Amid Inflation, Organizations Should Stick with Cost-of-Labor Budgeting
Workspan Daily
July 28, 2022
Comp's Role Amid Inflation
Key Takeaways

  • Cost of labor, not cost of living. Base your salary increase budgets on the cost of labor, not the cost of living. 
  • Consider geo pay differences. Factor in geographical differences when setting your salary increase budget. One size does not fit all.  
  • Focus on pay transparency. Revisit your compensation philosophy and communicate it to all levels of employees. 

“Welcome to the Twilight Zone. . .”  

While the situation compensation and benefits professionals are facing right now may not be quite other-worldly enough for the late, great Rod Serling, they are working in a new dimension — where inflation is running at a 40-year high during the times of an unprecedented tight job market. 

According to labor economists, that double whammy has happened only twice in the past century — 1946 and 1969. 

So, the comp corps are finding themselves being harangued from both management and workers asking for base pay increases to address inflation, which hit a 9.1% annual gain in June, going as high as 12.3% in some metro areas such as Phoenix.  

A Willis Towers Watson (WTW) survey found that companies are budgeting an overall average increase of 4.1% for next year, up from this year’s 4% — that poll’s largest projected increase since 2008. Almost two in three (64%) U.S. employers have budgeted for higher employee pay raises than last year, while 41% have upped their budgets since original projections were made earlier this year. Less than half of companies (45%) are sticking with the pay budgets they set at the start of the year. 

Cost of Labor vs. Cost of Living 

In the face of those inflationary pressures, stick to your cost-of-labor guns, agree leading HR consultants. Base your base salary increase budgets on the cost of labor in relative markets instead of cost of living and inflation. 

“The cost of labor is the supply and demand in a given market — usually it’s geographic but at the senior level generally more industry-specific,” said Lori Wisper, who along with fellow  WTW managing director John Bremen, is writing inflation-related compensation articles.   

“Cost of living is the market basket of goods, such as housing, food and fuel,” she said. “The two are related but are two very different things. Cost of labor is how expensive it is to hire people in an area, such as Chicago, not how expensive it is to live in Chicago. A senior accountant might demand $100,000 in Chicago but that $100K won’t buy as much as it did. 

“Comp and benefits folks — you are being tested. It’s how you will react.” 

According to WorldatWork and Salary.com, most companies do base their budgets on the cost of labor with 15-20% of organizations using a cost of living/inflation-based approach. 

If an organization is feeling compelled to up pay to reflect the inflationary environment, consider using a variable pay program instead of a permanent and ongoing increase in base salary, advised Korn Ferry’s Tom McMullen and Brian Reidy in a recent Chief Executive article

“When utilizing an inflation-based variable pay strategy, firms must consider context — meaning within your organization there are multiple competing priorities for every available compensation dollar. The prioritization of inflation-based variable pay must be assessed relative to other programs including overall salary budgets, internal pay equity adjustments, hot-skills market adjustments and supplemental bonuses.  

“There is also a question of eligibility in who receives inflation-based adjustments — all employees, targeted employee groups only, critical-need jobs, employees in lower job levels, lower-paid employees across most job levels?” 

Recent Korn Ferry research from 5,000 organizations in more than 100 countries indicates that leaders are using several tools — both financial and nonfinancial. Among the compensation programs seeing increased usage are: 

  • Special incentives/bonuses outside of regular bonus programs (20% increase in usage) 
  • Sign-on bonuses and increased use of internal referral bonuses (18%) 
  • Retention bonuses (18%) 

The ‘Stickiness’ of Base Raises 

Wisper and Bremen point to the labor economics concept of “stickiness.” Some phenomena, such as inflation, are rather temporary while base pay raises are more permanent — or sticky.  

“Inflation has been low for the last decade and economists are telling us it will probably drop again soon,” Wisper said. “What happens when inflation drops and you are still paying high salaries? Be judicious — (if you pay) too high, the only way to course correct is layoffs.” 

“Leaders have been through this before. They lived through ’08,” added Bremen, referring to the Great Recession. “And, even when they were laying people off, there were still jobs where there was a skills shortage. We will see that again.” 

Bremen pointed out that salary budget increases had exceeded inflation every year since 2008, but he didn’t hear anyone complaining then.  

Despite that history, base pay increases have become particularly crucial with frontline hourly workers, Wisper said. 

“Those workers have become much more important in any kind of business,” she said. “Hourly based pay started ratcheting up when Amazon went to $15 (per hour) in 2018. I have clients who have gone up to $15 and are asking ‘Now what?’ 

“You have to decide what you can afford. Think total rewards more than salary, but that’s tough for hourly jobs where people will change employers for a relatively small increase in pay.”  

Wisper also urges compensation professionals to factor in geographic pay differentials. She points to a client in San Jose who is flying people in to work instead of paying the 27% differential that’s needed to be competitive in that market. 

“You need to know who your competitors are, how they impact your workforce and how to respond in a segmented way,” she said. 

Both  Korn Ferry and WTW compensation consultants offer several recommendations. 

The Importance of Implementation 

Korn Ferry’s McMullen and Reidy suggest: 

  • Developing base salary increase budgets based on the cost of labor in comparator markets vs. cost of living/inflation 
  • Considering the magnitude, eligibility and management of off-cycle increases, including promotions, counteroffers, pay equity adjustments, hot-skills adjustments, and in-band lateral adjustments 
  • Utilizing the entire compensation tool kit, including sign-on, retention, referral and project bonuses, to attract, engage and retain key talent 
  • Using highly leveraged nonfinancial rewards such as career development, organization transformation initiatives, recognition and providing meaningful work 

“We typically see the best rewards programs being the ones that are more effectively implemented as opposed to those with an elegant strategy and design,” McMullen and Reidy wrote. “Great implementation includes leader engagement and alignment, providing managers with support capability and well thought out and direct communications.” 

WTW’s Wisper and Bremen recommend: 

  • Revisiting and refreshing your organization’s pay philosophy. Remind your employees of your overall pay philosophy, which should be grounded in paying competitively based on the supply and demand of labor in each market in which you compete for talent. 
  • Focusing on retention. Develop a strategy that is as sharp as the strategy you use for customers. Understand how inflation affects your employees and how the experience and culture of your company help them manage their cost of living. Use that intelligence to review all your rewards programs to help ensure you are addressing their needs that also help retain them. 
  • Educating and communicating. Some employees are probably referencing “real-time data” online and think they are getting a pay cut because your salary increases don’t match inflation. Educate them on basic economics and labor markets. Don’t underestimate the importance of this education effort. 

The uncertainties caused by the pandemic have, in many ways, eliminated people’s ability to plan.  

“There is a reluctance to build in full-time costs,” Bremen said. “If companies could understand the future, it would be a lot easier. Compensation and HR professionals are under pressure from employees at all levels to provide insight and guidance in these unusual times.  

“Understanding how it all fits together, considering all perspectives and ensuring you have a solid compensation philosophy to back you up will be your best tools in responding.” 

Related WorldatWork Resources
Indiana Employers Speak Out on State’s Abortion Law
Market Trends in Private Equity Portfolio Company Long-Term Incentives
Pondering Equity-Based Long-Term Incentive Plans
Related WorldatWork Courses
Understanding Pay Equity
Quantitative Principles in Compensation Management
Geographic Pay Strategies