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Expatriate Cost of Living Allowance Formula
A cost of living allowance (COLA) is a salary supplement paid to employees to cover differences in the cost of purchases from basket groups, particularly as a result of international assignments.
The amount should be able to enable an expatriate to purchase as many goods and services in the host location as in his home country. The basis for calculating COLA is the cost of living index (COLI), which indexes the costs of the same basket of goods and services in different geographic locations. This variable salary is a simple accurate method of measuring purchasing power and ensuring equality.
Cost of living index
Xpatulator’s index measures the cost of 230 products and services in 13 different basket groups in 950 cities around the world. The data is collected by a team of research analysts who survey comparable items available internationally. A minimum of 3 prices for the same brand/size/product volume are used to determine the average price of each item at each location. Commodities are priced on a quarterly basis and rise and fall with inflation. The 13 different basket categories are as follows:
1. Alcohol and Tobacco: Alcoholic beverages and tobacco products
2. Apparel: Clothing and footwear products
5. Furniture and appliances: Furniture, household appliances and household appliances
6. Groceries: Food, non-alcoholic beverages and cleaning supplies
7. Healthcare: General healthcare, medical and medical insurance
8. Household accommodation: Housing, water, electricity, household gas, household fuel, local rates and residential taxes
9. Miscellaneous: Fixed, linen and general goods and services
10. Personal Care: Personal care products and services
11. Entertainment and Culture
12. Restaurants, eating out and hotels
13. Transport: Public transport, vehicle costs, vehicle fuel, vehicle insurance and vehicle maintenance
Each basket category does not count equally and is weighted in the final calculation based on foreign spending patterns.
In order to calculate the correct index for a specific individual, basket items that are not relevant to the individual should be excluded from the calculation. For example if education and housing are provided by the employer then these basket categories will be excluded from the cost of living index calculation. This increases the accuracy of the index and makes it possible for each individual to obtain their own customized COLI based on their specific arrangement, rather than using an overall “general” index that includes costs that are not personally relevant.
The formula for calculating the specific index for international assignment is as follows:
Cost of Living Index = Adjusted COLI for Host City / COLI for Home City
When moving to a high-cost host city, the index will be greater than 1 (positive). Moving to a low-cost host city will have an index less than 1 (negative). Where the index is negative it means that in real terms costs in the host city are lower than in the home city. This means that if a negative index is applied to an employee’s salary, they will actually be paid a proportionally less expendable salary in the host city. It is important to note that most organizations do not implement a negative cost of living index as it makes it difficult to convince employees to take up assignments as they see it as a cut in salary.
Examples of cost of living index calculations using our data:
An Australian employee moving from Perth to London where healthcare and communications will be provided by the employer
More expensive in London:
Alcohol and Tobacco + 4.77%
Furniture & Appliances +16.03%
Household + 50.72%
Personal Care +11.18%
Entertainment and Culture -6.82%
Restaurant Dining Out & Hotel +34.99%
The overall difference moving from Perth to London is +28.06%.
In this case the index is positive and it will be applied as such.
British employee moving from London to Mumbai where the employer will provide accommodation and education
More expensive in Mumbai:
Alcohol and Tobacco -37.53%
Clothing – 9.58%
Communication – 44.92%
Furniture and Appliances -19.31%
Groceries – 24.03%
Healthcare – 31.24%
Personal Care – 24.94%
Entertainment and Culture -35.73%
Dining out at restaurants and hotels -33.11%
The overall difference moving from London to Mumbai is -30.53%.
In this case the index is negative and will not apply.
Net expendable salary
Differences in the cost of living affect only the portion of the salary that can be spent in the host country. Home country items such as retirement funds, medical insurance and other home based costs are not affected by host country costs.
Determine what amount/portion (in domestic currency) of the current salary is spent on maintaining the employee’s current standard of living/lifestyle to determine the total expendable salary. What does the expatriate need to spend his salary in the host country? For example housing will be provided or the employee will pay rent, health care will be provided etc. All goods which are either supplied in kind or expendable in the country. Deduct the notional amount of taxes, social contributions and any other statutory deductions applicable in the country from the disposable salary. What is left is the net expendable salary.
The formula for calculating the Cost of Living Allowance (COLA) using the inputs discussed is as follows:
(Self-expendable salary x Cost of living index x difficulty index x exchange rate) less (own disposable income x exchange rate) = COLA
Examples of COLA calculations using our data
An Australian employee with a net spendable salary of AUD$100,000 moving from Perth to London where healthcare and communications will be provided by the employer.
($100,000.00 X 1.2806 X 1 X 0.4768) less ($100,000.00 X 0.4768) = 13,379.44 (GBP) of COLA
Based on all the above factors a person needs a living allowance cost of 13,379.44 (GBP). Compensation for relocation from Perth to London in addition to current salary of 100,000.00 Australian Dollars (AUD). This cost of life allowance compensates for an overall cost of life difference of +28.06% and a relative difference in difficulty of 0%.
A British employee with a net disposable salary of 18,000 moving from London to Mumbai where the employer will provide accommodation and education.
Note: Because COLI is negative it does not apply.
(18,000.00 X 1 X 1.3 X 67.2852) less (18,000.00 X 67.2852) = COLA of INR 363,340.32
Based on all the above factors an individual would need a living allowance cost of 363,340.32 (INR) in addition to his current salary of 18,000.00 British Pounds (GBP) to compensate for his relocation from London to Mumbai. This COLA compensates for the overall cost difference [-30.53%] and a relative difference in difficulty of 30%.
COLA is paid net of tax as a salary supplement (ie as an additional allowance) in the host country. If the COLA is a taxable allowance in the host country then the full amount of the calculated COLA must be credited as the basis of calculation is the net expendable salary as it is paid net of tax. The cost of living allowance is often combined with other allowances and facilities such as flight home, transfer/accommodation allowance, and furnishing allowance.
Exchange rate fluctuations
Significant changes in exchange rates can cause significant differences in COLA calculations. Some major global exchange rates changed by 30-40% in 2010-2011.
COLI reflects changes due to inflation and exchange rates. In the short term there may be an imbalance between inflation and the exchange rate (one pushes the other), but over time the cost of living index provides the most accurate view of the cost of living.
It is important to remind expatriates that when the COL difference is negative, and the negative value is not applied, they have higher purchasing power in the host country than at home.
Where a negative COLI is not applied (our recommended approach), and changes in the exchange rate indicate that an upward adjustment to the COLA may be necessary, the COLA should not be adjusted upwards unless the COLI is positive i.e. COL. Shows the “real” increase in the cost of living between home and host countries. This may mean that their COLA will not increase as a result of exchange rate fluctuations for some time. During this period the purchasing power of the employee decreases. But it is important to remember that unless the cost of living differential is positive, individuals will still have higher purchasing power than their home country.
Instead of reacting to every fluctuation in the exchange rate, it is better to set currency protection rules. For example The rule may state that the COLA will be reviewed if the exchange rate or local inflation increases by more than +10% during a year. It is important to note that prices of goods and services in local currency are unlikely to decrease. This happens only during periods of deflation (negative inflation). Hence the currency protection rule generally provides for upward adjustment in COLA and not downward adjustment at the time of assignment of the employee. A downward adjustment in the existing COLA without any decline in the prices of local goods and services places great pressure on the employee’s host currency budget commitments and may expose the employee to financial hardship.
Using an independent service provider provides an independent, objective basis for determining an employee’s COLA.
We therefore recommend that COLA is calculated by applying the specific (adjusted) cost of living index to the net disposable salary at the start of the assignment, in addition to the annual salary review and then monitoring exchange rate fluctuations.
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