Many of you are getting pay raises this time of year. You are hoping it will be high enough to cover what inflation did to your budget last year. Here in the U.S. we are paying higher prices for things like housing and food.
But smart employers do not match merit increase budgets to the inflation rate. They know the difference between the Cost of Living and the Cost of Labor.
Cost of Living and Cost of Labor can often cause confusion when referencing compensation and total rewards.
(1) Cost of Living represents the costs a consumer has in a specific geographic location for food, shelter, transportation, energy, clothing, education, healthcare, childcare, taxes, entertainment, etc. It is the cost consumers incur to maintain a certain standard of living. The Cost of Living is often tied to the Consumer Price Index or CPI, which reflects inflation.
(2) Cost of Labor refers to the difference in pay or labor market for a job from one geographic location to another. It is compensation for jobs performed in a geographic area based on the supply and demand for labor. Cost of Labor is what is represented in external market-based compensation data. It often trails the Cost of Living and inflation numbers. Most employers use Cost of Labor data to establish the total compensation opportunity for jobs.
Why does the Cost of Labor trail inflation?
When inflation is increasing, employers typically watch to see what their competition for talent or other employers do in response. Employers do not want to increase the pay of employees if the inflation rate increase is going to reverse and go back down in the short-term.
Once an employer increases the pay of their employees, it is difficult for them to then take that money away and reduce pay. That is why you see most employers wait to see if an inflation increase is a long-term trend.
Also, employers don’t typically match the inflation rate percentage when they decide to increase their employees’ pay. For example, if the inflation rate is 6% then they may choose to increase employee pay by 4 – 5%. Most employers are careful about how much additional cost they incur because they must cover it with additional revenue in the long-term.
Inflation in the U.S. increased 3.1% in January 2024 from a year ago.
Bottomline: Employers will usually use Cost of Labor data to benchmark the total compensation they provide to employees. And they will watch Cost of Living (CPI, inflation) numbers because they know it impacts their employees, but it isn’t the primary data source used for establishing pay opportunity or merit increase budgets.
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