Cost of Living vs. Cost of Labor — Is There a Difference?

June 1, 2022
Cost of Living vs. Cost of Labor — Is There a Difference?

Have you ever wondered why people talk differently about the cost of living versus the cost of labor? After all, shouldn’t they be the same thing? It’s an often-asked question, and we’re here to help provide some clarity.

Costs of living and labor are 2 disparate measures of calculated values.

  • Cost of living: a government-based metric using economic factors that look at how people spend money to live their day-to-day lives.
  • Cost of labor: a metric based on how much employers must pay to hire for specific roles.

This conversation typically comes up when companies communicate the average merit increase percentage. So, let’s dig into it a bit more and understand why there’s a difference between the two and how companies calculate how to pay their employees.

What defines the cost of living?

Every year the government’s Department of Labor Bureau of Labor Statistics analyzes consumer spending habits and patterns. They evaluate what people have generally spent on items such as:

  • Food/Household items
  • Education
  • Healthcare
  • Housing
  • Taxes
  • Utilities

Once these factors have been analyzed for the entire country, an overall difference in the expenses is evaluated based on comparing the average costs for the individual aspects of the previous year. This year-over-year variance is the first piece of the basis for deciding what the government’s published cost of living increases will be.

It doesn’t end there, though. Next, projections are calculated in an effort to anticipate what those same factors will cost people in the current year. Nobody has the proverbial fiscal crystal ball. So (as much as the economists and mathematicians would disagree), this calculation is more of an art form than a science. The 3rd piece of this puzzle is the available budget.

How are the cost of living adjustments applied to real life?

These calculations are going to result in a significant government expense. After all, the cost of living phrase is used as part of the cost of living adjustment (COLA) that is applied to pensioned government retirees and social security recipients. There are approximately 70+ million individuals that would ultimately be a part of this COLA distribution. In 2022, the communicated automatic cost of living adjustment given to those pensioned government retirees and social security recipients was 5.9% When this is applied, it is added to the recipients’ existing monthly retirement and/or social security payments. Active government employees may receive COLAs as well. However, they are calculated at a different (usually lower) rate than that of those on retirement income. Even so, that represents an additional 4+ million payments that must be budgeted.

How long have COLAs existed?

Congress enacted special legislation in 1972 providing the provision that allowed cost of living adjustments to be made to social security and pensioned government employees. The change in how these payments were made became effective in 1975 with an authorized 8.00% applied COLA. Since that time, the various annual COLAs have ranged from a low of 0.00% in 2010, 2011, and 2016 (0.03% in 2017) to a high of 14.3% in 1980. With a few exceptions, COLAs have generally stayed somewhere between 1.00%-3.00%. So, why don’t all companies apply cost of living adjustments? To understand that, we need to talk about what cost of labor entails.

Why don’t private companies use cost of living?

Unlike the government, private and publicly owned companies exist to make a profit. Their focus is the bottom line and increasing shareholder value. Therefore, their focus is on the cost of labor — what it costs them to hire and retain employees for the various jobs they need to fill.

What is cost of labor?

Cost of labor considers how much specific positions cost to employ by evaluating both:

  • Direct (areas that are profit centers like sales)
  • Indirect (departments that are a pure expense but necessary for the company to run — for example, finance, janitorial services, etc.) labor costs.

The primary factors involved in calculating the cost of labor include:

  • Salaries, wages, incentives, commissions, and bonuses
  • Benefits (health, paid vacation, paid sick leave, paid holidays, etc.)
  • Payroll taxes
  • Employee perks (bottled water, discounted cafeterias, etc.)

Once companies can calculate their existing cost of labor, they also need to consider how those positions’ value changes in the labor market.

How do companies evaluate changing costs of labor?

Companies that have a Human Resources department usually look to them to provide this type of information. HR may either purchase or commission an unbiased, third-party salary survey. This will provide this type of information for the majority of the relevant positions. These salary surveys provide information regarding how:

  • The position is generally defined
  • That role is paid

This information usually includes a distribution showing how companies pay from the lowest (10%) to the higher end (90th percentile) of how they compensate the job. Some companies take an anecdotal approach to salary comparison and make phone calls to local organizations asking how they pay or even just look at job posting boards. While it is less defensible, it is one way some choose to look at a segment of the employment “market.” Once companies have this updated salary information, they:

  • Evaluate the differences between how they pay for various jobs and the market’s average pay levels.
  • Consider the operating budget and what they are willing to budget for the next year as a general merit increase budget.
  • Communicate an average amount of salary increase departments can spend.

How are average merit increases applied?

Companies expect workers to earn salary increases in a cost of labor model — the increases are not entitlements. This generally means that there are a variety of salary increases that may be offered that vary from 0.00% to over the general average that was communicated to the departments. In a merit-based organization, performance and contribution are (or should be) the contributing factors in determining how much of a salary increase various individual employees have earned and will receive.

Having complex discussions about how COLAs and merits differ

This is one of the most challenging discussions HR and managers must have regarding salary increases in non-governmental organizations. If profits have not been strong, the chances are good that what the Bureau of Labor Statistics publishes and disseminates via the media as their cost of living increases will be higher than a company’s average merit increase budget. Companies need to educate their employees about:

  • The cost of labor
  • Their use of merit increases
  • How employees can positively impact their income

The absence of these conversations leads to employee misinterpretations that companies don’t care about how they can afford their lives when that’s not the case at all.

This communication is for informational purposes only; it is not legal, tax or accounting advice; and is not an offer to sell, buy or procure insurance.

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