What is the cost of
living index?
What's the
methodology behind the index?
How is the index
applied to compensation calculations?
What is the high
index?
What happens when the
cost-of-living index is negative?
Quality of life
What is the cost of
living index?
The cost-of-living
index, or general index, shows the difference in
living costs between cities. The cost of living in the
base city is always expressed as 100. The cost of
living in the destination is then indexed against this
number. So to take a simple example, if London is the
base (100) and New York is the destination, and the
New York index is 120, then New York is 20% more
expensive than London. Similarly, if London is the
base and Budapest is the destination, and the Budapest
index is 80, than the cost of living in Budapest is
80% of London's.
What's the
methodology behind the index?
The cost-of-living
index expresses the difference in the cost of living
between any two cities in the survey. How is this
index calculated?
Using exactly the same
price data, but different methods of calculation, a
number of different people could come up with a number
of markedly different indices. The challenge,
therefore, when seeking to construct an index is to
know which method is best for the problem at hand and
to represent equitably (in one figure) the general
trend of price differences in separate locations. To
illustrate this point, let us take a simple price
survey comparing two fictional cities, "Westwood" and
"Leville."
| |
Westwood |
Leville |
| Bread
(1kg) |
1.00 |
1.25 |
|
Potatoes (1kg) |
3.00 |
2.00 |
|
Coffee (1kg) |
2.50 |
1.75 |
| Sugar
(1kg) |
1.00 |
1.75 |
|
TOTAL |
7.50 |
6.75 |
| |
Assuming we give equal
weight to each of the products, which of the two towns
deserves the higher cost of living index number? The
answer is: it all depends on how the calculation is
made.
1) Westwood is more
expensive if we simply add up the prices of the four
items in the index and compare the two cities on that
basis.
2) Leville, however, is
more expensive when we use Westwood as a base city and
calculate an index based on the average of relative
prices in the two cities:
| |
Westwood |
Leville |
|
Bread |
100 |
125 |
|
Potatoes |
100 |
67 |
|
Coffee |
100 |
70 |
|
Sugar |
100 |
175 |
|
Index |
100 |
109 |
| |
However, if the same
calculation is done with Leville serving as a base
city, Westwood becomes the more expensive city:
| |
Leville |
Westwood |
|
Bread |
100 |
80 |
|
Potatoes |
100 |
150 |
|
Coffee |
100 |
143 |
|
Sugar |
100 |
57 |
|
Index |
100 |
107.50 |
| |
Thus with the standard
price-relatives calculation we can end up in the
paradoxical situation where each city is more
expensive than the other.
3) Using a different
method, both Leville and Westwood would have the same
index number, ie 100, and neither would be considered
more expensive than the other. Such a calculation
would be made according to a well-established
statistical formula that takes prices in both cities,
makes an average of them, and uses this average as the
basis for the index comparison. This formula, adopted
by the Economist Intelligence Unit for its indices,
has some distinct advantages over the standard
price-relatives calculation described in Step 2 above.
With the EIU formula, for example, the paradoxical
situation of the two cities being more expensive than
each other cannot arise: if city A = 100 and city B =
110, then this relationship is maintained, even if
city B is used as a base (when B = 100 then A = 91).
In other words, the EIU indices are reversible. This
property ensures that the cost of living allowances
established with the aid of the indices are consistent
in that executives transferred from city A to B can be
dealt with on the same footing as those transferred
from city B to A. In addition, the indices are nearly
circular. This means that the relationship between any
three cities is maintained regardless of which of the
cities is used as a base with which to compare the
other two. This logical inter-relationship is
important in assuring equitable cost of living
compensation as executives are transferred from
location to location.
The index formula.
