Author: Adam Silver, AIRINC
Have your assignees ever asked, “The price of gas went up 20%, so why hasn’t my cost-of-living allowance (COLA) increased to match?”
Inflation is the change in price of goods and services over time. While exchange rates tend to receive most of the focus, inflation can have just as big an impact on allowances but is often less understood. Let’s look at how inflation can impact your assignees’ COLAs and give you a strong foundation to answer questions as they arise!
How do we measure inflation?
Inflation is measured by comparing the price of a good or service today with the price of the same good or service at a point in time in the past. If the price of an apple was CAD 1.00 last year and it’s CAD 1.10 today, that’s: ((1.1-1.0)/1.0) = .1 = 10% inflation.
For a COLA, the price changes across hundreds of goods and services are blended together according to their importance within the market basket. Gas is a bigger expense than cookies, so changes in the price of gas receive more weight in the average than changes in the price of cookies.
Price changes are measured in both the home and host locations since COLA measures the difference in costs between them.
How does inflation impact allowances?
COLA is intended to ensure that assignees maintain the same goods and services purchasing power at host as they had at home, statistically speaking. The home purchasing power is the measure of what a person at a certain income can purchase given the prices of goods in their market basket at home. Once we’ve determined that, we can map that market basket to the host location costs using the host location prices. We measure inflation in the home and the host location in order to track the changes in home purchasing power and map them to the host cost context over time.
Without a raise, if prices at home increase then the assignee will lose purchasing power. That lowered purchasing power is then mapped to the host location via the host prices. If the price of a good goes up more at host than it did at home, then it costs the assignee more at host than it did to buy their now-smaller market basket and more COLA is needed.
However, if the price of a good goes up more at home than at host, then the home loss of purchasing power is not fully offset and the COLA goes down. Assignees understandably often focus on host price changes and forget that changes in home prices are also factored into the calculation.
Let’s look at how this works by focusing on one item in the market basket: flour. All figures below are in a fictional currency, CU, in order to remove exchange rates from the equation. In this case, our assignee budgets 100 CU/year for flour. Initially, this allows the assignee to buy 50 kgs of flour at the home price of 2 CU/kg. In the host location, the assignee needs CU 115 to buy that same amount of flour at the host price of CU 2.3. Since the assignee’s budget at home is only CU 100, the company will kick in a COLA of CU 15 to cover the difference.
Moving forward 6 months, the home price of flour has gone up 5%, but the assignee has not received a raise, so their budget is still CU 100. Now, they can only purchase 47.6 kgs of flour at the new home price of CU 2.1. At the host, the price of flour has increased 9%, so they will need CU 119.05 to buy their 47.6 kgs of flour. The company will now need to kick in CU 19 in COLA to bridge the gap between the assignee’s home flour budget and the cost of that flour at host. Note that the assignee has still lost purchasing power because they didn’t get a raise. Even though their COLA has gone up they can still only buy 47.6 bags of flour at host! Adjusting the COLA upwards ensures that they have the same purchasing power at host as they did at home.
What happens when the home price changes exceed the host price changes? Let’s look at our example again, but keep the host price the same.
In this case, the COLA goes down. The assignee’s reduced purchasing power at home (from 50 to 47.6 kgs of flour) is being reflected and the price at host hasn’t changed, so they need less to purchase their home market basket at host (from CU 115 to 110).
What are key factors to consider when looking at inflation figures?
Assignees often cite figures published in news reports to bolster their cases for higher COLAs due to inflation. It’s important to ask some key questions about the published inflation figure cited and the inflation that’s used to update your allowances.
What period of time does the inflation represent?
In the media, inflation is often reported as an annual figure. However, for cost-of-living allowance purposes, inflation is often measured over shorter periods of time – usually quarterly or semi-annually. Comparing annual to quarterly figures is not an apples-to-apples comparison! Inflation figures should be pro-rated to fit matching periods of time before comparing. Even then, the comparison is not perfect since inflation can occur unevenly, which means pro-rating could miss or magnify big changes in prices that happen over shorter periods.
What market basket does the inflation represent?
This is important because the inflation used for COLAs is for goods and services only. The Consumer Price Index (CPI) inflation reported in the media may cover goods and services, housing, health care, and a host of other categories that the COLA is not intended to cover. Also, a reported figure may only be for one good or one sub-category of goods. These mismatches can drive big differences between what your assignees see in the news and what you use to update your COLAs.
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