Cost of Living vs. Cost of Labor and How They Impact Compensation

Cost of Living and Cost of Labor mean different things and often times lead to confusion when talking about how they impact compensation and total rewards.

Cost of Living refers to the costs to a consumer in a specific geographic area. It reflects the price of food, housing, groceries, transportation, taxes, entertainment, etc. In other words, it’s the cost of maintaining a certain standard of living. Cost of living is typically tied to the consumer price index (CPI) and reflects inflation.

Cost of Labor refers to the difference in pay or labor market for a job from one location to another. Another way to look at it is the “going rate” or compensation for jobs in a particular geographic market based on supply and demand. Cost of labor is what is represented in market-based compensation data. Cost of labor typically trails cost of living and inflation, but not always.

Cost of labor and cost of living can be very different from one another. For example, cities where the cost of living is extremely expensive, like San Francisco, may have a much higher cost of living due to the desirability to be in this city. Cost of labor is also likely higher than many other cities, but not nearly to the same level as cost of living. The opposite can be true as well where cost of living is lower than cost of labor. An example of this is with hot jobs that are scarce in markets, especially outside of metropolitan areas where competing for talent is difficult.

Many organizations are planning year-end increases which may include general increases/cost of living adjustments (COLA) or merit increases. Merit increases typically reflect the cost of labor and the external labor market based on what other companies plan to pay for their compensation increases. It is typically recommended to base salaries off of cost of labor not cost of living. This is coming to light more and more with remote work where employees don’t need to be physically in a specific location, so cost of living can become irrelevant when setting pay.

This differentiation is important especially if your compensation philosophy and strategy is to target market competitive rates. When paying for a role, it's important to focus on cost of labor in order to pay competitively. When creating salary structures, many organizations will create their primary salary structure around the cost of labor where their company is headquartered and apply a geographical differential reflecting cost of labor to the compensation structure for the additional locations to maintain consistency.

At times the two can be used together such as if an organization is looking at key decisions regarding relocation of business or offshoring; then the factors of both cost of living and cost of labor would be important things to consider with the decision-making process.

Cost of labor trend and pay data for individual roles is easy to attain through Cascade's quality survey sources. Reach out to our Compensation Team for help finding the right survey, or for support with creating a competitive pay structure.