When you are evaluating how to spend your money, most people make a fairly simple comparison – if the benefit you think you will get from the purchase is bigger than the cost, then most people go ahead with the purchase.
When you are working to master your personal finances, you might notice a problem. There are far more potential purchases you can make that you think are “worth the money”, so very little might get set aside for savings. This is when you need to start thinking long-term, and build a toolkit that lets you think about a purchase, and how it will impact you over time.
Opportunity Cost and Depreciation
When you start to plan your purchases across time, you stop thinking about whether or not a potential purchase is “worth the money”, and start to think about how this purchase will impact you moving forward. To make this easy, you can start applying some economic and financial concepts to your purchases.
The “Opportunity Cost” of a purchase is what you are giving up when you buy something. If you purchase a new smartphone for $800, it means that it cost you not just the $800, but also all of the other potential purchases you could have made with that same amount. It also means you cannot save or invest that $800, earning interest or returns on the investment.
When you want to make a bigger purchase, instead of thinking of cash in your pocket, keep in mind you are taking that money from everything else. If that $800 was currently invested in the stock market, would you be willing to pull it out of your investments to buy the smartphone? What if instead of the latest model, you only needed to pull out $500 for a 2-year old model, leaving the other $300 to continue to grow?
Amortization and Depreciation
Amortization means you can spread the value of a purchase over its useful life instead of counting it was one sunk cost, then “free usage” until it breaks or you get rid of it. This means that if you buy an $800 phone and use it for 3 years, you could count it as costing $266.67 per year.
Depreciation is a related idea. This means that the value of every purchase you make will slowly go down over time. The new smartphone you purchased will start to get slower and less reliable. The novelty you get when you first purchase it and show off all the new features will wear off the instant a newer model is released.
Depreciation also works in the opposite direction. If you are comparing an expensive, high-quality good and a cheap, low-quality version that will break faster, it usually will show a better value for the more expensive version, since you are getting more value over a longer lifespan.
When you want to plan for a purchase, you will be playing a balancing act between the value, monetary cost, opportunity cost, and depreciation of the purchase. The more expensive, and the longer you think the purchase will last, the more important this balance becomes (as opposed to just whether you can afford it).
Keeping with our smartphone example, let’s assume you are still trying to decide between the $800 newest model, and a two-year-old model at $500. To make our decision, we need the following information:
- On average, people keep their smartphones between 2 and 3 years. You will keep your phone for 3 years.
- We also need something to compare our purchase against – S&P 500 stock index has an average long-term return of about 11%. We do not want to be too optimistic, so let’s assume we can invest in the SPY ETF and expect to earn 8% per year.
Step 1: Calculate Realized Purchase Cost
Your “Realized” purchase cost will be the sticker value, plus the opportunity cost. In this case, if we buy the new phone, it costs $800 flat. If we buy the older phone, it costs $500, but we are investing that extra $300 savings at a rate of 8% for 2 years.
Using our compound interest calculator, we can see that our $300 will grow to $378 – an extra $78. Since this is cash we would not have otherwise, we can subtract it from the purchase cost.
Now we are comparing an $800 new phone with a $422 old phone.
Step 2: Amortize the Cost
Next, we can amortize the cost over the phone’s useful life.
- Our $800 phone costs $266.67 per year for 3 years.
- Our $422 phone costs $140.67 per year for 3 years.
We can see that it is still much cheaper per year, but we knew that before. We also know that we value the $800 more than the $500 phone, or else we would not need to think about the trade-offs so much. The purpose of amortizing the cost is to give ourselves a yearly number that we can depreciate – what this phone is costing us per year.
Step 3: Depreciate the Value
Next, we need to figure out how quickly the value of our phone will disappear. If we assume how much we value the phones decays at the same rate of the market, we know that an $800 phone will decay to $500 ($300), 37.5% within 2 years, or 18.75% per year.
At this point, we have not yet specified how much we personally value each of the phones in front of us. It could be that the new phone has some amazing new feature that we would be willing to pay $3,000 for, and the $800 asking price is a real steal. Or it could be that our value of the phone is just a little bit more than the asking price. When you depreciate the value of a phone, you are not depreciating the money it costs you to buy – you are depreciating the value you place on owning it.
