Compensation Considerations: Cost of Living, Labor & Hot Markets

Compensation continues to be front of mind for both employers and employees in 2022. States across the country are signing new laws seemingly left and right that bolster pay transparency and/or pay reporting, with California’s new law (SB 1162) being the most recent example, and employees are continuing to seek new roles at record-setting rates. The workforce is more distributed than ever before as COVID has eliminated or drastically reduced in-office work for many organizations in the US. Pay is considered the number one issue for many employees seeking new roles, and employers are struggling with a big question: How should we pay our people?

Cost of Living vs. Cost of Labor:

Employers with a distributed workforce will frequently (though not always) pay their employees differently based upon where those employees are located. One of the first issues that employers with a distributed workforce must reckon with when making compensation decisions is the question of whether to pay based upon Cost of Living or Cost of Labor. Cost of Living refers to the actual cost of living in a specific area—e.g., how much does it cost the average person to live in Chicago? Cost of Labor, on the other hand, refers to the average market rates that jobs in a specific area demand—e.g., how much do workers in Chicago tend to get paid? This may seem like semantics, but the differences between these two figures can be significant. For example, workers in San Diego tend to get paid approximately 15-20% more than the US average, but the cost of living is more than 40-70% (depending on where you look) higher than the US average. That difference is a big deal for companies and workers! So, there are a number of factors that employers should consider when deciding between these two options:

Q: Does it even make sense to pay based upon location?

A: It all depends! If the organization is primarily focused on retention and employee satisfaction, then paying all employees based upon the location in which they live can support that strategy. However, if the organization offers positions that are completely remote and not tied to any specific area of the country, then it often makes the most sense for an employer to pay all remote positions based on the US-average or based on a single location. For example, take a company that has half of their employees in a home office based in St. Louis and the other half are completely remote. The best option is often to pay every employee based on the St. Louis market. If it doesn’t matter to the employer where their remote workers are located, then there is no real reason to offer higher pay to somebody living in a higher pay market as the decision regarding where to live is completely at the discretion of the employee. The most important thing is that the employer remains consistent with whatever decision they make. If some remote employees are being paid on the basis of the St. Louis market and others are paid on the basis of the market in which they reside, this can open up potential legal issues.

On the other hand, if an employer requires that their workers be in a specific region or proximate to an office location, then it is typically considered a best practice to pay employees based on those markets. For example, if a company has office locations in Louisville, Atlanta, Denver, and Baltimore and requires that their hybrid employees appear in the office a few times a month, then they should create ‘Zones’ that have different premium codes based on the specific office each employee is tied to. An employee who is tied to the Denver office should be paid more than an employee tied to the Louisville location to compensate for the difference between those two markets.

Q: When does it make more sense to use Cost of Living compared to Cost of Labor?

A: This is up to the discretion of the employer, and it depends upon the goals and philosophies of the organization. Does the organization want to ensure that employees are compensated in a way that allows them to maintain their standard of living no matter where they are? If so, then paying based upon Cost of Living is the preferred strategy. This would mean paying somebody who lives in San Diego about 50% more than what they would offer somebody in the same role in Cincinnati so that both people have the same standard of living. Many times, using cost of living for every employee is the best way for companies to keep their pay competitive in a remote world with a hot job market. However, if the goal is remaining competitive within each market that the organization has employees, then paying based upon Cost of Labor will best allow an employer to do that. That would mean paying approximately 10-15% more for an employee in San Diego than in Cincinnati as those are the differences in the labor markets between those two locations. The most employee-centric response, and thus the response that will help the most with attraction and retention, is simply choosing whichever of the two values is higher—i.e., paying for Cost of Living in San Diego because that will result in higher quality of living for employees. The best answer for many employers lies somewhere in the middle—creating a hybrid of Cost of Living & Cost of Labor. This allows an employer to balance between the competing priorities and compensate for when there are large differences between the two figures.

Q: How should companies respond to Hot Jobs & Markets?

A: In the current labor market, there are certain jobs and areas that are in high demand and thus more difficult to hire for. For example, in the current market, Austin, TX is considered among the best cities and tech roles among the best jobs for job seekers. The reason these are considered the ‘best’ is that job growth and demand for new employees in these roles and areas outweigh the supply of applicants, and organizations hiring in these competitive markets are likely to struggle if they don’t raise their typical offers. Employers are often unsure: Can we pay more for a position or area simply because it’s more difficult to hire for? The answer is yes! The key is consistency and documentation. Codify the roles and areas that are considered “Hot” and have a set structure for how that changes the offer. For instance, an employer might decide that both Hot Jobs & Hot Markets receive a 10% premium. If an employer determines that the demand in Austin is too high to be able to compete with a typical offer, and that they’re losing Data Scientists because of the demand for that position, then the employer would codify Data Scientists & Austin as “Hot” in their HRIS. Then, if they were to be hiring for a Data Scientist located in Austin, that person would receive both premiums and receive a 20% premium above what would typically be offered. However, if/when employers opt to make the decisions to add premiums to jobs or areas, then they should consider applying this premium to current employees in these jobs or areas as well. Otherwise, the organization will likely see wage compression occur between newer employees and more tenured employees.

Conclusion:

With the volatility of the current labor market and all of the changing legislation, it can be difficult for HR professionals to stay abreast of best practices. One of the most difficult things about compensation questions is that many of them don’t have a prescribed answer—it depends on the strategy and priorities of the organization. A good rule of thumb to keep in mind is consistency: Consistently applying (and documenting) the same standards to each employee in an organization will help protect organizations from legal backlash and employee dissatisfaction. Finding the right compensation strategy may be a challenge, but once determined and applied consistently, an organization is able to make the best decisions for its future.