Let’s talk about a common mistake most of us make when we buy stuff.
We search for the item we want, then we look at the price. If that’s below an arbitrary threshold we like to call “too expensive”, we buy it.
The problem here is that we’re not being strategic about what we classify as “too expensive”.
Most of the time, “too expensive” just means “more than I feel like spending right now”.
And that mentality is easily influenced by completely irrelevant things like, “I just got a bonus, so why not treat myself” or “Well, the stock market’s down this week, so I should probably hold off on this”.
Neither of these circumstances should have any bearing on our decision to make a purchase.
So now you’re probably wondering, how should I decide to buy something?
I’m going to introduce a concept I call “your True Cost”. And I do mean “Your” true cost, not “the” true cost, because there is no single “true” cost. Everyone’s true cost is specific to their own situation.
But fortunately, the way we calculate our true cost is the same for all of us.
And by learning how to calculate it, we can make much smarter purchasing decisions.
So if you want to learn how to make better spending choices, stick around.
What is Your True Cost
Okay, so let’s start with the problem.
The biggest mistake we make when we buy things is that we fail to account for our True Cost of the item.
What do I mean by “True Cost”?
your True Cost is the ratio of how much you paid for something and how much benefit you get out of it.
Think of it as Price divided by Benefit. The quotient is your True Cost.
And since price is the numerator, a higher price means a higher True Cost. And since benefit is the denominator, a higher benefit means a lower True Cost.
The lower your True Cost is, the better deal you’re getting. By contrast, as your True Cost rises, you’re going to get less bang for your buck, meaning you’ll want to reconsider your purchase..
Ultimately, you want your True Cost to be lower than 1. Anything above 1 implies that the amount you’re paying exceeds the benefit you’re getting. And that’s bad, mmmk?
Example 1: Restaurants
To make sure we’ve got this concept down, let’s take a look at a real-world example.
We’ll go with something universally relevant, like food.
We all need food to survive. Without it, things get ugly fast. No one likes hangry.
So the value we get out of food is really high.
But not all food is made equal.
A simple meal of rice and beans costs less than a dollar. And you can live off rice and beans for… pretty much ever. I can personally attest to that.
So your True Cost of rice and beans is super low. You pay very little and get… life, which is a pretty good deal.
Contrast that with a dinner at a 3-star Michelin restaurant. The kind where you can’t get a reservation unless you know someone who knows someone.
A meal like that could easily run you $500 to $1,000 bucks. Per person.
Yet the benefit you get is basically the same as the rice and beans.
Sure, there’s the rush of spending a ton of money, and you get to taste flavors and ingredients that you didn’t even know existed, but after the thrill of all that fades, you’re ultimately left with the same reward: a full belly.
So your True Cost of that fancy meal is very high. You got virtually the same benefit at a much higher price.
And in this case, your True Cost gets higher and higher each time you have that meal, because each time, the novelty of it begins to fade.
Economists call that diminishing returns. The more it scales, the less you get out of it.
I call it bad value.
Example 2: Mattresses
Let’s now look at a different example.
And we’ll stick with the theme of “universally applicable”. Let’s go with sleep.
We all need to sleep. Most of us don’t get enough of it.
One way to get better sleep is to use a mattress.
But holy smokes: mattresses are expensive.
Fortunately, there are some really cheap options on the market. Particularly when you go second-hand.
And since any old mattress will do the trick, let’s just grab that $20 air mattress and call it a day, right? Isn’t this the same thing as the rice and beans?
Well, not necessarily.
When it comes to mattresses, quality matters. A bad mattress means bad sleep.
So a cheap mattress might score well on price, but it also scores poorly on benefit. In other words, in this mattress scenario, even though your numerator is low, your denominator is also low, which means the quotient, your True Cost, is still high.
In this case, you’re better off increasing the price a bit, because by going up a bit in price, your quality of sleep increases by an even greater amount. So, your benefit increases much more than your price.
This increase in benefit drives your True Cost down, which is what you want.
In fact, this situation is essentially the opposite of the Michelin Star restaurant example we discussed earlier.
The more you use the mattress, the more nights of great sleep you get, which means your benefit continues to grow, while the price you paid stays fixed.
So your numerator doesn’t change, while the denominator keeps getting bigger. That means every night you use the mattress, your True Cost gets lower!
In economics, we call that Economies of Scale.
I call that awesome value.
In situations like this, where you get a lot of cumulative value out of a fixed price, you want to make sure you factor that accumulated value into your purchase.
When we do that, we discover that the denominator is much bigger than we realize. And as a result, the True Cost is way lower than we first thought.
This is especially the case with big-ticket purchase like a car or a house.
Since we plan to use those assets for a long time, and get a ton of cumulative value out of them, our denominator is massive, and thus we can rationalize spending a lot more on those items.
Identifying the Middle Ground
Now, in both the food and the mattress example, there’s obviously a middle ground.
You’ll eventually get sick of eating rice and beans. So maybe you spend a few cents more and upgrade to quinoa, or switch out your protein for tofu or chicken. In those cases, your price doesn’t change much, but your taste buds are way happier, so the benefit increases more than the price.
Likewise, with a mattress, there’s definitely a sweet spot where you have just the right balance of price and benefit. At a certain point, spending more money on the mattress doesn’t really provide much more in the way of benefit.
In economics, this spectrum of cost vs benefit is called your “Utility Curve”. Your benefit is the utility and the curve is the line that plots the various possible price/benefit combinations.
The curve is often not linear, meaning it’s not a straight line.
If Price is on the horizontal X axis, and Benefit is on the vertical Y axis, at the lower extreme, the curve is quite steep. That means for every one unit of increase in price, you get a much bigger increase in value. This would be like upgrading from an air mattress to a basic foam mattress. Not a huge price difference but a huge increase in the quality of sleep.
On the other extreme, the curve is quite flat. That means for one unit increase in price, you get a much lower increase in value. This would be the equivalent of upgrading from a value brand to a designer brand, where they basically have the same product, but the brand-name charges more because the fanciness of the brand name demands a higher price. You pay more, but you don’t get much more benefit.
With every purchase, your goal is to find the sweet-spot on this curve, where every one unit increase in price equals one unit increase in benefit. That’s generally somewhere in the middle.
We call that area the best “bang for your buck”.
How Do We Calculate Benefit?
Now the philosophers among you are probably squirming in your seats. Because we haven’t really discussed a critical part of this equation.
The price is objective. There’s no questioning it. The value has already been assigned.
But how on earth do we calculate the “Benefit” part of the equation?
Unfortunately, there’s no easy answer. Calculating benefit is more of an art than a science.
It’s highly specific to each of us, and in a nutshell, it comes down to knowing ourselves. The better we understand our needs, the more accurately we can assign a value to the benefit.
But don’t worry, I won’t leave you in the lurch.
Since knowing what we need is another gnarly topic of its own, we’ll save that conversation for another video.
So that’s my advice for making smart purchases.
Calculate Your True Value by dividing the price of the item by the benefit you receive from it, and if the number is less than one, you’re pretty much in the clear.
Of course, you can always price shop to drive your True Cost down to as close to zero as possible, but at a certain point, you’ll end up wasting more time looking for better deals than you would just going with the solid option in front of you.
So be smart. Your time is a cost as well. If you get your True Cost below one, pull the trigger and get on with your day.
As with everything in life, it comes down to striking the right balance. Figure out that balance, and you’ll go far, my friend.