Cost of living (COL) indexes are used to prevent the internationally-transferred employee suffering or benefiting from an unintentional change in his/her purchasing power. A COL index can be compiled from comparing the cost of a certain package of goods and services in one country (or town) to the cost of a comparable package of goods and services in another.

How to apply the COL index

The COL index is used to adapt the salary to the higher (or lower) cost of living in another country. Therefore, the index should be applied on the part of the salary that is usually spent on the goods and services included in the index.

This means that the COL index should always be applied on a part of the net salary. Before applying the cost of living index the part of the net salary spent on "savings" is excluded. The term savings is used for the part of the net income that is used for long-term investments, is put aside, or is spent on durable goods. This part of income is not affected by the cost of living in the other country.

Leaving out housing and utilities

Generally, housing costs and costs for utilities are also not included in the section of salary to which COL indexes are applied.

This is because housing costs are related to the individual circumstances of the employee (eg: the area they choose to live in, the size of their house, family size, etc), and since the housing costs form a major part of the spendable salary, this may have a distorting effect on the cost of living index.

Furthermore, many companies provide their expatriates with some sort of assistance for host country housing costs.

A cost of living comparison is based on the costs of goods and services expressed in the currency of the countries involved. In order to calculate the index the exchange rate on the date of price collection is typically used. As a result a close relationship exists between the exchange rate and the index. The index should always be used with the exchange rate of the date of collection. If another exchange rate is used the index should be adapted.

How to calculate a COL allowance

To protect the expatriate from a higher cost of living, the employer may provide the expatriate with a cost of living allowance (cola). The allowance is calculated by multiplying the part of the net salary (after the above- mentioned deductions) with the percentage difference in the home country and host country index as follows (In this example the home index is 100, and host index is 120):

salary x (120-100)/100

Alternatively, the host country net salary may be calculated directly by multiplying this with the index, as follows:

salary x 120/100

Types of indexes

There are different providers for cost of living data. Each provider has their own philosophy on the composition of the package of goods and services, data collection and the different indexes that they provide.

According to these philosophies, packages may be based on:

• Average spending patterns of the local population or the expatriate community.
• Different types of goods and services.
• Data collected by travelling data collectors, resident data collectors or expatriates themselves.

Once the data provider is chosen, the company will have to decide which index of the several indexes provided should be used. Generally at least three types of indexes will be provided, which vary based on the spending pattern and on the level of prices collected (home-based index, efficient-purchaser index, adapted index, international index, etc).

Survey data

The 1999 PricewaterhouseCoopers European "International Assignments Survey" shows that 91 percent of the companies with internationally mobile employees use COL indexes. The main providers are ECA (37 percent), ORC (24 percent) and CRG (17 percent). Most companies use the standard index, however one of every eight companies uses the effective purchaser index.

According to the survey, 60 percent of companies do not apply COL indexes lower than 100 (that would lead to a negative adaptation of the salary).

A COL index is not a figure that can be applied arbitrarily. In choosing an index, the philosophy of the provider, the goods and services included in the index, the data collection and which type of index bests fit the type of assignment and the assignment policy and objectives should be considered. Furthermore it needs to be decided which part of the net income will be adjusted for cost of living and also whether or not the COL index will be applied when this leads to a negative salary adjustment.