The index is based on the arithmetic mean of price
levels in the two selected cities. In order to
calculate the index for the two hypothetical cities
examined on the previous page, we must first calculate
the average price of each item:
| |
Westwood |
Leville |
Average price |
|
Bread |
1.00 |
1.25 |
1.125 |
|
Potatoes |
3.00 |
2.00 |
2.500 |
|
Coffee |
2.50 |
1.75 |
2.125 |
|
Sugar |
1.00 |
1.75 |
1.375 |
| |
Next we compare prices
in each town to these average prices:
| |
Average |
Westwood |
Leville |
|
Bread |
100 |
89 |
111 |
|
Potatoes |
100 |
120 |
80 |
|
Coffee |
100 |
118 |
82 |
|
Sugar |
100 |
73 |
127 |
|
General Index |
100 |
100 |
100 |
| |
As we can see the
relationship between Westwood and Leville prices
remains intact: bread is still 25% more expensive in
Leville, potatoes are still 50% more expensive in
Westwood. If we want to compare Westwood as a base
city to Leville, we must divide Leville's index by
that of Westwood and multiply by 100. The result is
100. If we reverse the operation and use Leville as
base, the result is also 100. The two cities are
equally expensive.
There is another
element to the discussion. In the example above, we
have assumed that each item is as important as the
other. But that's clearly not true of every product in
the survey: the price of a car is more important in
determining the index than the cost of a loaf of
bread, for example. Every EIU Cost of Living index
therefore applies an identical set of weights for each
product in the survey. The weights have been selected
on the basis of research that indicates that while
there are certainly differences among the various
national spending patterns, there are also some
average figures that can probably be accepted by most
companies.
The figures below
indicate the sum of individual weights attributed to
all the items which compose each of the index
categories. They are as follows:
| |
% |
|
Shopping basket |
25.0 |
|
Alcoholic beverages |
3.5 |
|
Household supplies |
4.5 |
|
Personal care |
4.0 |
|
Tobacco |
2.5 |
|
Utilities |
6.5 |
|
Clothing |
13.0 |
|
Domestic help |
3.5 |
|
Recreation & entertainment |
18.0 |
|
Transportation |
19.5 |
|
TOTAL |
100.0 |
| |
Of course, the average
weightings shown above should not be taken to indicate
that the average expatriate spends 25% of his total
income on food. What is meant is that of the amount
spent on products included in sections one to ten of
the present survey, about 25% on average goes into the
types of products included in section one (shopping
basket).
The Economist
Intelligence Unit believes that its indices reflect
the most sensible approach to cost of living
calculation that can be taken: The Worldwide Cost of
Living Survey is not oriented toward any one
nationality, but based upon a single set of
international weights. And each index assumes that
employees will modify their spending patterns somewhat
when transferred abroad. This is inherent in the
division of each city's prices by the average of both
city's prices for each item in the index. In some
instances an index may be higher or lower than another
index calculated according to a different formula. But
for a large group of consumer goods and services
typically used by the international businessman, the
Worldwide Cost of Living Survey index is the best
choice available.
Special cases.
While the Economist Intelligence Unit believes that
this weighting pattern fits the needs for most
companies with overseas employees, it is clear that
special circumstances may arise whereby a company
would feel that a modification in the weights might be
desirable. In such cases, the EIU is in a position to
offer companies a "tailor-made" index based on any
national or individual weighting pattern that may be
necessary. Please contact Jon Copestake on
joncopestake@eiu.com for further details.
How is the index
applied to compensation calculations?
The cost of living
index is not generally applied to base salary but to
that portion of an employee's pay which is often
termed "spendable income"--ie the assumed amount that
the employee ordinarily spends on food, clothing,
recreation and transportation etc. in his home city.
Defining this sum--which does not usually include
taxes, monthly rent, insurance, savings and
investments--is not an easy matter. Much depends on
spending patterns in the home country, tax situations,
housing costs, size of family and so on.
