Understanding the balance sheet basics

5th January 2007, Comments 0 comments

The details of the 'balance sheet' methodology remain a mystery to most expats. Our expert puts this straight.

The balance sheet method:
easy concept, complex calculation.

It has been the standard approach to expatriate compensation for the past 30 years – the Balance Sheet.  Most expatriates and HR professionals know that it is designed to "keep assignees whole" or ensure that they are "no worse off" during the assignment than they were at home.

However, despite the considerable time and effort spent communicating terms and conditions of assignments in multi-national corporations, the details of the Balance Sheet methodology remain a mystery to most expatriates – and even to some HR professionals tasked with administering the plan.

The black box

In policy and practice benchmarking surveys, 83 percent of companies reported using the home country balance sheet as the primary basis for their long-term expatriate compensation.  The same percentage of corporations pays a Cost of Living Allowance in one form or another.

Though the concept may be easily understood, the calculation is extraordinarily complex.  How does one keep assignees from any home country going to any host location "whole?" How do companies consider the spending patterns of hundreds of thousands of expatriates – who spend their money on everything from new cars to candy bars – and protect them for price differences and exchange rate changes?  And what about the extra expenses that all expatriates incur because of their assignment – from increased international long distance fees to extra baby-sitting because Grandma and Grandpa are no longer easily available for free child-minding on Friday night?

In recent employee satisfaction metrics studies of more than 7000 assignees at 15 blue-chip companies, the areas of "contract preparation and communication", "information about expatriate pay" and "changes to expatriate pay" ranked as among the most challenging aspects of expatriate assignments.

Clearly, there is a great need for companies to understand and effectively communicate the details of the pay package in order to facilitate more successful assignments.

What is the balance sheet?

The goal of the 'balance sheet' system is to provide an equivalent lifestyle in the host location as an employee had at home. 

It starts by establishing how families spend their money at home.  Most often, this is accomplished using statistical averages based on each national government’s consumer expenditure survey.  Home spending is calculated as follows:

  • Establish taxes by income and family size.
  • Apportion the remaining disposable income between savings and consumption.  This is done by creating a savings model for each country by using the tax calculation, information on changes in savings levels and data on propensities to consume in each country.
  • A consumption model is developed for each country by apportioning consumption into two elements:  Goods and Services ('home spendable income') and Housing and Utilities.

'Home country spendable income' is comprised of twelve categories: food at home, household supplies and services, personal care, clothing, medical care, telephone and communications, household furnishings and equipment, domestic help, transportation, recreation and entertainment, food away from home, and alcohol and tobacco.  Individual items in these categories can be weighted for each nationality.  For example, Japanese nationals might proportionately spend more on Fish and Rice than German nationals, who might spend more on Pork and Potatoes. 

This market basket then has to be priced and delivered in the host location.  So, the next step is to compare the prices collected at the home location to the prices collected at the host location to begin to discover the cost differences between equivalent lifestyles in the two locations. 

Of course, due to cultural differences, a family’s lifestyle will never be exactly the same at post as it was at home.  For this reason, a company may layer increased usage of items such as international telephone, food away from home, domestic help; on top of simple price differences.  This reflects the fact that a foreign assignment can significantly increase the costs of maintaining a family’s lifestyle beyond the impact of price differences alone. 

Lastly, the 'cost of living index' is calculated.  The cost of living index represents the difference in the cost between comparable market baskets of goods and services at the home and host location at a particular exchange rate.  A cost of living index above 100 indicates the host location is more expensive, whereas an index below 100 indicates it is less expensive. 

To determine the amount paid to the employee, the cost of living index is applied to the 'home spendable income'.  The result is the 'cost of living allowance' (COLA).  The COLA is intended to supplement the assignee's 'home spendable income' and protect purchasing power in the host location. 

In other words, an assignee is not expected to live on the COLA alone, but rather 'home spendable income' plus the COLA.

Changes to pay over time

 This one-time calculation has to be revisited regularly to protect assignees against inflation, changes to exchange rate and even changes to the items they would typically purchase.

For example, over the past decade products such as CDs, music downloads, DVDs, internet usage, laptop computers and family-oriented fitness clubs have been added to the mix.  Moreover, many items that reflect the preferences of the growing group of Asian, Latin American, and Middle Eastern expatriates have been added to market baskets.

Continuous, gradual updating of the market basket ensures that the basket is current at all times.  A company must then integrate new pricing items and ensure consistent price collection on-site. 

More common is updating for exchange rate and inflation changes.  The majority of companies change the COLA every six months to reflect these economic changes.  The COLA can go up or down during these reviews, depending on economic circumstances.

The COLA will go up when (1) there is higher inflation in the host location than in the home country and/or (2) devaluation of the home country currency requiring a greater amount of home country currency to purchase the same amount of host currency.

The COLA will go down when (1) there is lower inflation in the host location than in the home country and/or (2) devaluation of host currency requiring a smaller amount of home country to purchase the same amount of host currency. 

It is important to remember that the amount needed to purchase 'goods' and 'services' at the host location equals the COLA plus the 'home spendable income'.  An exchange rate change affects the entire host 'goods and services expenditure'.  Since the 'home spendable income' remains unchanged at a fixed salary, the resulting change to the COLA will be greater than the exchange rate change. 

This often leads to assignees complaining that the COLA has decreased by a greater rate than the change in exchange rate or inflation, when, in fact, their purchasing power will continue to remain whole in local currency.

Creating transparency

In order to lift the veil many companies involve assignees directly in the survey process.  Some vendors use assignees and their spouses to collect prices, while others make voluntary questionnaires available online that ask about lifestyle choices and pattern of living changes.  Additionally, many interview assignees at the host location.  These methods have obvious implications for the integrity and objectivity of the data collected.

Regardless of the method of involvement, a high degree of transparency around the calculation of expatriate pay, and the terms and conditions under which that pay may be revised up or down, are essential to a successful expatriate programme.

January 2007

John Pfeiffer is with AIRINC, a human resources consulting firm dedicated to facilitating global mobility, with European headquarters at Avenue Louise 391, 1050 Brussels, Belgium. (www.air-inc.com).

[Copyright Expatica 2007]

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