Saving money is critical to achieving financial independence. As I’ve mentioned before, I’m not particularly fond of extreme frugality. I’ve also mentioned that I prefer to make thoughtful decisions about everything that I’m going to purchase. One of the factors that goes into that decision is how much I feel that a given purchase will improve my life. The other factor is how much it costs. Have you ever wondered how much something costs? Probably not, because it’s usually right there on the label. But there are many, many ways to determine the “true” cost of a purchase. They all have their strengths and weaknesses, but the more aware you become of just how much something is costing you, the more thought you’ll put into every purchase.
1. Sticker price
It all starts here. This is probably the simplest way to think about the price of something, and the way that we are all familiar with. How much does it cost? It says $10 on the price tag, so it costs $10. Okay, $10 plus tax. That was simple.
2. Total yearly cost of a recurring expense
Coffee, purchased from Starbucks, is the most commonly used example of this. I will admit to loving my coffee and to having ran head first into this exact situation. I did the math and immediately switched to making my coffee at home. Here’s how to approach the cost.
Let’s say that you buy a nice mocha for $4.00 every day (Mon-Fri) at your local coffee hole (*). $4 is chump change for most people. So we gladly part with it. The problem isn’t that you’re spending $4 on coffee, everyone deserves to splurge on themselves every now and then. The problem is that you’re spending $4 a day, five days a week on coffee.
$4/day X 5 = $20/week
$20/week X 4 = $80/month
$80/month X 12 = $960/year. Holy crap!
However, this can be applied to other things. Let’s take my internet bill of $60/month. It’s good to be a monopoly.
$60/month x 12 = $720/year.
Holy shit! I was actually spending more money on coffee during my grad school days in a low cost of living city than I am on internet service in a high cost of living city several years later.
Needless to say, I now make all my own coffee at home.
3. Cost to sustain in financial independence
Since this blog is all about financial independence, it’s always good to know how much money you need to have in the bank in order to finance any given recurring expense.
Let’s assume that your portfolio throws off an average of 3% in dividends per year. Multiply the yearly cost by 33 to get an estimate of how much money you need to have in your brokerage account to sustain any given expense for the rest of your life.
Sticking with our coffee and internet examples:
Coffee: $960/year x 33 = $31,680
Internet: $720/year x 33 = $23,760
Wow! Is a daily mocha at Starbucks really worth $31,680? Maybe it is, and maybe it isn’t (my vote is no). The point of this example is to drive home just how hard both you and your investments are going to have to work to pay for any given expense.
4. Opportunity cost (or what that money could have been doing instead)
Back to our coffee example. I refuse to give up my coffee, so I try to make it at home. I go to the store and buy one of those big 2 pound containers of coffee and make my own. I buy some milk as well. So let’s just say that the whole expense runs me $15 per month. $15 x 12 = $180/year for homemade coffee.
Money saved by making my coffee at home: $960 – $180 = $780/year.
What would I do with $780? Put it into my investment account, of course. Compound interest time!
Let’s assume that by reducing our coffee expenses we have freed up $780/year. We’ll also assume that our investments net an 8% per year total return (capital gains plus reinvested dividends). Finally, we’ll assume that we do this for 10 years. That’s $12,203.48 more towards financial independence.
You can easily compute this for yourself by using a compound interest calculator.
5. Total cost of ownership
This is probably best applied to cars, but can be applied to anything else that requires maintenance and upkeep. I spent ~$6,000 for my very used car (with license plate and registration included). But my car expenses haven’t ended there. Insurance runs me about $1,000 a year. Maintenance work, another $1,500 per year. Fuel, probably around $1,300 per year.
So my total cost of ownership isn’t just the $6,000 I spent on the vehicle. It also include almost $4,000 per year in upkeep. Which if we remember the previous example, requires about $132,000 in my portfolio in order to sustain this expense. Given that no car equals no freedom, I consider this an acceptable expense.
6. Cost per use
I drive my car about 6 days out of 7, or 312 days per year. Probably a bit more. Based on the $4,000/year operating cost, my car is costing me an average of $12.82 per use. On the other hand, that $6,000 initial expense is down to about $3.20 per use and will continue to drop as long as I keep the car.
How about another example. I buy a shirt for $25. If I only wear it once, that’s $25 per use. If I wear it 25 times, then it’s only costing me $1 per use.
If you buy a high quality item, use it regularly, and keep it for life, the cost per use drops to near zero. On the other hand, if you buy low quality items that continually break and need to be replaced, your cost per use will remain much higher.
(*) My hunch is that coffee is more expensive these days, but I’m too lazy to go and check.
Readers: How do you think about your purchases? Do you use different methods for different products?