Whatever figures are
used to define spendable income (government
statistics, corporate estimates, privately
commissioned studies) it is important to remember that
spendable income does not rise in tandem with salary
increases: an executive who earns twice as much as
another does not usually have twice as much spendable
income. Let us take the following example of two
executives with base salaries of $25,000 and $50,000
respectively, and how a cost of living allowance for
each might be calculated if both were transferred to a
post with a cost of living index of 115.
| |
Base
$25,000 |
Base
$50,000 |
|
Taxes, insurance etc |
5,000 |
13,000 |
|
Housing costs |
5,000 |
9,000 |
|
Savings, investments |
3,000 |
10,000 |
|
Spendable income |
12,000 |
18,000 |
| |
For the executive with
a spendable income of $12,000 the annual cost of
living allowance in the new location would be $1,800 (spendable
income multiplied by the cost of living differential,
ie 15%). For the second executive the annual allowance
would be $2,700.
Applying the index to
spendable income in order to determine cost of living
allowances is only one among many possible methods of
application of the index. Use of the index allows a
great deal of flexibility for companies to develop
allowances within individually tailored expatriate
compensation programmes based on other methodologies
such as "split salary" schemes. Of course, many other
features should be common to any programme of cost of
living allowances. These include establishing
increases in the cost of living allowance by fixed
percentage when the executive has a spouse and a given
number of children.
Readers requiring
assistance regarding methods of application of the
index should feel free to contact the Executive
Development & Data Division at the EIU in London.
What is the high
index?
Each city report
includes two indices: the mean index and the high
index. The former compares average prices (based on
the set of all prices for each item as observed in all
stores visited) in the home city to average prices in
the foreign city--it is an index that most companies
will normally use when calculating a cost of living
allowance.
In some cases, however,
a company may wish to make a special allowance for an
employee who is new to overseas service or to a
particular region, and who thus may run into extra
expenses in the new location before settling into a
normal expenditure pattern. In such cases, the high
index can be used: it compares the average prices in
the home city to the highest prices (based on the
highest price for each item as observed mainly in
speciality type stores) in the foreign city.
Some firms may use the
high index for only a certain period of time,
expecting the executive to eventually become settled
into the local milieu and to approximate local
spending patterns and habits. After this settling-in
period, the company may decrease the cost of living
allocation to the level of the mean index.
What happens when
the cost-of-living index is negative?
When the foreign cost
of living index is less than 100 it is said to be
negative. The basic question in such cases is: should
this negative index number be reflected in the
expatriate's remuneration package?
While many companies do
not respond to negative indices, many others feel
strongly that if a cost of living index falls below a
certain level, eg 90, it is sound policy to reduce
remuneration. Indeed, such a policy is simply an
extension of the principle of equity in payment
practices: proponents of the recognition of negative
indices feel that the windfall benefits that accrue to
an expatriate who is transferred to a cheap location
but kept at an inappropriately high level of
remuneration puts him at an unfair advantage vis-a-vis
his colleagues. And ultimately the overseas experience
may prove discomfiting to him if he upgrades his
standard of living to a level that he will not be able
to maintain on repatriation.
Still, the application
of negative differentials remains a highly delicate
subject, and corporate practices in this area vary
considerably. For those companies that do not
recognise negative cost of living indices, it is
important to check whether the pricing data for the
foreign post indicates that all of the products in the
home country survey are indeed available at the new
post. A post in Central Europe, for example Baku, will
have a negative cost of living index when compared to
most Western capitals, but it must be realised that:
1) Many of the items
included in the cost of living index are either not
available in the destination city in Eastern Europe,
or of a quality that does not permit them to be
included in the city report.
2) This absence of
certain items reduces the index comparison to only
those items that are available and are of reasonable
quality. These items are often relatively low in price
due to local economic factors, and they usually tend
to be everyday necessities such as sugar, light bulbs
etc. Thus in order to acquire many of the more
sophisticated items normally included in the cost of
living index, the expatriate in such a city, would
have to make supplementary purchases in his home
country or on the local black market, if one exists.
(Black market prices are not included in indices)
Given these realities,
companies would be well-advised to use the cost of
living index for such problem cities as only a partial
guide to fixing remuneration levels in these cities.
