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.

More About Warren

Warren Heaps

Warren on LinkedIn

Developing Markets Compensation and Benefits Group on LinkedIn

Email Warren

13 responses to “What About Inflation?

  1. Pingback: What About Inflation? - International HR Forum - Member Blogs - HR Blogs - HR Space from Personnel Today and Xpert HR

  2. Warren’s opinion is just apt; my organisation use a combination of Cost of living, Cost of Labour, Competition ratios (compa-ratios) and Appraisal results to draw up our annual merit budget for staff remuneration. My industry (Advertising) is a unique one, where good talents are becoming more rare, thus the forces of demand seem to be far outstripping supply. In a situation like this, and as the market leader, my first consideration for talent retention is competitive remuneration (monetised and non-monetised incentive schemes). That is, the order of priority for me is Compa-ratios, Cost of labour, Cost of living and Merit Pay. (Olakanmi, Lagos-Nigeria)

    • Olakanmi,

      Thank you for your comments. I believe the situation you described illustrates perfectly the law of supply and demand as it applies to talent acquisition and retention in the market. I think your approach is a good example of a strategic approach to managing compensation that is very aligned with the business realities of your firm and market conditions in-country as well. In particular, it’s clear that you determine pay increases primarily based on the market, not inflation. Good job!


  3. Warren is right and basically the adage must be that good practice means you don’t do abroad what you wouldn’t do at home. (Except in extremes and with good advice). So, get the external and internal equity right and stay within budget. Luckily at present most places have relatively low inflation but there are exceptions and the increasing price of fuel at the pumps is a very visible marker for bargaining.

  4. Very Informative and straight to the point..It clarified lots of ambiguties I had in regard with Merit Increase Budget and the relevant criterias required to be considered for this purpose. Thanks Warren.

  5. This is a great article…very useful and logical.

  6. Chris Foster

    Hi Warren: Thank you for Part 2 to your “Impact of Devaluation on Local Pay”. As salary increase budgets are set, you have outlined solid consideration points that I will refer to going forward.

    You asked “What has been your experience in managing pay versus inflation?”
    One of the challenges in setting the salary budget is the small window of time for assessment, validation, discussion and agreement between business leadership, finance and human resources. Many salary budget surveys, not all, are published late in the season (Sep,Oct) when budgets for the following year have already been set. As a result, for many countries, we are relying on only one salary budget survey which can be risky especially in developing markets. Additionally, regions and countries within the regions may take a different approach in deciding which factors they will consider and how they would be applied, if at all. Factors being: survey results, cost of living, cost of labor, inflation, devaluation, unemployment, etc. There are a lot of “touch points”, which is a good thing to ensure validation and trust; however, a common approach (meaning more like a decision flow chart, not peanut butter approach) for arriving at final decisions may be a good course to take. Perhaps developing a set of guiding principles that outline strategic guidance, factors of consideration important to the business and budget, along with clarity around local flexibility decisions would be a good tool to develop for the coming year. Thanks Warren!

    • Thanks for your excellent feedback, Chris.

      It’s interesting that you mention salary increase surveys. These surveys are, in fact, surveys of what companies think they might do, yet oftentimes employers rely on them more as what WILL happen as opposed to what MIGHT happen. At Birches Group, we have developed an alternative, which calculates projected increases based on a best-fit regression of actual survey data. The results can be used to estimate market movement over a 12- to 18-month period going forward. While it is not as precise as, say, rocket science, it’s good enough for budgeting. We even compared the results of our methodology to the leading salary increase surveys, with little difference.

      I think your idea of developing a process for internal use is a solid one. It would allow you to set corporate standards, but still allow for appropriate local variations.

  7. Pingback: Square Peg in a Round Hole: Balancing the Global Salary Budget | International HR Forum

  8. Thank you for comment, but please what the calculation method of Cost of Labour, cost of living.

    Thank you.

    • Mimi –

      There isn’t a calculation method, per se. Cost of labor is measured through market surveys, and changes in cost of labor would be reflected in the movement of values in the market surveys over time. For example, if an accountant was paid 1000 monthly in 2010, and the 2011 survey showed the going rate was 1200, then the cost of labor for that job has increased (by 20%).

      Cost of living is as measured by an independent body, usually the government statistical service. Most inflation/cost of living calculations are based on a specific basket of good and services with weightings. They are useful in measuring movement over time in the elements included in the basket, but generally are not indicative of the salary market. In certain developing countries, many experts have taken issue with official government inflation statistics and rely on alternative sources such as universities or multi-lateral organizations such as the World Bank or OECD for such data.

      Hope this helps.