There are often questions surrounding the COLA. How does one apply a COLA properly? What is included in a typical COLA? Why can a COLA Index be positive in both directions? We take you through the essentials.

Be sure of what the index represents before applying it to an expat's pay packet

No matter what you call it – Goods and Services Differential, Commodities and Services Allowance, Cost-of-Living Index, COLA (cost of living allowance) – the additional money needed by global assignees due to cost differences and living pattern changes between the home and host locations is a high profile element of the compensation package.

Basis of 100

COLA Indices assume the home country has an index of 100. All host locations are measured relative to this.

An index above 100 indicates that the cost of living in the host country is higher overall than the cost of living in the home country. If the index is below 100, the cost of living in the host country is lower. If a host city has an index of 130, this means the relative cost of living in that city is 30 percent more expensive than at home. Conversely, an index of 90 implies that the host city is 10 percent cheaper than the home.

How do I get an Allowance from an Index?

In order to get an allowance from an index, it is essential to know what is included in the calculation behind the index. Many COLA Indices published for expatriate application are based on a market basket of goods and services only. In any event, the index should only be applied to those elements of the salary used to calculate price relationships.

The spendable income (SI) is the portion of salary that is normally spent for the purchase of goods and services (every day living expenses in the home country). These figures can be provided by a data vendor, government statistics or derived as a percentage of gross or net income.

If the spendable Income is 50,000 and the index is 130, the allowance is computed as:

(130 / 100 – 1) = 0.3 x 50,000 = 15,000

In this case, the employee needs an additional 15,000 to cover additional costs for goods and services only.

Of course this is not the entire story! Significant costs – housing and utilities, education, taxes – are not included in the index. Applying this index to a gross annual salary could under- or over-compensate the employee. It is important to be sure of what the index represents before applying it to an expatriate’s pay packet, and make provisions for accounting for the other elements of pay that can be affected.

How can an index be positive in both directions?

People often assume that, if an index from A to B is 150, the index from B to A must be the opposite, or 66. However, emails from expatriates in the field would have us believe that "here" is always more expensive than home. And, in fact, many times administrators puzzle over indexes that are positive in both directions.

Every nationality has certain specialty items that are more expensive in a foreign city. Whether it is foi gras in Paris, Texas, or barbecue sauce in Paris, France, expatriates will always have to purchase certain items in high-priced specialty shops.

Price differences alone are an insufficient point of comparison in modelling the expatriate experience. Analysis of overseas living patterns indicates that, in many locations, expatriates change the types and quantity of the goods and services they consume, with the result being more out-of-pocket expense to the employee.

Domestic help (no more 'free' babysitting from grandma and grandpa) and telephone (higher usage of international calls, faxes and emails) are good examples of expenditure categories where expatriates consistently alter their consumption patterns from location to location. These extra costs impact employees moving from London to Tokyo as much as they do those moving from Tokyo to London.

Why did my index go down if prices on the shelf stayed the same?

Every index is valid only at a given exchange rate. As the exchange rate between the home and host currency moves, the index will move up or down – even if prices remain stable.

The recent weakness of the US Dollar relative to the Euro, for example, has made the United States "cheaper" for employees paid in Euros, although prices in New York have certainly not gone down. Where it once cost EUR 125 to buy a 100 Dollar item, today the same 100 Dollar item costs only 83 Euros.

The opposite is true for US employees in Europe. Dollar-based Americans perceive Europe as more expensive, although prices in Euros might be the same.

It is important, then, to be sure the exchange rate attached to the implemented index is current. Companies generally update index figures for home-based employees every six months, or when exchange rates move by more than 5 percent.

Conclusion

While COLA indices vary, they all have the same goal: to ensure that international assignees neither gain nor lose purchasing power during the course of an assignment.

By applying a correctly calculated, up-to-date index to the proper amount of salary, a company can bring this goal closer to fulfilment.

January 2005

John Pfeiffer is the managing director of AIRINC Europe

Subject: Cost of living