In order to attract and retain top talent in an organization, employers must offer competitive salaries. As time goes on, if the salary remains stagnant, it will become less effective because its purchasing power will have decreased due to the rise in the cost of living. To account for this change, some employers and governments offer annual cost-of-living adjustments (COLAs) to accommodate for the change.

How Inflation Works

Inflation, which is typically expressed as a percentage, is a measurement of the rate at which average price levels for goods or services increases over time. It is this constant rise in prices that causes a particular currency to become less valuable.

For example, a cup of coffee that cost 25 cents in 1970 now costs $1.59 due to inflation – an increase of more than 600%. Price increases are the fundamental cause of inflation, but the price increases themselves can be caused by several factors

Describing Cost-of-Living Adjustments

COLA – which can stand for cost-of-living adjustments or cost-of-living allowances – are the annual increases businesses and governments use to help counteract some of the purchasing power lost due to inflation. Rent, gas, utilities, food, clothing, insurance and all other living expenses get more expensive with time. For employees to, at minimum, keep their lifestyle the same, their pay has to increase at the exact same rate as inflation. If it does not, a job that may have been attractive because of the salary suddenly becomes less attractive and employees begin to look elsewhere for work.

This could end up costing employers more money as a high employee turnover rate means increased recruiting and training expenses, along with loss of productivity between hires.

Calculating an Employee's COLA

Employers will typically outline the method they use to figure out an employee's COLA in the employment agreement. Most use the U.S. Department of Labor's Consumer Price Index (CPI) in their cost of living adjustment formula. Private and smaller companies may decide not to use the CPI and instead negotiate a set rate that they and the employee agree on.

The current inflation rate in the U.S. is 2.8%, so to offset this increase, an employer would need to offer a COLA in 2019 of at least 2.8%.

With a 2.8% COLA, if an employee were making $50,000 last year, their salary would need to increase to $51,400 the next year. Luckily for employees, COLA does not work in the opposite direction.

In the event that the economy experiences deflation – which is when the prices of goods and services drop – an employee's salary should not be decreased. A glance at an annual cost-of-living chart, however, will show that is unlikely to happen.

COLA for Relocation

COLA increases may also happen with job relocations that result in an employee moving to an area with a much higher cost-of-living. If an employee is making $50,000 in North Carolina, an employer cannot reasonably expect them to maintain a comparable standard of living if they are relocated to San Francisco with that same salary.

To account for this, a COLA will typically be set in place. If relocation is a possibility, be sure to ask about the company's cost-of-living adjustment history.

Automating the Process

As with many business processes in today's time, setting the COLA for employees has become a less tedious task thanks to technology. The COLA process can be automated in the majority of payroll software systems. The company may need to provide the software with information like employee's salary and other cost-of-living information. Then, the software will calculate the COLA and automatically adjust it accordingly.