Cost of living (COL) indices are designed to ensure that an employee’s spending power is maintained when they are on an international assignment, while preserving their home country housing and savings obligations. ECA publishes a wide range of indices – over 90! – for each available home to host combination to suit different policies and assignment objectives. This article looks at the many options available and how to use them to manage assignment salaries effectively.
Applying the index
COL indices are most commonly used in home-based assignment salary calculations, which is the method used by more than two thirds of the companies who took part in ECA’s last Expatriate Salary Management Survey. To summarise from previous Mobility Basics posts, in this approach hypothetical tax and social security is deducted from the home country gross salary and the COL index applied to a portion of the remaining net salary known as the ‘home spendable’.
When the COL index is applied to the home spendable this results in a host spendable that ensures the purchasing power in the home and host country will be equivalent. This amount can also be referred to as the home spendable plus Cost of Living Adjustment (COLA). It is important to highlight the fact that COLA is an adjustment and not an allowance, since its value can be negative.
COL indices can also be used in other approaches to calculating assignment pay, such as the hybrid approach or the net-to-net approach. This latter method assesses the suitability of a local salary in the host location by comparing the local net salary against the home country net, taking the difference in living costs into account too. The type of salary approach used can affect the choice of COL index used. For example, a company may apply a generous index in a home-based approach for a two-year assignment to a developing country but use a cost-effective index in a net-to-net for a permanent transfer from one developed location to another.
Choosing an index type
ECA publishes three different index types; standard home-based, cost-effective home-based and cost-effective international. These indices vary according to what type of spending pattern is referenced to allocate weights to the items in the shopping basket and the price levels that are compared in the home and host locations (as assignees may be able to shop less cost-effectively than at home in some circumstances). Depending on the assumptions made, the index will be higher or lower.
By understanding the methodology behind each index, global mobility managers can select the most appropriate one according to the nature of the assignment. The graphic below summarises the characteristics of each index and provides example scenarios for when each might be suitable.
There has been a trend over recent years for companies to move to using cost-effective indices rather than standard indices. Cost-effective indices tend to be lower than standard ones, which is no doubt a factor in their increasing popularity with cost-conscious employers. There is also a perception that it is becoming generally easier for assignees and their dependants to adapt to local retail conditions. This is partly a result of the general improvement in the global distribution of goods and services. Furthermore, the choice of consumer items in many expatriating countries is evolving to reflect more cosmopolitan tastes. This might explain the preference among European companies to use cost-effective indices, shown in the graph below.
© Employment Conditions Abroad 2018
Overall though the standard home-based index remains the most commonly used, with 48% of companies opting for this index compared to 41% using cost-effective indices. Just 11% apply a mix of both standard and cost-effective indices, highlighting that most companies prefer to adopt a consistent approach across all their assignments. Where a company does apply different indices, the choice is usually governed by the assignment location: the standard index is more likely to be used in less developed locations with relatively few outlets selling goods and services of acceptable quality.
There are also scenarios in which companies may choose to start an assignment using the standard home-based index and then switch to a cost-effective index later. If, for example, the home and host locations have very different shopping environments, there may be a case to switch to the cost-effective index once the expatriate has adjusted to the new location.
The choice of index can have a substantial impact on the overall assignment cost, as the graphic below shows. When selecting which index to use it is worthwhile considering not only which one would be most applicable for the assignee, but also whether unnecessary costs can be avoided for the company.
Customised expenditure groups
ECA’s indices compare spending on over 160 basic goods and services, but there are circumstances where companies may require some groups of expenditure to be added to or excluded from the index calculations. This may be because the company covers some costs through separate allowances or deems some types of expenditure to be unnecessary for the specific assignment.
For example, an assignee may be provided with a car and driver by their employer and thus the motoring group may be excluded. Exclusions can also be a result of the shopping environment, for instance, if the clothing available in the host location is not of a suitable standard for expatriates, then the clothing group may be excluded.
ECA’s Cost of Living Calculator allows companies to tailor their index to their policy by including or excluding specific groups of expenditure as summarised below.
It is important to remember that adding an expenditure group will not always result in a higher index and nor will excluding a group always lower it. For example, for an assignment from Bremen to Vilnius in our September 2017 Cost of Living Survey, the index without utilities is 103.1. When utilities are added to the calculation, the index drops to 97.1 because utilities costs in Vilnius are a lot cheaper than those in Bremen. So, despite adding in an expenditure group, the index has not only gone down but moved from being positive to negative.
Given the number of options available to adjust their COL index, it is perhaps surprising that many companies adopt a one-size-fits-all approach. While this promotes consistency, is it realistic to assume that all assignments are the same? Is it worth sacrificing simplicity for a case-by-case approach? How can the benefits of personalisation be balanced with the practicality of calculating salaries for hundreds of assignees?
Understanding and being aware of the various ways in which a COL index can be calculated can greatly help any global mobility professional. Whichever choice seems most appropriate for the company’s business needs and culture, it is best to ensure your policy covers all eventualities so that each assignment uses an appropriate calculation methodology.
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