To compare financial data over time, analysts compare financial figures for consecutive years, ratios, or percentages. An index represents a change in value over time and is used to compare financial figures for different time frames. For example, stock prices in January 2012 and January 2013 are compared against a benchmark of 100 for the first of these months in order to determine the percentage increase or decrease in value over the year.
What is a price index?
A price index is a measure of relative price changes so that you can equally compare the values of different periods of time or places. Most indexes use a weighted average to compare the cost of the markets over time or location. For example, a price index can help you determine the cost of bread in the year 1912 vs 2021.
Consumer Price Index
The consumer price index measures the cost of living based on changes in retail prices. These indexes are based on the data from the sample of a population to determine the “market basket” of goods and services. Prices are combined with the relative importance of the goods to create a compare index price of the goods or services.
The Laspeyres index was created by German economist Étienne Laspeyres (1834–1913). It is a consumer price index principle used to measure current prices or quantities in relation to a selected time period. The Laspeyres price index is calculated by taking the ratio of the total cost of purchasing a specified group of commodities at current prices to the cost of that same group at base-period prices and multiplying by 100.
Other price indexes
Over centuries economists developed different methods for calculating indexes that determine the normalized value of goods and services and purchasing power. Other common price indexes include:
- Paasche index
- Lowe indices
- Fisher index and Marshall–Edgeworth index
Price index formula
Consumer Price Index Formula (CPI):
To calculate consumer price index or CPI for short use this formula:
CPI=Cost of Market Basket in Base Year/ Cost of Market Basket in Given Year×100
CPI will give you an accurate comparison of two market baskets in any given year. For example, the average cost of a home in 2005 vs 2021.
How to Calculate Price Index
Calculating the price index is easy using these 3 steps. For example, let’s say you want to calculate the price index of a product or service between three different years.
Step 1: Determine base value
Determine the different values you want to compare. In this case, we are looking at goods with different prices over three different years.
Now for the number of items:
Step 2: Plug your values into the formula
Now plug your values into the Laspeyres price index formula.
Price index Year 0 = (10×110) + (15×220) + (18×280) / (10×110) + (15×220) + (18×280)
Price index Year 1 = (15×120) + (10×220) + (20×300) / (10×110) + (15×220) + (18×280)
Price index Year 2 = (12×130) + (15×240) + (24×350) / (10×110) + (15×220) + (18×280)
Step 3: Complete the formula
Now with a few quick calculations, we can determine the price index for each year. The price index for each year are as follows:
- Year 0: 100
- Year 1: 105.93
- Year 2: 143.64