By Lynne F. Molnar
Youve just been through a trying, but exciting, time moving to your new assignment abroad and finally settling down into more of a routine. However, your cash flow is a bit different than it was upon arrival, particularly the money youre spending on goods and services. What causes a fluctuation in your cost-of-living allowance (COLA), or differential (which represents the difference between what you spent at home for goods and services and what you will spend abroad for those same items)?
Although there is no quick and easy description of what influences periodic changes to the amount you receive, the following explanation should provide a basic understanding of the economic reasons behind fluctuations in your COLA and help you relate these factors to your own situation.
Start With the Basic Equation
Your company probably uses a balance sheet system of expatriate compensation, a widely accepted approach among multinational companies designed to ensure that their employees maintain a purchasing power broadly comparable to what they enjoyed at home. The COLA is one element of this balancing. Housing, taxes, and reserve/savingsrepresenting the other major categories of your expendituresare not included in the COLA equation.
Regardless of where you are sent on your international assignment, economic conditions will affect the goods and services index appropriate to your assignment location and, consequently, any COLA you may receive to make up for the difference in cost levels measured by the index. Three external economic variables will impact the index and differentialexchange rates, price movement abroad, and price movement at home. Before we examine these variables to see exactly how they work, it is important to understand the following fundamentals:
The portion of your salary spent on goods and services varies according to your salary and family size.
Any gap that exists between the amount you spent at home for goods and services and the amount you now need to buy the same or similar items in your assignment location is filled by the goods and service differential, which is designed to increase or decrease as needed. In effect:
Or, said in another way, a loaf of bread costs 1.35 currency units (CUs) at home, but 2.00 CUs in your new location. Therefore, you need an additional 0.65 CUs to buy the bread. You are responsible for paying the first 1.35 CUs (home-country spendable income), your employer adds 0.65 CUs (the differential), and you now have 2.00 CUs (assignment-location spendable income) to make your purchase.
This basic equation underlies the balance sheet approach to equalizing expatriate pay. As we said earlier, it is meant to keep your purchasing power whole during the international assignment. We will now move on to the first variable in this equation: exchange rates.
Exchange Rate Variances
Foreign exchange rates change on a daily basis. The goods and services differential plays a key role, by design, in stabilizing your pay in the face of exchange rate fluctuationsboth up and down:
- A stronger home-country currency means that you need a smaller differential to purchase goods and services abroad. The differential will decreasebut only in home-country currency. Your assignment-location spendable income, which is always designated in foreign currency, remains stable.
- When your home-country currency weakens, it takes more home-country currency to purchase these same items. The differential will increasebut only in home-country currency. Again, your assignment-location spendable income, in foreign currency, remains stable.
- The only other change you would see is if a new pricing survey establishes relative new costs between home and abroad, or if your base pay or family size changes.
Chart 1 illustrates how the balance sheet approach protects your purchasing power, no matter what happens to foreign exchange rates. The scenario, which involves a U.S. expatriate assigned to Tokyo, shows that although U.S. spendable income in dollars remains constant, the U.S. dollar purchases a different number of Japanese yen in each example.
Example. If the U.S. dollar strengthens in a given period (e.g., between January and February) from a value of ¥ 105 to ¥ 107, your differential in both U.S. dollars and Japanese yen decreases because the basic U.S. spendable income amountUS$ 3,000now buys more yen than it did under the exchange rate in January. Total spendable in Japanese yen, however, stays virtually the same.
Example. If in March, the dollar weakens to ¥ 103, the U.S. spendable amountUS$ 3,000would then buy fewer yen. An increase in the differential would be necessary to maintain the former purchasing power.
Notice that the assignment-location spendable income remained relatively stable over time, even though the differential rose or fell because of changes to the exchange rate.
Inflation Is Rising, but Your Differential is Going Down!
In addition to exchange rates, price increases affect your index and differential. The goods and services index is based on the assumption that you will purchase goods and services in the assignment location as you are accustomed to do at home. One important point often overlooked is that prices change not only in your assignment location, but also at home; therefore, the difference between the two costs will also change. In fact, your differential could actually drop in the face of increasing foreign inflation for one of two reasons:
1.Costs at home are rising faster than assignment-location costs. In other words, prices in the assignment location are no longer as high as they used to be when compared with home-country prices. Is this what youre experiencing?
Example. The price of butter for a U.S. expatriate was US$2.00 at home in Philadelphia and US$3.00 in Tokyo last month. Butter is now US$2.50 at home and US$3.25 in Tokyo. Last month's differential was US$1.00. Even though the cost of butter in Tokyo increased, this month's differential for butter is only US$0.75.
2.Or have you been experiencing devaluation of the local currency? When foreign currency grows weaker, particularly in a volatile economy, the differential will slide along with the indexeven though the assignment location is experiencing an increase in prices.
Example. Remember the Asian economic crisis three years ago? In Bangkok, the index dropped severely, even as prices increased locally. At the same time, the Thai baht weakened against the U.S. dollar. While the differential went down, the assignment-location spendable income in Thai baht increased slightly.
This example illustrates a key point: the assignment-location spendable income in local currencynot the differential in home-country currencyrepresents your real purchasing power abroad. The differential is simply the amount your employer must provide in order to keep the level of your assignment-location spendable income constant.
Rising Costs: Your Differential Is ZeroOr Worse!
However, if prices overseas are still lower than prices back home, the index would be less than 100. In other words, you need less spendable income to maintain a home-country standard of living while on assignment. Therefore, you do not need a differential to bridge the gap in cost differences, since it is actually cheaper to live abroad than at home.
The Proverbial Bottom Line
When it comes to COLAs, there are really only three key points to keep in mind despite the complexity of the subject:
- You are expected to spend a portion of your base salary on goods and services abroadas you did at home. In fact, you would have been spending this home-country spendable income had you never left home. The company does not intend to pay for items that you and your family would purchase as part of your normal living expenditures.
- The goods and services differential protects your home-country spendable income not total base payagainst higher costs abroad. Said in another way, the differential is not intended to cover the full costs of goods and services in the assignment location; it is intended to equalize the portion of income spent on goods and services at home and abroad.
- While the differential in home-country currency may increase or decrease according to exchange rate fluctuations, total assignment-location spendable in local currency remains constant until a pricing survey establishes new relative costs between home and abroad, or until your base pay or family size changes.
|Effects of Currency Fluctuations on Pay for a U.S.Tokyo Transfer |
|¥ 105:US $1|
|¥ 107:US $1|
|¥ 103:US $1|
|¥ 315,000||¥ 321,000||¥ 309,000|
|Total Tokyo Spendable||¥ 859,950**||¥ 860,280**||¥ 859,020**|
*Multiply by FX to get spendable in Japanese yen.
**Difference due to rounding.
Lynne F. Molnar is a senior consultant in Organization Resources Counselors international compensation practice area in New York. For more information about ORC, contact email@example.com.
This article first appeared in ORCs Expatriate Observer.
Organization Resources Counselors, Inc. is a leading international human resources consulting firm headquartered in New York. Serving the business community for 45 years, ORC consultants offer their expertise and research capability to help clients respond effectively to a wide range of human resources management issues and challenges, as well as achieve a competitive edge in the present global economy.
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