Cost of Living vs. Cost of Labor: Untangling Compensation Complexities in a Changing World
The world of work has transformed dramatically since 2020. Rising inflation, the explosion of remote work, and the transparency of open jobs posted with salary ranges have fundamentally reshaped how employees perceive their compensation. With work location now a key factor influencing market pay, the confusion surrounding the cost of living and its impact on employee pay expectations has intensified. This blog aims to clarify how compensation professionals use cost of labor data to differentiate pay across locations, while addressing the common misconception that cost of living should be the primary driver of compensation decisions.
Cost of Labor: The Foundation of Competitive Pay
Cost of labor represents the investment an employer makes to attract and retain qualified individuals with the necessary skills and experience for a specific job. It’s heavily influenced by the dynamics of supply and demand in the local labor market. Compensation professionals rely on market data to establish competitive pay ranges that reflect what other employers in the same geographic area are paying for comparable positions.
Cost of Living: A Personal Perspective
Cost of living, on the other hand, is the amount of money needed to maintain a certain standard of living, encompassing essential expenses such as housing, food, taxes, and healthcare. While it typically rises over time, it can fluctuate based on economic conditions. Many employees expect annual raises to “keep up” with the cost of living, even when it may not be increasing significantly.
The Geographic Disparity: Cost of Living vs. Cost of Labor
As the data below demonstrates, the cost of living is often higher in major metropolitan areas than the cost of labor. We’ll use the Economic Research Institute’s Geographic Assessor, which provides differentials for both cost of living and cost of labor by salary level compared to the US national average. It compares the salary rate of $100,000 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 12% more in San Diego ($111,777) than Newport News. However, the cost of living in San Diego is significantly more than Newport News or 63%. 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.
The Remote Work Conundrum: Navigating New Terrain
The rise of remote work has introduced a unique set of challenges for determining geographic pay differentials. Should remote employees be paid based on the cost of labor in their location, or should they be aligned with a company facility? We’ve observed several approaches:
- US National Average: Paying all remote employees based on the national average cost of labor.
- Headquarters Location: Aligning remote employee pay with the cost of labor at the company’s headquarters.
- State Average: Using the average cost of labor for the employee’s state, often lower than major metropolitan areas within that state.
- Local Market: Paying based on the cost of labor closest to the employee’s remote location, recognizing that local conditions influence their purchasing power.
The optimal approach depends on various factors, including the nature of the jobs, company culture, and geographic distribution of the workforce.
Pay Differentials: Striking the Right Balance
When establishing pay differentials between locations, the question arises: how significant should the difference be? Should it be 5%, 10%, or more? The answer lies in the width of the salary ranges and the organization’s pay philosophy. Small differences (5% or less) can often be accommodated within a broad salary range. Larger differences (10% or more) may require a separate range because of careful consideration alongside other factors like performance and experience to avoid creating internal pay inequities.
Annual Salary Increases: Aligning with Pay Philosophy
While market pay is constantly evolving, the question of how much to increase salaries and the rationale behind those increases remains. Applying a blanket “cost of living” increase to all employees can be problematic, as it fails to recognize individual performance and the varying market dynamics of different jobs. Salary increase methodologies generally fall into three categories:
- Performance-Based: Differentiated increases based on individual performance or merit ratings.
- Cost of Living: A uniform percentage increase applied to all employees, also referred to as a general increase.
- Hybrid Approach: Combining a cost-of-living increase with a smaller, differentiated amount based on performance.
In addition to conducting market analyses, organizations can utilize salary planning surveys to understand industry and location-specific trends in salary increase budgets. These surveys often break down increases by category, such as cost of living, merit, and other adjustments.
Need Assistance?
Navigating the complexities of cost of labor, cost of living, and geographic pay differentials to ensure market competitive and internally equitable employee pay can be challenging. If you need help developing a compensation philosophy, designing a base pay program, or establishing geographic pay ranges, we’re here to assist you.
