Most of us think about expenses the wrong way.
Our instinct is to treat expenses as one-off events. Pay the bill and it’s off your plate.
But that type of short-term thinking can cause you to make a lot of spending mistakes. And that’s what I want to talk about today.
What I’m going to do is propose a long-term way of thinking about your expenses, based on cumulative value.
It’s an approach I use everyday and it should equip you to be much smarter about managing your cash flow.
So if smarter spending is your jam, stick around.
Amortizing Costs Over Time
In a separate lesson, I introduced the concept of your True Cost, which is the price you pay divided by the benefit you receive. If the quotient of that ratio is above one, you’ve paid too much. If it’s below one, you’re getting a good deal.
In particular, we discussed how certain items you purchase can produce consistent cumulative benefit, even as their price stays fixed. The example we used was a mattress. You pay once to buy it, and then every night you use it, you get a bit more benefit out of it.
So each morning you wake up after a good night of sleep, your True Cost on the item decreases. This is because the numerator, the price you paid, doesn’t change, whereas the denominator, the benefit you receive, continues to increase.
That’s why we’re willing to pay a lot for a mattress. Because we know we’re going to use it for a long time and get a lot out of it. So it may cost a lot more than the things we usually buy, but since we expect it to provide so much long-term value, we’re okay with it.
In business, we have a way of accounting for this long-term value. We call it amortization.
When you amortize an expense, you distribute the item’s cost across a certain period of time, which represents the expected useful life of the item.
So sticking with this mattress example, if the mattress cost us $1,000, and we estimate that we’ll use the mattress for a total of 5 years, then we can amortize the expense over that period of time. So instead of saying the mattress costs $1,000, we can say it costs $200 per year over five years (1000/5 = 200).
Two hundred dollars sounds a lot more palatable than $1,000, doesn’t it?
But why stop there? Let’s break it down even further.
Two hundred dollars a year, divided by 12 months, gives us just $16.67 per month.
Now you look me in the eye and tell me that five years of good sleep isn’t worth $16.67 per month.
That’s less than a week’s worth of Starbucks lattes.
Suddenly, this $1,000 mattress sounds downright cheap!
Now are you ready for your mind to be blown?
Let’s say that instead of using the mattress for five years, you end up using it for a full 10 years.
Now, your monthly cost plunges to just $8.33. That’s the cost of a decent beer in New York City. Before tip.
So what’ll it be? A beer or ten years of blissful sleep?
I’ll take the sleep, thank you very much.
That’s why with some of these bigger ticket items like mattresses and laptops, which you use daily, it’s worth shelling out a bit more cash than feels comfortable.
You get so much cumulative value out of them that it’s silly to shortchange yourself.
Let’s say instead you got a $250 mattress. Wow, you just saved $750 bucks. That’s a lot, right?
Well, when we break it down into our monthly expense, we’re looking at the difference between $8 per month and $2 per month. Mathematically speaking, that’s a 4x difference, and that’s big. But in practical terms, the absolute difference is negligible.
Is spending $6 more per month really going to make a difference in your budget? Particularly when it means a glorious night of sleep, rather than a mediocre one?
That’s why amortizing your expenses can be so powerful. It can prevent you from making short-sighted mistakes like sacrificing quality sleep for negligible real-life savings.
Amortizing by Frequency of Use
Now the opposite is also true. Amortizing costs can prevent you from spending more than you should.
Instead of a mattress, let’s look at buying a sports car. The kind that costs a lot and only fits two people and purse.
Let’s say the car costs $80,000 and you plan to use it for five years. Cool, so same deal as the mattress. Let’s divide that by five and then by twelve, right?
Hold on there, cowboy, or cowgirl. This situation is a bit different.
Unlike a mattress, which you use every day, this car is too nice for quotidian tasks. In fact, you only take it out on weekends, and only when the weather’s nice. And winter’s out of the question since you don’t want snow and salt gumming up your powertrain. So of course that rules out December through March.
When you factor in all of these caveats, you aren’t getting value out of this car every day. In fact, you’re only getting value out of it for an average of two days a month, eight months of the year. That’s a grand total of 16 days of use per year.
So how does that change things? let’s do the math.
Eighty-thousand divided by five years is $16,000 per year. And $16,000 / 16 is… wait for it… an eye-popping $1,000 per drive. That means each of the sixteen times per year you take that puppy out for a spin, you’re spending more than you would on a plane ticket that could fly you halfway around the world.
Is a Sunday drive, just a few times a year, really worth $1,000?
For some people, maybe. Personally, I can think of better ways to spend my hard-earned cash.
Now, you may not be big into cars. That’s fine. Swap out this example for any other expensive item you’re debating about purchasing.
The same concept applies.
Take whatever it is you’re purchasing, estimate how long you’re going to use it, and with what frequency, and use that to amortize the cost over the useful life of the item.
My favorite example is a computer monitor, which I use way more than I care to admit. I’m prepared to pay a lot more for that than the average person spends because, when I amortize the cost on an hourly basis, it’s ridiculously cheap.
In other words, I get so much cumulative value out of having a good computer monitor, that I basically ignore the price when I shop for one.
By contrast, when it comes to my car, I bought one of the cheapest ones on the market because I barely drive, and when I do, it’s rarely for long distances. So even though the car’s cheap, since I use it so rarely, it’s still one of the biggest recurring cost centers in my monthly budget.
Always Do the Math
So the key takeaway here is to amortize everything you buy, especially when something feels expensive. Sometimes items that seem expensive, turn out to be pretty reasonable, once you factor in how much you’ll use them.
And sometimes, items you thought seemed reasonable, turn out to be horrendously expensive, once you realize you’ll only use them a few times per month.
Our instincts can be deceiving. Our brains are not good at evaluating big numbers over long periods of time.
That’s why we need to do the math and let the numbers tell the story.
Once we break big numbers down into bite-sized amounts and manageably short timeframes, we can much more easily determine if an item is worth buying.
Corporations have figured this out as well. You can bet that any big-ticket item will have a monthly financing option. A $2,000 65-inch OLED screen feels a lot cheaper when it’s broken down into two years of monthly payments.
But be careful, because they often bake high-interest rates into those monthly payments, so you end up paying a lot more than $2,000 in the end.
And as we saw with the sportscar example, if it’s not something you use every day, monthly payments can conceal a surprisingly high true cost.
Knowing this, if it’s not something you use every day, make sure you break the price down by the number of times you use the item, rather than the duration of time you own it. That way, you can determine the actual cost per use.
You might be surprised by the results.
