It is that time of year when clients start asking me how much they should budget for salary increases in the New Year. I dread those calls. If I give them the number they want, I am doing my part to contribute to wage inflation and run-away salary costs. And if I slow down and try to explain the complexity of the situation, their eyes glaze over and I can sense them thinking "I ask him for the time, he tells me how to build a watch."
In a recent entry, I explained in detail the pitfalls of blindly increasing base salaries every year just because everyone else does. See The Peculiar Inflationary Bias of Salary Surveys. In this entry, I will go the the next step and explain why you also don't want to blindly increase base salaries because of an increase in the Consumer Price Index (CPI).
Let's take CPI out of the equation once and for all. To do this, let's begin with an explanation of what the CPI is (and is not).
WHAT IS THE CPI?According to the Bureau of Labor Statistics (BLS), "the CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." It includes several hundred specific items organized into the following eight major groups:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories)
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services)
PROBLEMS WITH THE CPI
While the CPI is a convenient way to monitor changes from year to year, it does not provide a completely accurate estimate of the cost of living. There are four common criticisms with the index:
1. More Than One CPI -- First of all, there is not just one CPI. True, they are all produced by the BLS, but one glance at their websitereveals dozens of different CPIs based on different geographic regions, population groups, and consumer goods included in the calculation.
2. Substitution Bias -- The second problem with the CPI is substitution bias. As the prices of goods and services change from year to year, they do not all change the same amount. Purchasing habits change based on the relative price of the items. But since the items measured by the CPI are fixed, it does not reflect consumers' preference for items that increase less. For example, if the price of shoes doubles while the cost of apples goes down, a consumer would likely purchase more apples and fewer shoes. This phenomenon of substituting lower priced items for higher priced items is not accounted for by the CPI.
3. Introduction Of New Items -- The third problem with the CPI is the introduction of new items. New products are produced constantly and despite their popularity it takes years for them to be included in the CPI market basket. This flaw is compounded by the fact the these new items often go down in price over time which, if they were included, would actually decrease the CPI.4. Quality Changes-- The fourth problem with the CPI is that is does not handle quality changes well. When an item in the fixed basket of goods increases or decreases in quality, the value and desirability of the item changes. For example, cell phones keep getting better every year even though their costs are coming down (the iphone is a perfect example). This contributes to an increased quality of life even though the cost of living hasn't changed.
RELATIONSHIP BETWEEN CPI AND PAYIn its explanation of the CPI, the BLS explicitly states that the CPI is used as a "deflator of other economic series." This is code-speak for "your earning power goes down when the CPI goes up." Even though companies make decisions about acquiring talent using many of the same factors that individuals use when they shop for products (i.e., quality, reliability, availability, performance, style, etc.), the markets for talent and consumer goods are entirely different markets.
While it is true that a person might not be able to purchase as many things in a year when the CPI goes up and their pay remains the same, the REASON their pay did not change has nothing to do with this fact. A person's pay should go up because:
- The knowledge, skills and abilities REQUIRED TO DO THE JOB have increased
- The VALUE TO THE COMPANY of the knowledge, skills and abilities required to do the job have increased
- The knowledge, skills and abilities of THE PERSON IN THE JOB have increased
- The SUPPLY AND DEMAND dynamics for the job have changed
- COMPETITORS have increased what they are willing to pay for the job
- The COMPANY can afford to pay more
- The RESULTS achieve by the person in the job have added value to the company
The cost of living is not, and should not be part of this list. The CPI is an independent variable, like the weather. Just because we experience a hot summer doesn't mean salaries should increase to pay for more air conditioning.
I am not sure why employees assume they can remain the same year after year and earn more money simply because circumstances around them change. And I certainly don't understand why companies would perpetuate this myth by increasing salaries every year. In 2007, the CPI increased 4.1 percent. And guess how much salaries went up? Yep, about the same amount. Employees can scarcely be blamed for inferring a connection when the two amounts are so similar in any given year. Interestingly this year will be a bit different. Due largely to the high price of fuel, the CPI is projected to increase 6.2% while salaries will go up around 4% again.
THE PERFECT PAY PLAN
When it comes to creating the Perfect Pay Plan, forget about tracking the CPI and eliminate automatic annual salary increases that bear a strong resemblance to the CPI. Encourage employees, instead, to increase their knowledge, skills, abilities, and to generate results that are valuable to the company. Pay them more when they accomplish these things. If you do, you will not only be stimulating the right behavior, you will break the cycle of paying more money every year while receiving nothing in return.