What About Inflation?

Warren Heaps – Birches Group LLC

In one of my recent posts, I explained why employers should be careful how they use devaluation as a factor in setting changes to salaries.  One reader sent me a long note describing her dilemma in managing the merit budget approval process for international locations in her company, specifically, how should she take inflation into account?  I realized that my conversation with this reader would probably be of broader interest, so I decided to write this follow-up post.

The fundamental question is:
How should inflation be considered when determining salary increase budgets?

The starting point is that market data will reflect what actually happened in the past period (usually a year). In terms of setting budgets for the future, while there are several schools of thought, I would observe that it’s really a function of these factors:

  1. Your company’s relative market position, for example, overall compa-ratio. If you are particularly low or high, the movement of your pay bands will be impacted accordingly.
  2. Your company’s ability to pay. Internal budget limitations are the most significant factor for most organizations. You can’t plan to pay more than you can afford.
  3. Statutory and collective bargaining agreements.  In many countries, there are minimum increases required by law, or under union contracts.
  4. The distribution of performance across the unit in question is key. If the performance distribution is skewed high, for example, it limits the amount of differentiation that can be provided through merit pay because, by the way, the budget is still the same (see #2 above).
  5. Finally, inflation and devaluation. These factors impact financial decisions in the company, such as the estimated price increases expected, or expected cost of imported raw materials, for example. But official inflation is very unreliable and does not reflect what companies actually do in the market with salaries.

So what’s the right approach?
It depends on what is actually happening in each individual country market, of course, but I would maintain that you should rely on market data as your primary data input to this decision.  Merit budgets should allow your company to achieve your desired market position, and fall within a cost structure that’s affordable.  Generally, merit budgets should be inclusive of any “cost-of-living” as well as merit pay.

A source of information that is sometimes used are salary increase surveys — surveys which compile what employers think they will be doing in the following year.  A few years ago, Birches Group ran a test to see if the results of the most popular salary increase surveys had any correlation to projected increases calculated using our Trends™ model, which estimates increases by calculating a best-fit regression line based on actual market data over five or ten years.  Not surprisingly, there was almost no difference between the salary increase surveys and the Trends™ data. What this means, we believe, is that in most years, companies plan to do, on average, what they’ve always done.

Cost of Labor Matters Most
As I’ve stated in several prior posts, cost of labor, not cost of living, is the best measure to determine what is happening in the salary market.  Cost of labor takes into account the most basic of economic rules which determines how much employers need to pay for staff – supply and demand.  While it’s true that during a period of high inflation, the purchasing power of employees might be diminished, it does not necessarily follow that employers should or will increase salaries to match inflationary trends.  Instead, they will base increases on actual market data and their budget.  The graph below (from my prior post on devaluation) illustrates this in spades:

You can easily see that the projected inflation (the yellow triangles) matches market movement in just one country out of ten!

The Best Way Forward
Clearly, employers should not set salary increases by matching inflation. Instead, analyzing reliable market survey data, and determining a strategic positioning in the market for your organization is the first priority.  The key driver is your budget — how much can your organization afford for salary increases?

Reliance on “quick and dirty” cost-of-living factors as a replacement for solid compensation analysis will result in problems later on, especially if the cost-of-living factors are based on high inflation numbers which employers cannot afford to match.

What has been your experience in managing pay versus inflation? Please share by adding a comment.

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