In working with clients in the development and management of base pay programs, we may hear about or receive questions about geographic cost of living being used to determine or justify pay rates. For example, “our Stanford, CT location has a much higher cost of living than the headquarters in Billerica, MA”. This may be based on employee experience and not actual cost of living information. This demonstrates confusion about what impact the cost of living has on pay levels. In addition, annual salary increases are sometimes referred to as cost of living increases.
What is Cost of Labor?
Cost of labor is what an employer pays to attract and retain an individual with the education, experience and skills needed to do a job. This is usually based on supply and demand in that location. Compensation professionals utilize ongoing employer-completed salary surveys (compensation market data) to establish and adjust pay ranges. Therefore, what employers pay in each geographic area reflect what other employers in that area are paying. Over time, pay for jobs increase when supply is low, and demand is high. When the demand drops, and the supply is high, the pay does not increase but can decrease.
What is Cost of Living?
“Cost of living is the amount of money needed to sustain a certain level of living, including basic expenses such as housing, food, taxes and health care” (Investopedia). Over time the cost of living has both increased and decreased. However, most don’t realize that it can decrease, and many employees still expect an annual increase to “maintain the same standard of living”.
Often, cost of living is higher in major metropolitan areas than the cost of labor. The Economic Research Institute Geographic Assessor provides differentials for both cost of living and cost of labor by salary levels compared to the US average.
As an example, the following table was created from our ERI subscription of Geographic Assessor. It compares the salary rate of $75,000 between the two cities of Newport News, Virginia and San Diego, California compared to the US Average and each other. It shows that the cost of labor is about 13% more in San Diego ($84,706) than Newport News. However, the cost of living in San Diego is significantly more than Newport News or 64%. If you want to live in a city where the cost of labor and cost of living is equal, Newport News is the place to be.
It is a prevailing practice or best practice for employers to use compensation market data to establish pay ranges, differentials between locations and establish salary increase budgets, not the cost of living. In these examples above, in developing a salary range for the two cities, we would recommend a 10-15% differential for these two cities for this pay level. We would not base it on the 64% differential in the cost of living.