Analyzing the Purchasing Power of Salaries Using Cost-of-Living Differentials

by Marillyn Tefft, Senior Researcher 7. August 2013 08:40

 

Attracting and retaining top talent is a key function for many HR, compensation, and relocation professionals. Analyzing the relationship between cost of living and salary for a specific location is a tool that can be used in certain situations to enhance presentations to management, educate relocating employees, and attract new hires.  Nominal (actual salary amount) and real (purchasing power of the salary) income may sound like terms only relevant to economists; however, they are informative and powerful concepts in workforce management, especially when home prices differ. Nominal income refers to a salary unadjusted for cost of living, while real income is expressed in terms of the goods and services it can purchase.

Cost of living is a spatial index where the base is a location (U.S. National Average) rather than a time period (as used in the Consumer Price Index). Cost-of-living data are collected for a standardized market basket of typically consumed goods and services by location. Local home price and apartment rental data are also surveyed since housing is typically the largest component of expenditure patterns.  An estimated federal, state, and local tax liability is also important to include as taxes are a required expenditure, and state and local taxes vary among locations.

To understand the purchasing power of a salary, let’s consider the following scenario.  

A young professional (engineer) has job offers with different salaries in several cities. Your organization has provided an offer of $110,000 for a job in Salt Lake City, UT. Given the variety of free or inexpensive cost-of-living resources available to individuals considering offers, it may be beneficial to explain your organization’s offer in terms of amount of the salary versus the purchasing power of the salary using trusted data. 

Although you may not have the luxury of knowing the specifics of other offers, having the ability to explain the purchasing power of the salary using cost-of-living differentials may enhance the attractiveness of your offer package. The table below uses cost-of-living data from ERI’s Relocation Assessor for three locations at specific salaries, assuming the potential employee intends to purchase a home of around 1,600 square feet in the city in which she accepts the position. In order to compare the salary offers in terms of purchasing power, the first step is to analyze each salary in relationship to the U.S. National Average (middle column provides the differentials from the U.S. National Average).  This is similar to the process of finding a common denominator when comparing two fractions. The resulting differential is used to adjust the salaries for direct comparison. It is important to note that COL differentials between locations decrease as the earnings level increases, thus a different salary offer in Houston would result in a different cost-of-living differential.

 

Location

Salary Offer

Cost of Living Differential

Purchasing Power of Salary

Houston, TX

$95,000

93.7 %

$101,387

Salt Lake City, UT

$110,000

100.3 %

$109,671

San Jose, CA

$120,000

123.2 %

$97,403

 

The following equation is used to figure the purchasing power of a salary (last column):

 

In this example, the salary offer in Salt Lake City holds the strongest purchasing power, while the highest unadjusted offer of $120,000 in San Jose results in the lowest purchasing power.

While this kind of analysis may not be suitable for employers to utilize in every situation, having the resources to understand, calculate, and communicate the purchasing power of a salary in a specific location, when needed, gives professionals another tool to call upon in securing top talent.