I talked a lot about budgeting, saving and investing money in the earlier posts.
However a fact of life is no matter how hard you try, there will be big purchases.
Some of them will be needs, while others may be simply wants.
These purchases are typically big ticket ones and can range from a thousand dollars to several hundred thousand dollars. For example, it can be an Apple iPhone/iPad to buying real estate for a primary home.
How do you decide when the purchase makes financial sense? After all, money will be spent and an opportunity to invest will be lost forever.
The P.V.T equation explained below helped me make the decision many times.
Although I have made bad decisions and recovered, but on hindsight sticking to a principle would have helped to be sensible 90% of the time.
What is the P.VT. equation?
The acronym stands for three important elements of a purchase decision.
To assign a score value to a purchase, it will have to be a combination of the relative success with above three parameters.
The main thing to guard against a purchase is whether it is a waste or not. So if we measure the waste factor, and try to keep it as low as possible, it is a sensible purchase.
The formula is as follows:
WF(Purchase) = WF(Price) x WF(Value) x WF(Time)
Where WF is the waste factor, in terms of how much of that parameter we are giving up during the purchase. Since it is a multiplication, a WF of zero will be approximated to 0.01 (1%).
Lets take 3 examples, an iPad, a car and a house.
Price ~ $1000 and lets say it being Apple, we cannot manage a discount.
So WF(Purchase) = 1.0 [we consider the full price as 100% waste factor]
Value – How much value will it add to your daily life? Are you going to use it for work, or just recreation? It will also depend on whether you have other laptops or similar tablets at home. Lets say you are going to use it for personal work (like reading, keeping tab of investments etc.). So you will use it 40% of your screen time.
Thus WF(Value) = 60% or 0.6
Time – How many years are you going to use it compared to the typical life of an iPad? Given that it is a technology product, the maximum life it can be used without needing replacement or becoming obsolete is probably 5 years. But you may be upgrading anyways after 3 years.
So WF(Time) = 2/5 or 0.4
Finally, WF(iPad) = 1.0 x 0.6 x 0.4 = 0.24
So 24% of the price is wasted. If you could have bought the iPad at 25% discount, then the purchase value will increase.
WF(discounted IPad) = (1.0 – 0.25) x 0.6 x 0.4 = 0.18, so now the purchase makes a little more sense.
Typically it is a good practice to buy used cars at a discount. So lets say you buy at 40% discount, usually a 2-3 year old car.
Let us also say that this is your primary car and you don’t fancy owning 2-3 cars, so you will use it 90% of your commute time. And lets say you are going to upgrade after 5 years, even though a car can be kept for 10+ years.
WF(Price) = 0.6, WF(Value) = 0.1 (high value to you), WF(Time)=0.5
WF(Car) = 0.6 * 0.1 * 0.5 = 0.03
See this is much better usage than the iPad with a WF of 0.24. Now if you hold the car for 9 years, then 9/10 will give a better score.
WF(Car) = 0.6 * 0.1 * 0.1 = 0.006
This is the biggest purchase in most people’s lives and possibly can be better quantified as well.
We will make the following assumptions:
- Price – You will buy the house at 20% discount to the retail/asking price.
- Value – If this is your primary residence, the value may be very close to 100%, or the WF will be 1% (to avoid zero).
- Time – A house can be held for 20-30 years, but lets say you plan to upgrade after 10 years or so. So WF(Time) = 20/30 = 0.66
WF(House) = 0.8 * 0.01 * 0.66 = 0.005
So the house purchase makes even more sense than the car. Even though the house is used only 1/3 of its whole lifetime and the car is used 9/10 years, the house purchase makes more sense. It also had a lesser relative discount than that of the car.
The above P.V.T equation also reveals another hidden aspect. You can adjust one parameter vs. another. For example, if you are going to use the house or car for longer, you can afford to buy at a less discount. Your WF(Price) will increase but will be offset by the other two.
You can even use this formula when you are trying to compare paying a higher price for a high quality product or buying cheap for a not-so-durable product.
High Quality: WF(Price) = 0.8 or higher, WF(Value) = 0.6, WF(Time) = 0.1 (it will last long) , WF (Purchase) = 0.048
Low Quality: WF(Price) = 0.5 (less price), WF(Value) = 0.6, WF(Time) = 0.5 (last 1/2 as long), WF (Purchase) = 0.15
As you see, it makes sense to buy the high quality product if the value is same for both. At least in this case, however there are situations where if you can get a significant discount and know that the item will last longer, the lower quality product (non-branded) may outperform a branded one.
Thus making purchases with such logic will keep your home clutter-free as below. You just have to choose a suitable threshold of the WF. For example, anything below 0.05 (5%) may be a good thumb rule to make the purchase.
Disclaimer: There will be many other factors in a purchase decision. The above formula acts as only a quick thumb rule and should not be the only criterion for decision making.