Cost of living indexes are meant to compare the expenses an average person can expect to incur to acquire food, shelter, transportation, energy, clothing, education, healthcare, childcare, and entertainment in different regions. A cost of living index is also used to track how much the costs of basic expenses rise over a period.

Although there is no official cost of living index created or reported by the U.S. government, there are a few offered by organizations that track the costs of living in different regions.

What Goes Into a Cost of Living Index

The costs of consumer goods and services vary between different urban and suburban residential areas. A person's salary might provide a high standard of living in a small city in the Midwest since rent and utilities would likely be cheaper than a large city like New York, LA, or Boston.

Another way to interpret what a cost of living index represents is to ask the question: "How many goods and services does a given sum of money purchase in a certain location?" For example, $100 tends to purchase more goods and services in Denver than it does in New York City.

The cost of living can impact a person's choice in work, and needed salary as well as where to live. The costs of living also directly impact a person's ability to save for a home, pay off college debt, whether to have a child, or when to retire.

Need-based expenses such as housing, clothing, healthcare, food, and electricity can increase over time and comprise of a greater share of a person's monthly income. A cost of living index can be used to track the changes in basic expenses so that a person can see how much costs are increasing. Also, the index can demonstrate how much need-based expenses vary from one city or town to another.

A cost of living index can help a person determine whether the income or salary being earned is enough to cover basic expenses. From there, a person can assess whether there's enough extra income left over to save for retirement or pay off debt.

How a Cost of Living Index Works

Although there are various types of cost of living indexes that use different variables and metrics, most set a base cost of living, often represented by 100. The base can either be the cost of living in one region—for instance, Chicago could be pegged as the base city and its cost of living set at 100—or it can be an average of multiple regions. Other regions are measured against the base region and assigned a cost of living number accordingly. If on average, it is 20% more expensive to live in Boston than in the base city, Boston's cost of living number would be 120.

It's important to consider the average income for a geographic area as well. For example, a town in the south might have a lower cost of living than most towns on the east or west coasts. However, the southern town's median income might be below the cost of living for that area.

Key Takeaways

  • Cost of living indexes are meant to compare the expenses from one town or geographic region to another.
  • Cost of living indexes include expenses such as food, shelter, transportation, energy, clothing, healthcare, and childcare.
  • A cost of living index is also used to track how much the costs of basic expenses rise over a period.

Examples of Cost of Living Indexes

As stated earlier, companies and organizations use different metrics or variables to determine the cost of living for a city or area. Below are three examples.

Economic Policy Institute

The Economic Policy Institute provides families with updated cost of living data for various cities and locations throughout the U.S. The institute also has a Family Budget Calculator for those considering a specific region of the country. The calculator helps families measure the differences in the cost of living for various geographic locations. Also, various expenses are factored into the calculation, such as food, housing, child care, transportation, and health care.

For example, the calculator found that San Francisco was the most expensive city to live in for parents with two children. The cost of living was estimated at slightly more than $148,000 per year, while the median income for San Francisco was approximately $108,000 per year. Although a salary of $108,000 is attractive, it doesn't cover the cost of living in the city.

ACCRA COLA

The ACCRA Cost of Living Index or ACCRA COLI is designed to compare the living expenses for various regions of the country. The index measures consumer spending on various items, including housing, utilities, groceries, health care, and transportation.

The quarterly publication is compiled and produced by the Council for Community and Economic Research. In Q1 2019, the report showed that Manhattan, New York had the highest cost of living, followed by San Francisco while Harlingen, TX had the lowest.

Social Security Administration's COLA

Cost of living adjustments or COLAs are made each year for retirees receiving Social Security benefits. The adjustment is based on the rate of inflation, which represents the pace of rising prices in the economy.

If a retiree is paid 20,000 per year, for example, and inflation rises by 3% per year, the income has less purchasing power due to rising prices. A 2% or 3% inflation rate might not appear to be a significant increase in costs, but over five-to-ten years, the percentages can add up to a substantial reduction in income in real terms, or factoring in inflation.

As a result, the cost of living adjustment or COLA is designed to increase the benefits paid by each year to keep pace with inflation as measured by the Consumer Price Index (CPI). The CPI is merely the average price of a basket of basic goods and services that are selected to measure rising prices in an economy. CPI includes prices for housing, apparel, transportation, education, food, and beverages. Although CPI is an imperfect measure since it doesn't include investments or big-ticket purchases such as real estate, it does provide a snapshot of inflationary trends for day-to-day purchases.

Below is a table from the Social Security Administration detailing the cost of living adjustments each year since 1975.

  • In most years, there was an upward adjustment in income with the two biggest increases in recent years being 2.8% in 2018 and 3.6% in 2011.
  • In some years, the inflation rate was negligible and resulted in no increase in benefits such as 2009, 2010, and 2015.
Social Security COLA adjustments
Social Security COLA adjustments. Investopedia 

Limitations of Using CPI as a Cost of Living Index

There are limitations of using CPI as a cost of living index since it's not intended to measure the actual costs of living in any given area or region. 

A typical cost of living indicator would measure changes in costs over time that are required to maintain a specific standard of living. Also, a cost of living indicator would factor in changes in consumer buying that stem from economic conditions, adjustments in spending, and habits that people make, such as using alternative products when a product becomes prohibitively expensive.

The process of shifting expenditures is commonly referred to as substitution. Substitution means that the cost of maintaining a certain standard of living is probably somewhat less than the pure calculation of increased prices since consumers can mitigate price increases by utilizing a less expensive substitute.