Economist Group SitesAbout usContact usHelp
Home
PurchaseLogin

Help

How is the cost-of-living index calculated?

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?
Liveability

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 Jon Copestake on joncopestake@eiu.com.

Liveability

The concept of liveability is simple: it assesses which locations around the world provide the best or the worst living conditions. Assessing liveability has a broad range of uses, from benchmarking perceptions of development levels to assigning a hardship allowance as part of expatriate relocation packages. The Economist Intelligence Unit’s liveability rating quantifies the challenges that might be presented to an individual's lifestyle in any given location, and allows for direct comparison between locations.

Each city is assigned a rating of relative comfort for over 30 qualitative and quantitative factors across five broad categories: stability; healthcare; culture and environment; education; and Infrastructure. Each factor in each city is rated as acceptable, tolerable, uncomfortable, undesirable or intolerable. For qualitative indicators, a rating is awarded based on the judgment of in–house analysts and in–city contributors. For quantitative indicators, a rating is calculated based on the relative performance of a number of external data points.

The scores are then compiled and weighted to provide a score of 1–100, where 1 is considered intolerable and 100 is considered ideal. The liveability rating is provided both as an overall score and as a score for each category. To provide points of reference, the score is also given for each category relative to New York and an overall position in the ranking of 140 cities is provided.

The suggested liveability scale

Companies pay a premium (usually a percentage of a salary) to employees who move to cities where living conditions are particularly difficult, and there is excessive physical hardship or notably unhealthy conditions.

The Economist Intelligence Unit has given a suggested allowance to correspond with the 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.

Rating

Description

Suggested allowance (%)

80–100

There are few, if any, challenges to living standards

0

70–80

Day–to–day living is fine, in general, but some aspects of life may entail problems

5

60–70

Negative factors have an impact on day-to-day living

10

50–60

Liveability is substantially constrained

15

50 or less

Most aspects of living are severely restricted

20

The liveability score is reached through category weights, which are equally divided into relevant subcategories to ensure that the score covers as many indicators as possible. Indicators are scored as acceptable, tolerable, uncomfortable, undesirable or intolerable. These are then weighted to produce a rating, where 100 means that liveability in a city is ideal and 1 means that it is intolerable.

For qualitative variables, an "EIU rating" is awarded based on the judgment of in–house expert country analysts and a field correspondent based in each city. For quantitative variables, a rating is calculated based on the relative performance of a location using external data sources.

Category 1: Stability (weight: 25% of total)

Indicator

Source

Prevalence of petty crime

EIU rating

Prevalence of violent crime

EIU rating

Threat of terror

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

Adapted from World Bank

Category 3: Culture & Environment (weight: 25% of total)

Indicator

Source

Humidity/temperature rating

Adapted from average weather conditions

Discomfort of climate to travellers

EIU rating

Level of corruption

Adapted from Transparency International

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

Adapted from World Bank

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