It is important to note that payment of a hardship
premium does not solve the problem where there is a
shortage of goods. One solution would be to form a
"composite index" combining prices in the home country
(or a third country near the location where the
expatriate could obtain these goods) with those in the
destination country to arrive at a more realistic
index. However, such a solution must be complemented
with the possibility for the expatriate to have
"shopping leave" to obtain the necessary goods. Other
solutions include measuring costs of obtaining these
goods through importing channels.
Guidance in these
matters is available from the Economist Intelligence
Unit's Executive Services Division. Contact
eiu@bharatbook.com
Quality of living
The concept of the
quality of living index is simple: companies give a
premium (usually a percentage of a salary) to
employees in locations that present extraordinarily
difficult living conditions, excessive physical
hardship or notably unhealthy conditions.
The Economist
Intelligence Unit's Expatriate Quality of Life Index
quantifies the level of hardship in all of the
locations covered by the WCOL survey. This allows
direct comparison between locations. There are five
categories included in the index: Stability;
Healthcare; Culture & Environment; Education; and
Infrastructure. Across the survey a mixture of
quantitative and qualitative data are used, which are
combined to give an overall Quality of Life Index
rating. The index is supported by an extensive city
information report.
The Economist
Intelligence Unit has given a suggested allowance to
correspond with the index rating. However, the actual
level of the allowance is often a matter of company
policy. It is not uncommon, for example, for companies
to pay higher allowances-perhaps up to double the
Economist Intelligence Unit's suggested level.
Quality of life
scale
|
|
Description |
Suggested allowance |
|
0-19% |
There are few, if any,
challenges to quality of living |
0% |
|
20-29% |
Although, generally,
day-to-day living is fine, some aspects of life
may entail problems |
5% |
|
30-39% |
Many negative factors
affect day-to-day quality of living |
10% |
|
40-49% |
Quality of life is
substantially constrained |
15% |
|
over 49% |
Most aspects of living
quality are severely restricted |
20% |
Category 1: Stability (weight: 25% of total)
|
Indicator |
Source |
|
Prevalence of petty
crime |
EIU rating |
|
Prevalence of violent
crime |
EIU rating |
|
Threat of military
conflict |
EIU rating |
|
Threat of civil
unrest/conflict |
EIU rating |
Category 2: Healthcare (weight: 20% of total)
|
Indicator |
Source |
|
Availability of
private healthcare |
EIU rating |
|
Quality of private
healthcare |
EIU rating |
|
Availability of public
healthcare |
EIU rating |
|
Quality of public
healthcare |
EIU rating |
|
Availability of
over-the-counter drugs |
EIU rating
|
|
General healthcare
indicators |
EIU rating, using up
to 13 indicators |
Category 3: Culture & Environment (weight: 25% of
total)
|
Indicator |
Source |
|
Humidity/Temperature
rating |
EIU rating
|
|
Discomfort of climate
to travellers |
EIU rating |
|
Level of corruption |
Transparency
international /EIU rating |
|
Social or Religious
restrictions |
EIU rating |
|
Level of censorship |
EIU rating |
|
Sporting availability |
EIU field rating of 3
sport indicators |
|
Cultural availability |
EIU field rating of 4
cultural indicators |
|
Food and drink |
EIU field rating of 4
cultural indicators |
|
Consumer goods and
services |
EIU rating of product
availability |
Category 4: Education (weight: 10% of total)
|
Indicator |
Source |
|
Availability of private
education |
EIU rating |
|
Quality of private education |
EIU rating |
|
Public education indicators |
EIU rating, using up to 12
indicators |
Category 5: Infrastructure (weight: 20% of total)
|
Indicator |
Source |
|
Quality of road network |
EIU rating |
|
Quality of public transport |
EIU rating |
|
Quality of international links |
EIU rating |
|
Availability of good quality
housing |
EIU rating |
|
Quality of energy provision |
EIU rating |
|
Quality of water provision |
EIU rating |
|
Quality of telecommunications |
EIU rating |
Indicators are given a rating of between one and
five, where one means there is no reduction in quality
of life and five means quality of living is extremely
challenging. These are then weighted to produce an
index, where 0% means the quality of life in a city is
exceptional and 100% means it is intolerable. |
