When you are evaluating how to spend your money, most people make a fairly simple comparison. If the benefit they believe they will receive from the purchase is greater 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 with this idea. There are many potential purchases you can make that you believe are “worth the money,” so you spend money now instead of saving for the future. In order to change your mindset, you need to start thinking long-term. By building a toolkit that lets you think about a purchase and how it will impact you over time, you can begin making smarter financial decisions.
Opportunity Cost and Depreciation
When you start to plan for purchases instead of shopping with no plan in mind, you no longer just focus on whether or not a purchase is “worth the money.” You start to think about how this purchase will impact you moving forward. To make this process easier, start by applying some economic and financial concepts to your purchases.
The opportunity cost of a purchase focuses on what you are giving up when you buy something. For example, if you purchase a new smartphone for $1,000, the cost to consider isn’t just the $1,000 you spent on the phone but other things you could have done with the $1,000 including purchasing other products, saving the money, or investing the money and gaining interest on it down the road.
When you make an expensive purchase, instead of just thinking about the cash in your pocket, keep in mind that you are making that money unavailable for other wants and needs. If you had that $1,000 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 smartphone, you only needed to pull out $500 for a 2-year old model, leaving the other $500 to continue to grow? Would that be a wiser decision?
Amortization and Depreciation
Amortization means you spread the value of a purchase over the useful life of the item instead of counting it as one sunk cost now and then “free usage” until it breaks or you get rid of it. Thinking this way allows you to spread the cost over a span of time. For example, if you buy a $1,000 phone and plan to use it for 3 years, you could view the cost as $266.67 per year.
Depreciation describes the fact that most items lose value over time. The new smartphone you purchased will start to get slower and less reliable in the coming years. The novelty you got when you first purchased it will wear off the instant a newer model is released. However, that item still has value. Your $1,000 new smartphone may only be worth $600 two years later, but it still has value.
More expensive, higher-quality items tend to depreciate in value slower. This means you are getting more value over a longer lifespan. Consider this when you are comparing higher-quality and lower-quality items. It may be worth the extra money to purchase a more expensive item if it will retain its value for a longer period of time.
When you plan for a purchase, you should consider a balance of the value of the item, the monetary cost, your opportunity cost, and the depreciation rate of the purchase. The more expensive the item is and the longer you think it will last, the more important this balance becomes. You’ve learned to look beyond the simple idea of whether or not you can afford it.
Keeping with our smartphone example, let’s assume you we still trying to decide between the $1,000 newest model and a two-year-old model priced at $600. To make a decision, we need the following information:
- On average, people keep their smartphones between 2 and 3 years. We will keep the phone for 3 years.
- We also need something to compare the purchase against. The S&P 500 stock index has an average long-term return of about 11%. We won’t be too optimistic, so let’s assume we can invest in the S&P 500 Index Fund (SPY ETF) and receive a return of 8% per year.
Step 1: Calculate Realized Purchase Cost
Our “realized” purchase cost will be the sticker value, plus the opportunity cost. In this case, if we buy the new phone, it costs $1,000 flat. If we buy the older phone, it costs $600, but we are investing that extra $400 savings at a rate of 8% for 3 years.
Using our compound interest calculator, we can see that our $400 will grow to $504 – an extra $104. Since this is cash we would not otherwise gained, we can subtract it from the purchase cost.
Now we are comparing a $1,000 new phone with a $496 older phone.
Step 2: Amortize the Cost
Next, we can amortize the cost over the phone’s useful life.
- Our $1,000 phone costs $333.33 per year for 3 years.
- Our $496 phone costs $165.33 per year for 3 years.
We can see that the older phone is still much cheaper per year, but we knew that before. We also knew that we value the $1,000 phone more than the $600 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 use market data to assess the decay rate of our smartphone, we can see that our $1,000 phone will decay to $600 (a $400 decrease), within 3 years, 60% within 2 years, or 30% 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 $1,000 asking price is a 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 it. 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.
|Year 1||Year 2||Year 3||Total|
|New Phone||$333.33||$333.33 – 30% = $233.33||$333.33 – 60% = $133.32||$699.98|
|Old Phone||$165.33||$165.33 – 30% = $115.73||$165.33 – 60% = $65.33||$346.39|
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: $1,000.00 – $699.98 = $300.02
This means we need to factor in $300.02 in lost value over the life of the phone by adding it back in to our purchase price.
$1,000 + $300.02 = $1,300.02 break-even point
For us to consider purchasing the new smartphone, we need to value it at $1,300.02 or more. (Notice we are not even comparing the new and old phones.) 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 $1,300.02 of value out of the new phone, our decision is over. Do not buy it.
Old phone: $496.00 – $346.39 = $149.61
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.
$496 + $149.61 = $645.61 break-even point.
For us to consider purchasing the old smartphone, we need to value it at $645.61 or more. (Again, we are 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 $645.61 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 value each phone. Now we can calculate the difference in these values:
$1300.02 – $645.61 = $654.41
Now we can finally make our decision of which phone we want to buy. Do you think you will get $654.41 more in value from the new phone than from the old phone?
This is only up to you. Nobody can tell you how much you personally value either phone. The purpose of the 4-step process is not to tell you which choice is “best.” It is for you to see the full impact of your decision across time.
Once we factor in opportunity cost, amortization, and depreciation, the choice of phone looks a lot different. A $400 sticker price difference transforms into a $654.41 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 $654.41 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 decision, 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 out on.
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 the item is, it will break, a better alternative will enter the market and you will buy it, or the reason you originally bought the item will eventually disappear from your life. Always consider the maximum useful life of every purchase. This will at least give 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 cell phone example was decaying at about 30% 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 since 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 will help you see the true value and cost of your long-term purchases.
- Using examples from your own life, explain what opportunity cost is.
- Why should depreciation be a consideration when purchasing a product?
- In the text above, what is meant by the real cost?
- Explain what you understand by the term amortization and how would you explain it to someone else using an example?