Price vs. Cost: The Difference Is HUGE
What if I told you that the $100 pair of jeans you want to buy doesn’t actually cost $100. They cost $1,238.48
Looking to drop $500 on a new television? Too bad it will cost you $6,192.40
Do you like Starbucks? I love Venti Caramel Macchiatos, for which I pay about $5.50. Drinking one per week for an entire year would cost $3,411.71
- $100 Jeans = $1,238.48
- $500 Television = $6,192.40
- Weekly $5.50 Venti Caramel Macchiatos = $3,411.71
What lies behind this quirky math is a truth that we all “know”, but it’s only understood once someone points it out to you – perhaps in a blog post or youtube video. Wealthy individuals understand this concept, and use it to guide their purchasing decisions. I think it’s time everyone else joins the club.
There is a difference between Price and Cost
What most of us understand as “cost” isn’t actually cost at all. It’s “price”. Ever heard of a cost tag? I haven’t. Price tag? That’s more like it.
“Price” is the amount of money that leaves your wallet or purse (or iPhone, if you’re a techie – I’m not) when you pick up those new shoes at Nordstrom Rack. “Cost” is a more nefarious term. Cost represents what is forever lost after the price is paid; you can never get it back
In finance and economics, probably in an effort to sound more intellectual, we lengthen the term “cost” to opportunity cost. It is defined as a loss of potential gain from other alternatives when one alternative is chosen.
In plain English, it means that if you spend $500 on a new TV, you can’t buy $500 worth of something else, say, stocks or bonds. And because stocks or bonds will probably pay you dividends and interest, then you also don’t get to enjoy the passive income that would accrue over time.
But that’s not all…
The prices you pay are in after-tax dollars.
How much money do you have to earn in order to buy a $500 TV?
If you said, “$500,” you’re wrong. Those five Benjamins are what you got in your last paycheck after taxes were taken out.
To buy a $500 TV, you’ll need to earn $769.23 in pre-tax income (assuming a 35% tax rate). I can do some fancy math and determine that for every $1 you spend, you first need to earn $1.54. Suddenly things are looking more expensive, no?
How does this affect cost?
What is an alternative spending scenario for our money? What is a plausible opportunity that we are missing out on by spending our after-tax dollars frivolously?
There is an investment account you can open called an Individual Retirement Account, also known as an IRA. (You pronounce it by saying each letter, I – R – A, or saying it phonetically, EYE-ruh)
The cool part about this investment account is that the money you deposit isn’t taxed. If you earn $769 and put it into your IRA, Uncle Sam won’t make you pay income tax on that $769 – at least not yet. In other words, by contributing to your IRA, you immediately save money because those contributions skip taxation.
Another powerful feature is that anything you earn in your IRA is also free from taxation!
Say you buy Apple stock at $10 in your IRA, and ten years later you sell it for $150. Guess what, you don’t have to pay taxes on that gain! In a “regular” account you’d have to pay around $25 in taxes, cutting your profit down from $140 to $115. Wouldn’t you rather keep that $25?
Avoiding these large tax expenses really speeds up compounding!
Because your contributions and your earnings are not taxed in IRAs (and in 401(k)s), these types of accounts are called tax-deferred accounts. You don’t pay any taxes until you take money out of the account, at which point it is taxed like any other source of income.
Why a $500 TV costs $6,192.40
Stick with my train of thought here:
- The price of a TV is $500 in after-tax dollars
- But you had to earn $769.23 before taxes to buy it
- What if instead you deposited that $769.23 into an IRA
- What if you purchased an S&P 500 Index Fund and let it compound over thirty years?
- I assume that you earn, on average, about 8% per year
- At the end of 30 years, your $769.23 will have grown to $7,740.50
Alas, you need to pay taxes on that money when you take it out of your IRA. The hope is that when you pull money out of your IRA, you’ll be at a lower tax bracket than when you put it in. Assuming a 20% tax rate, you’d be able to take home $6,192.40
I could make the scenario more dramatic by extending the investment time to 40 years and assume a 10% rate of return ($769 would grow to $27,851.85). I could honestly get whatever number I wanted at the end of my equation, but the above example is highly plausible and reasonable.
This many not seem like a big deal. You may not want to wait 30 years, or you think $6,192.40 isn’t that much money. If this is the case, know that wealthy individuals understand this concept and use it to their advantage when making purchasing decisions. And what works for them might just work for you too.
What you pay for an item is the price. But the price doesn’t reflect the economic value lost to you over the course of your life by making that purchase. That is the cost!
EVERYTHING YOU BUY HAS A COST. Do you know what that cost is? Start thinking about it.
Do you have a question, or would like me to cover a particular topic, feel free to leave a comment below!