Once upon a time you could buy a gallon of milk for a few cents. Today a gallon of milk costs more than three dollars. Tomorrow a gallon of milk will cost even more than it does today. Anyone old enough to read this article knows this story well. It is an ancient story, as old as the existence of price tags. It is also a story that is as true for other goods and services, like gardening supplies and legal counsel, as it is for milk.
Scene 1: Protagonist Appears, Audience Experiences Déjà vu
We all know this story’s protagonist – inflation, a rise in the general level of prices of goods and services in an economy over a period of time. Because of inflation, you can’t buy as much with ten dollars today as you could have with ten dollars a few decades ago. In fact, I have to use ten dollars instead of one dollar in the sentence because it’s almost not worth discussing what one dollar will buy you these days. Look at that, even word choice suffers from inflation!
Scene 2: Protagonist Causes “Fruit salad” Trouble for Others
Because of inflation, the value of a dollar today is not the same as the value of a dollar from years gone by. This means that comparing dollar figures from today with dollar figures from years gone by, without adjusting for inflation, amounts to an inappropriate comparison between apples and oranges. If you are making recommendations or decisions based on financial data that span years or decades, in order to make appropriate comparisons and inferences, it is very important to ensure the data are “adjusted for inflation”. To see what I mean by adjusted for inflation, let’s discuss an example.
Suppose you have annual data on personnel costs from 1990 to 2010 and you want to make a statement about the change in the cost of personnel from 1990 to 2010. At first glance, you might think it’s appropriate to subtract the dollar amount for 1990 (e.g. $500,000) from the dollar amount for 2010 (e.g. $900,000), without adjusting for inflation, and state the difference ($400,000) as the increased cost of personnel from 1990 to 2010, but that calculation fails to account for inflation and so misstates, and overstates, the real change in personnel costs from 1990 to 2010.
Scene 3: Characters Get “Real” and Learn How to Solve Their Problem
To calculate the real, inflation-adjusted change in personnel costs between 1990 and 2010, you need to convert the personnel cost data from nominal dollars, which are simply the dollar amounts initially recorded for each year, to real dollars, which are dollar amounts that are adjusted for inflation based on a price index and base year. In the United States, the standard price index is the Consumer Price Index, or CPI-U, which represents changes in prices of all goods and services purchased for consumption by urban households. Based on a table of historical CPI-U values, where the years 1982-84 equal 100, the annual average CPI-U for the year 1990 is 130.7 and the CPI-U for 2010 is 218.1.
To adjust the personnel cost data for inflation, you need to use these two CPI-U values and convert the dollar amount for 1990 (originally $500,000) into an equivalent dollar amount in 2010 dollars. To do so, divide the CPI-U for 2010 by the CPI-U for 1990 (i.e. 218.1 / 130.7 = 1.67). Next, multiply this inflation adjustment factor by the dollar amount for 1990 (i.e. 1.67 * $500,000 = $835,000). At this point, both dollar amounts are stated in real 2010 dollars, so you can subtract them to calculate the inflation-adjusted change in personnel costs from 1990 to 2010 (i.e. $900,000 – $835,000 = $65,000).
In this case, inflation represents the majority of the increase in personnel costs between 1990 and 2010. Using the unadjusted figures, it appears personnel costs have increased by $400,000; however, using the inflation-adjusted figures, we see that personnel costs have really only risen by $65,000 from 1990 to 2010.
Scene 4: Characters Have Reconciled, All is Peaceful in the Land
As you can see, it is incredibly important to know whether the dollar figures you’re evaluating have been adjusted for inflation, especially if they span years or decades. People can present unadjusted dollar figures or compare unadjusted to adjusted dollar figures to misrepresent the situation or to advocate a point. By knowing how to adjust for inflation and understanding the importance of doing so, you will be able guard yourself against unscrupulous advocacy efforts, demand data and comparisons that accurately represent changes over time, and make knowledgeable inferences and decisions.