Cost of living and cost of labor are both critical calculations for competitive compensation packages. Yet, as often as these two terms are bantered about, there is still some confusion about what they really mean—and why they are so important to employers and job seekers alike.
The goal of this blog is to clear up the confusion, define each term and how each is calculated, and how the terms factor into compensation strategy.
Let’s start with some definitions:
Cost of living refers to the amount of money a consumer needs to maintain an acceptable standard of living in a specific geographic area. This number is tied to the Consumer Price Index (CPI), and reflects the combined price of food, housing, groceries, transportation, taxes, health services and entertainment.
Cost of labor refers to the cost to hire and retain employees with the education and skills to do a job in a specific industry and geographic location. This calculation is impacted by the availability of talent as well as the “going rate” paid to that talent in a particular geographic market. The cost varies, based on supply and demand.
Which is greater: Cost of living or cost of labor?
The real answer to this question is: it depends. Cost-of-living rates can be far greater than cost of labor, depending on the city. For example, in Boston, New York and San Francisco, cost of living frequently outpaces cost of labor. The difference between the two costs can be attributed to the desirability of these cities. Lots of people live there, which increases the demand for housing, food, entertainment, and all of the other essentials. So, prices for these items follow suit.
It’s also possible that cost-of-living rates can be lower than cost-of-labor rates in particular areas. For example, oil and gas companies are often located in more rural areas, where cost of living is low, but have a lower talent pool to choose from. So, these companies have to pay more to get the talent they need, even when the cost of living in these areas is well below national averages.
How do you calculate cost of living?
To figure out what the cost of living is for a particular area, factor in the cost of healthcare, groceries, housing, transportation and all other necessities. To help you do this easily, without creating your own spreadsheet, Payscale offers a cost of living calculator.
Payscale also offers a tool to get a personalized report on a worker’s market worth in various cities, to ensure offers are in line with what the job should be paid.
In addition, MIT has put together a living wage calculator that estimates the cost of living in communities or regions based on typical expenses. It helps individuals, communities and employers determine a local wage rate that allows residents to meet minimum standards of living.
How do you calculate labor costs?
After determining an organization’s compensation structure, , employers have to calculate labor costs to ensure the structure is financially feasible.
The basic calculation is:
Cost of labor = (total sales x percentage of labor) / hourly average of worker salaries
This calculation assumes that the cost of benefits and payroll taxes are rolled into the average hourly rate.
For example: If the organization’s total sales were $2,000,000, the percentage of labor equaled 12 percent, and the average hourly rate of labor was $13.50, labor costs would be calculated as:
($2,000,000 x .12) / $13.50 = (240,000) / $13.50 = $17,777.78
The different types of labor costs
Labor costs can take a number of different forms, including:
Direct labor costs: The costs associated with supply chain employees involved in the production of whatever the company is making and selling. Whether it’s the assemblers, manufacturers, heavy machinery users, fabricators, craftsmen, or other hands-on employees, these are the people who help the organization produce their goods and deliver these to its customers.
Indirect labor costs: The costs associated with employees whose positions, while still extremely important, aren’t essential to the direct production of the company’s products. These positions can include administration, marketing, HR and finance.
Fixed labor costs: The costs that will stay the same for a specific period of time, like an annual salary.
Variable labor costs: The costs that fluctuate with production. For example, the personnel required to run machinery is considered a variable labor cost as the number of hours they work vary with product demand. If the business that hires extra help during busy seasons, the wages paid to seasonal employees would be considered a variable cost.
When do you use cost of living vs. cost of labor?
Job seekers considering relocation should look at cost of living to determine how much more (or less) income they’ll need to maintain the same lifestyle in the new locale.
Employers who want to develop a competitive compensation strategy should look at both cost of living and the cost of labor for their industry in their region to determine pay ranges for employees.
Why it’s important to get these two terms straight
If your organization’s compensation philosophy is targeted to market-competitive rates of pay, the main focus is cost of labor. While there will be a cost-of-living difference when employees move to a new city, when you are talking about the rate of base pay in relation to that move, you should be talking about the cost of labor only.
By adjusting pay to cost-of-labor data, you would be aligning employee pay with appropriate rates for adequately recruiting and retaining talent.
If organizations that have a market-driven compensation philosophy adjust the compensation of relocating employees based on the cost of living, those businesses would be at risk of overpaying or even underpaying employees relative to the labor market for their job.
Companies today are also grappling with how to manage an increasingly remote workforce. Do they lower the pay when an employee who was hired to work in New York moves to a small town in Idaho where the cost of living is substantially less? Or in the remote world, does cost of living factor into compensation at all?
The way companies approach these situations, like the work model itself, are continuing to evolve. But, no matter how things change, it’s imperative for both employer and job seeker alike to stay on top of costs of living and costs of labor in their industry and region to effectively plan for the future.
