Saturday, November 7, 2009

Price, Cost, and Value.

Is it worth it? That's the question we face every time we make a buying decision. The reasonable answer is that if the value exceeds the cost, then it makes sense to pry open the wallet. If it costs more than it's worth to us then it doesn't make sense to buy it.

So what? While price is simple, cost and value are both complicated moving targets. Here's how.

Suppose you want to buy a hamburger. How much does a hamburger cost? A typical fast food chain would set the price somewhere around $4.

Hold it for a second. See what happened there? It's a mistake that gets made all the time. We asked about the cost, but answered the question in terms of the price. Cost is so much more complicated, and confusing the two can get us in trouble.

If you value burgers at $6, and they're for sale for $4 you're up two dollars in value for each one you buy. Each successive burger, however, is worth less to you than the previous one. You can only eat so many burgers in a day.

Now you need to consider the opportunity cost. What else can you do with that $4. If you buy the burger you can't spend that money on anything else later. Money is only worth what you can trade it for.

You also need to count the time and cost that it takes you to get to and from the restaurant, and how much exercise you'll need to do to work off all those calories.

So is the hamburger worth it? That depends on how much you want the burger, relative to everything else you could trade that money for.

Did you just finish thanksgiving dinner, because then you'd probably turn down a free burger. If instead you're starving and stuck on an airplane, a $30 burger could be worth it, even though that's much higher than we normally think a burger should cost.

Cost and value are moving targets. It's ok to pay for value, but don't confuse cost and price. They're not the same.

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