What Is Cost of Living? And How Is It Calculated?

Money
Updated: 1st Oct 2021
Written by Bradon Matthews
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Money
October 1, 2021
Written by Bradon Matthews

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If you’re above the age of 18, chances are you’ve realized living in certain places is expensive. Pretty much everything you do has a price tag on it.

You probably also know that keeping track of your finances is crucial to being financially successful in the long run. For this reason, you may be looking to create a budget.

One of the biggest factors in this pursuit is understanding how much money it costs for you to live the way you do. This is exactly what the term “cost of living” refers to.

What is cost of living? How can you calculate your cost of living? And why is the concept important for your financial health?

This article will explore these questions so you can better manage your fixed and variable expenses.

What Is Cost of Living?

To start, let’s explain what cost of living really means. Cost of living is the amount of money it takes to maintain the lifestyle you currently maintain.

When you think of cost of living, what may come to mind are your necessary expenses. Things like housing, food, and transportation are often the first things factored into cost of living.

While these are big pieces of the overall picture, they aren’t the whole story. Everything you buy factors into your cost of living.

This means that every time you stop for a coffee, every time you hit the town, you’re changing the calculation to some degree.

Your cost of living reflects all the money you spend, regardless of where it goes.

How Does Cost of Living Work?

Cost of living is multifactorial and highly dynamic. It involves nearly every choice you make.

Your cost of living can increase in several ways. Obvious things, like moving into a nicer apartment, can make your cost of living increase dramatically.

Little things can influence your cost of living just as much. If you eat out four nights a week, you’ll raise your cost of living significantly. These little purchases can be even more insidious, as they are easier to ignore.

Taking on debt also impacts your cost of living, so do recurring monthly bills.

All these factors go into determining your cost of living. While it may seem stressful at first calculating your living cost, it is quite easy once you identify where your money goes each month.

How Cost of Living is Calculated

Calculating your cost of living is a rather simple process.

Because cost of living involves pretty much everything it takes to live your current lifestyle, all you really have to do is look at where your money goes in a certain period.

To calculate your own cost of living, just look at how much money you spend in a given month or take a monthly average over the last year or so. That number is your current cost of living.

You may not want to include one-off purchases in these calculations. A financial emergency might skew your cost of living for a month and may not be indicative of what it takes to maintain your lifestyle generally.

More broadly, cost of living is used to compare different geographic locations against one another. Many organizations that measure cost of living do so by comparing the average costs of necessities across cities.

How much it costs the average person in a given place to buy food, insurance, and housing is a good indicator of how expensive it is to live there.

This information can then be used to rank areas against each other, providing insight into what places provide the best value for your dollar.

Common Expenses Considered in Cost of Living

While cost of living can include almost anything, some of the most common expenses included are:

  • Food
  • Housing
  • Clothing
  • Ongoing education
  • Health care and insurance
  • Recreational activities
  • General consumer goods

What Is a Cost-of-Living Adjustment (COLA)?

As stated above, cost of living is often calculated on a geographic basis. Doing this gives entities insight into how expensive it is to live in a certain area.

The government is one organization that uses this information. This occurs through something called a cost-of-living adjustment.

Back in 1973, Congress passed legislation to ensure social security payments matched the cost of living in various areas.

The government isn’t the only organization to use COLAs, though. Many employers do the same.

In these instances, employers use indexes that track the cost of living in various areas to determine employee pay.

This practice aims to ensure that employees living in more expensive cities receive the same net pay, rather than having salary increases eaten up by increased expenses.

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What Is the Cost of Living Index?

The cost-of-living index is a document that compares the cost of living in different cities or states.

Typically, this index includes comparisons of purchases deemed essential, such as housing and food, and general lifestyle purchases like recreational activities.

The index is used by both the government and other organizations to determine how much people should be paid in various regions.

Individuals can also use this index to find cheaper places to live should they want to further their money.

>> More: Compare the Best Budgeting Apps

How to Compare the Cost of Living Between Two Cities

Comparing the cost of living between two cities can be done using the cost-of-living index. As stated above, this should directly show the cost associated with average necessities and lifestyle purchases between locations.

All you need to do is look at the numbers of the two cities to find the difference.

You may also want to look at the average salaries in the two locations. Some places are cheaper to live in, but with COLAs, they may also pay less. In this case, moving there may be a wash.

Why Is Cost of Living Important to Know?

It is important to know cost of living for a few reasons.

Knowing your own cost of living is an essential part of building a sound budget. Analyzing how much it costs to live your current lifestyle will keep you aware of how much you need to make and might show you places you could stand to cut back.

On a broader level, knowing the cost of living in various cities can help you decide where to live. If you make the same salary but live somewhere where everything is cheaper, you can save or pay down debt without making any lifestyle changes.

>> More: What Is the 50/30/20 Budgeting Rule?

Bottom Line: What Is Cost of Living?

Cost of living is just the amount of money it takes to live a given lifestyle in a given place.

On an individual level, understanding your cost of living lets you budget and achieve financial stability.

More generally, cost of living comparisons between cities allows salary adjustments to ensure workers are paid adequately.

If you don’t know your current cost of living, it’s worth figuring out. Doing so can be the first step to becoming financially healthy and increasing your monetary freedom.

Bradon Matthews
Bradon Matthews
Bradon is a philosophy student-turned content writer. He enjoys analyzing market information and trends to help you make sense of the complex and ever-changing world of finance. Through this, he hopes to provide practical advice so you can feel more confident managing your money.