Escalation: Understanding Inflation and Escalation – Video 2

Welcome to the second video and our series: Understanding Inflation and Escalation in Defense Acquisition: A Guide for Better Public Understanding. Today we will present an overview on how the Department of Defense utilizes the price index escalation to support the development of certain cost figures and cost estimates. Let’s begin. Recall the definition of escalation from video 1. Escalation is a price change measured by the increase in the price for a specific good or service. But what does this mean? Imagine you’re at a grocery store looking to buy some apples. However as you are selecting apples to purchase, you recall that the price per pound has changed. The exact same apples had been cheaper last year, and the price per pound has increased. Since you observed this change in price, we know that this is a result of escalation because escalation is observable. If the opposite had happened, say instead that the price of the apples had dropped, this would be an example of de-escalation. Take a look at the observable prices of apples. Over time you can see that the price per pound rises. Although tracking the observable price changes of apples over time is useful, an analyst may prefer to convert observable price changes into a price index. As you may recall, a price index depicts the rate of change over a period of time for the price of a class of a good or service. From apples to computers, everything has a unique escalation rate. This also includes aspects such as the material and labor used to produce them. In the Department of Defense, escalation rates are used to develop a realistic cost estimate; however, when developing a realistic cost estimate, an analyst for instance cannot just use any escalation rate to predict the price change for a product. Notice how the escalation rate for apples increases over time while the escalation rate for computers decreases. Rather than use the escalation rate for computers to forecast the price change in apples, an analyst could use a proxy escalation rate such as the rate for other fresh produce or the cost of apple picking labor. Generally speaking, escalation rates are outside the influence of individual decisions. For example, the number of apples demanded by one consumer does not affect the price of an apple paid by another; however, if other consumers began demanding apples the escalation rate of apples can be reasonably expected to increase. Similarly the escalation rate for a particular military submarine is largely beyond the control of its decision maker. An escalation rate emerges from the decisions made by numerous industry participants, both within the government and the broader private sector. For the Columbia Class program, the 120 billion dollar figure reflects a realistic cost estimate using the escalation rates of the various types of material, tooling, labor, and other cost components included in the program. But what purpose does a realistic cost estimate serve? The 128 billion dollar figure represents the actual amount of dollars the government expects to spend on the Columbia Class program over thirty-five years. While the 120 billion dollar figure represents a realistic cost estimate of the Columbia Class program, the 100 billion dollar figure is also correct. Why? It’s because the cost of escalation built into an estimate contains two components: inflation and real price change. Inflation as we discussed in the intro is the average change in the price level among all goods and services in an economy. We’ll talk more about this in video 3. The other component, real price change, is the relative price changes unique to each good or service. It is important to understand that inflation and real price change are components of escalation because while the 128 billion dollar figure for the Columbia class program is a realistic estimate, the 100 billion dollar estimate reflects the exact same 128 billion dollar estimate with the effects of inflation are removed and the effects of real price change maintained. If you find this confusing don’t worry; we’ll cover it in the next few videos as well. In conclusion a realistic cost estimate derived from escalation rates is useful because it represents the actual amount of money the government will spend on a program. However, cost figures using escalation rates cannot be used to examine tradeoffs because escalation rates reflect the unique components of a program. You need to adjust for inflation to do that. Thank you for watching. This concludes Video 2 in our series, Understanding Inflation and Escalation in Defense Acquisition: A Guide for Better Public Understanding. For more information or additional resources on how inflation and escalation are used in defense acquisition, please visit our website at CADE.OSD.MIL/POLICY/INFLATION CADE.OSD.MIL/POLICY/INFLATION

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