Total cost of ownership
Purchases fall into two categories: consumables and non-consumables. Consumables are typically one and done; most food. Non-consumables often fall into tangible assets; a couch, a car, a home. Arguably, you can view your education as either of these; the classes were consumables, the learning was non-consumable. Purchases can be made using time, money, or both.
Most non-consumables are purchased multiple times. I tend to put these into three buckets:
- initial cost,
- maintenance cost, and
- replacement cost.
If we add those together we arrive at total cost of ownership.
We will use two examples throughout this article. One for investing and one for purchasing non-consumables.
When it comes to investments, initial cost is also referred to as cost basis. Cost basis can be viewed at various levels. The portfolio, individual securities, and individual lots (purchases of one or more shares at a time) all have a cost basis; how much did it cost. Maintenance costs for investments include your time reviewing, contributing to, withdrawing from, and rebalancing of the portfolio as a whole; mutual funds also come with the maintenance cost of the expense ration and any other management fees. Replacement costs would be any taxes and fees associated with, say, selling one holding and purchasing a similar holding; changes funds you’re invested in.
When it comes to non-consumables, let’s use a car, the initial cost is how much you paid to acquire the car; this includes tax, title, and other fees. Maintenance costs of a car include any annual taxes, parking lot fees (they would not exist if not for the car), refueling, and so on; anything that is an additional cost associating with keeping the vehicle in good working condition. Replacement costs would include replacing the whole vehicle or its sub-components; if you purchase a new radio for the car, you are replacing the current radio with the new—same for the engine, spark plugs, windshield wiper blades, and so on.
Over time, the total cost of ownership increases in time, money, emotion, or some combination.
Many of us start with the basic math approach. How much will this cost (in time, money, and emotion)? How much return on the investment can I assume?
You see a candy bar for sale at 2 USD. If the purpose is to consume it, is the nutrition and pleasure worth that 2 USD? How much did it cost me (in time, money, and emotion) to earn that 2 USD?
My first job paid by the hour and wasn’t very stressful; however, I didn’t need to supply any of my own tools or equipment to perform the job. I was paid minimum, which, at the time, was around 4 USD. The 2 USD candy bar was roughly 30 minutes of my life, no additional financial cost, and little emotional cost. If I bought the candy bar to consume it, I would classify the candy bar as a use-asset.
The equation changes if the purpose is to sell it at a later date.
When I was in primary school I used to buy candy in bulk and sell it to my classmates. Let’s say each candy bar cost 1 USD and I sold them for 2 USD. Some would say that’s doubling my money and that’s the simple math approach, however, it’s not a true reflection of return on investment. I’d walk to the store where I purchased the candy; over two hours of my life. I should have factored that into the total cost of acquisition; how much is my time worth per hour?
This would all go into the initial cost; also known as, the cost basis or the total cost of acquisition.
Using simple math, return on investment is calculated as initial cost minus sale price. What I’ll call true return on investment would be the sales price minus the total cost of ownership.
If I purchase a house for 100,000 USD. Put 50,000 USD in upgrades and pay 50,000 in taxes, home owner associate fees, and similar maintenance and replacement costs, I would need to sell the house for 200,000 USD to break even; that assumes no other fees associated with selling the house, which would increase the total cost of ownership.
When we talk about replacement costs it’s often focusing on the initial cost of a new version of the same thing. Everything has an estimated useful life. To minimize having an emergency situation, I prepare to replace everything in my world based on its estimated useful life; what I call the second purchase. This may be to replace the whole thing or a part of the thing.
The hot water heater in a house, for example, would have an estimated useful life of 8 to 20 years, depending on the type of hot water heater. Total cost of acquisition would be over 500 USD, which doesn’t include professional installation; let’s say total cost of acquisition was 1,000 USD to keep the math simple. The estimated useful life for the one I purchased was 10 years. I need to save 100 USD per year to have the 1,000 USD to replace the water heater using cash after 10 years. This assumes no inflation in the pricing. With inflation the estimated cost 10 years from now would be around 1,500 USD, which means I’d need to save 150 USD per year to prepare for replacing the hot water heater.
Do the same for the HVAC unit in the home. The plumbing as a whole or each toilet, sink, piping, and so on. How about insulation? The roof?
All that quickly adds up. Looking at total cost of ownership compared to true return on investment is the basis of my acquisition and savings strategies.