Price, Cost and Value
When considering the purchase of anything, that’s usually the first question we ask. Often, it’s the only question.
That’s too bad.
Most of the time, when someone asks, “How much?” they mean, “What is the price?”
That is a useful question, but it doesn't begin to give you enough information to skillfully make a significant purchase.
Let’s say you want to buy a house. After a bit of looking around, you find two you like and are considering. So naturally, you ask, “How much?”
$100,000 for house A and $250,000 for house B.
Does the choice seem obvious to you at this point? It shouldn't, because all you know is the price.
One seller obviously thinks his house is worth two and a half times more than the other guy. Maybe he’s right. Maybe he’s not. We won’t know until each house eventually sells.
If the houses both have the same floor plan, same amenities and were built in the same year, how would you explain the difference in price?
The difference in price could be due to the difference in cost. One house may simply be much more expensive to own, driving down the price an individual in the marketplace is willing to pay for the house.
What if both houses had been for sale for $250,000 two years ago, but one house was located in a flood zone and the government just announced it would no longer offer participation in the flood insurance program for that house. Suddenly the cost of ownership has gone way up, which drives the price the market is willing to pay way, way down. Down, in this case, to $100,000.
But cost of ownership is not the only factor influencing the price.
Value is often a huge consideration. Let’s go back to our two identical houses.
But this time one is located in Monroe, LA and the other in Monterey, CA.
According to Zillow.com, the average 3-bedroom home price in Monroe is $145,000, while the average 3-bedroom home price in Monterey, CA is $836,000. I’ve been to both places and both places are full of lovely people and interesting landscapes. But the price of the home in Monterey is telling us the market values that location nearly 600% more than the same home in Monroe.
Maybe it has something to do with having the Pacific Ocean as your back yard (go figure).
Thinking through the price - cost - value ratio is critical to making wise decisions, not only financially, but in life.
In some cases, the differences appear quickly. A cheap dress has a low cost, but it looks bad and falls apart after a few wearings. Therefore, the cost is high (you must replace it too soon) and it has little value (you don’t look good in it!).
But in other cases, the differences are subtler. You get a job offer to make more money (price). But to take the job, you’ve got to re-locate and you’ll be traveling more (cost). Not only that, but the additional stress and travel that come with the job put strain on your marriage and cause you to be away from your children (value).
And the differences are not always obvious. A student wants to attend college. The state college has a $10,000 annual tuition, vs. the private college with a $75,000 annual tuition (price). If the student attends the state college, that student can live at home, vs. the private college, which would require additional room and board (cost). But 100% of the successful biology graduates of the private college get accepted into a prestigious medical school, which produces doctors making $500,000+ per year (value).
Now, in the above example, if you change the pre-med student with a student earning an art history degree, does that change the outcome of the value equation? I told you it isn’t always crystal clear.
Price, cost and value should all be considered in any significant decision. The difference comes in where you focus.
Foolish people focus on price.
Cautious people focus on cost.
Wise people focus on value.
When the question of “how much?” comes up, where is your focus?
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