Unfortunately, right now we do not know how much we value these phones (either by themselves or relative to each other). Instead, what we will assume is that we value the phones at least as much as they cost us. This means we will take our amortized value and depreciate that to give ourselves a minimum amount we must value these phones to even consider buying them.
|$266.67 – 18.75% = $216.67
|$266.67 – 37.5% = $166.66
|$140.67 – 18.75% = $114.29
|$140.67 – 37.5% = $87.92
These totals are less than the price, so now we can find our break-even value for each phone.
The “Break Even” point is when the cost of the phone is equal to how much you value the phone, including how much value it loses over time. Regardless of the alternatives, you would not buy a phone for a higher cost than you value it.
New phone: $800.00 – $650.00 = $150.
This means we need to factor in $150 in lost value over the life of the phone by adding it back in to our purchase price.
$800 + $150 = $950 Break-even point.
For us to consider purchasing the new smartphone, we need to value it at $950 or more (not even comparing with the old phone). This is the minimum value we need to put on this phone for it to be an option. If we cannot say that we would get $950 of value out of the new phone, our decision is over: do not buy it.
Old phone: $422.00 – $342.88 = $79.12
This means we need to factor $79.12 in lost value over the life of the phone by adding this back into our purchase price.
$422.00 + $79.12 = $501.12 Break-even point.
For us to consider purchasing the old smartphone, we need to value it at $501.12 or more (not even comparing with the new phone). This is the minimum value we would put on this phone for it to be an option. If we cannot say that we would get at least $501.12 in value out of the old phone, our decision is over: do not buy it.
Step 4: Make a Decision
What we calculated in Step 3 was our minimum values for how much we might value each phone. Now we can calculate the difference in these values:
$950 – $501.12 = $448.88
Now we can finally make our decision of which phone we want to buy. Do you think you will get $448.88 more in value from the new phone than the old phone?
This is only up to you, nobody can tell you how much you personally value the new phone (or the old one). The purpose of the 4-step process is not to tell you which choice is “best”, but only for you to see the full impact of the decision across time.
Once you factor in opportunity cost, amortization, and depreciation, the choice of phone looks a lot different. A $300 sticker price difference transforms into a $448.88 value difference once we look at how the purchase impacts us across time. This means a smart shopper will go for the older phone, unless they can justify to themselves why the new phone is worth $448.88 more.
If you want to try out this exercise for yourself, you can download a sample spreadsheet here showing the steps above.
Hold On, This Is Way Too Complicated!
Now that you have seen all 4 steps in action, you can understand the value of looking at a purchase over a longer period of time, but actually making all these complicated calculations when you are standing in a store considering two alternatives seems a bit unlikely.
And you are completely right!
It will be very rare when you compare two or more options using this full process. At most, you might sit down for the full calculation once or twice per year. The important thing is not that you calculate the exact realized purchase cost, amortized cost, and depreciated value, but that you remember all three of these factors should weigh into your purchase, not just the sticker value.
Calculate at the Check-Out
The next time you make a purchase for something you expect to keep for a long time, try thinking specifically about how long you expect it to last. Next, remember that the money you are spending is money you are not using for something else, like investing, so add in a bit of extra cost to account for what you are missing.
Now divide that full cost over its useful life, whether it is 6 months or 5 years. Every purchase you make has a useful lifespan, do not fall into the trap of thinking a purchase is good “forever”. Whatever it is, it will break, a better alternative will come out that you purchase instead, or the reason you originally bought it will eventually disappear from your life. Always put a maximum useful life to every purchase. This gives you some idea of how much this purchase will cost per week, month, or year of its life.
Finally, consider how fast the purchase will lose its value. A lot of technology loses its value fast – our phone example was decaying at about 18.75% per year. Better alternatives are always coming out and new apps are released that require newer hardware. Your clothes will also have a fast decay rate, as they go out of fashion, or are damaged through normal use. Other purchases, like kitchenware or furniture, will lose value more slowly.
You do not need to take out your calculator and get exact numbers for each step, but you do need to remember that all of these factors exist! Just keeping that in the back of your mind will make you a much smarter shopper, and help see the true value and cost of your long-term purchases.