grow to match inflation, central banks might find it difficult to keep prices stable. If businesses can’t keep up with the higher prices of wages and supplies, they’ll need to cut costs elsewhere.
When crafting your own escalation procedure at work, you should keep both sides in mind. Ultimately, it’s natural for prices to rise in any growing economy, so escalation should be weighed up as part of any cost analysis. This accounts not only for inflation, but for all the other contributing factors that underlie the price increase.
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