Every second, you make a decision. Whether it be about what to eat for breakfast, buying a house or investing in stocks, a choice is always made. Approaching a problem like a business can simplify a difficult decision. Taking these scenarios into account: what would you choose?
Example 1: The $10 charging cable for phone isn’t working. Do you spend another $10 to buy a new one or do you fix it yourself for $3?
Example 2: Your car engine broke down and it will cost $1500 to fix it, but you spent $1200 fixing the transmission one month ago. At the moment, the car will sell for $1000. Do you buy a new car?
Example 3: You inherited a rocking chair that has belonged to your family for generations. However, it needs a woodworm treatment and restoration for some cracks. The full restoration cost is $250. On the other hand, a new chair of similar quality would cost $150. Do you keep the old chair?
Each example has a variety of decisions to be made. Different people will place a different value on the factors that will influence their decisions. Businesses try to make these decisions in an emotion-free environment.
These 3 concepts will provide you some tools businesses use when making these decisions.
When purchasing or investing in a good or service, a business will evaluate its full cost. This means taking into account not only the initial price of the product, but its operational costs, and long term use of capital and resources.
When businesses are striving for growth, investments are needed. For example, a company that wants faster technology and more advanced software, they might invest in a new computer system.
But how do they decide if it is worth the money? Using total cost of ownership, or TCO. This method analyzes the long term cost while taking into account possible maintenance costs, return on investment, and time saved or used. As such a large investment, computer systems can be a risk for the company.
By considering the initial costs of installation, product, and training software, they also consider the future costs. Are there routine maintenance costs? How much time do you save with faster speeds? How long will it last until it needs to be replaced and in this time, will it provide a return on investment?
By asking these types of questions, businesses make smarter and more profitable decisions.
With transactions, the price of a product not only has monetary means, but expresses the seller’s “ownership” of the product. Dan Ariely, Professor of Psychology and Behavioral Economics at Duke University, explains that price perception can be influenced by the amount of time we have spent with an item. His concept “price of ownership” defines these influences from three different principles:
When we attach these principles to our belongings, our “ownership” for the object strengthens. In other words, the more attached you are, the higher you make the price. Understanding how the “price of ownership” shapes the value of the product makes businesses and individuals more knowledgeable when making decisions.
New products and investments require time and money right from the start. These initial costs and other nonrefundable expenditures are sunk costs. The money and time invested cannot be returned, which can impact your decision on whether or not to continue with a project. This results in the sunk cost effect.
Devoting your time and effort into a project makes you more attached. To justify that your past investments were not a waste, you stay with the project and keep investing, which may not be the right decision. Sunk costs are nonrefundable in both the short term and long term. However, if you continue to invest, there is no freedom to discover new opportunities of investing that money elsewhere (Opportunity cost). If these sunk costs are not giving you what you want, both as an individual and business, then cut ties and move on.
Now let’s apply these concepts to the three scenarios and see how the decisions can become more clear.
“The $10 charging cable for phone isn’t working. Do you spend another $10 to buy a new one or do you fix it yourself?”
From a Total Cost of Ownership viewpoint – The TCO will be whatever you paid for the cable the first time + the cost to replace or fix the cable. Assuming your fix will last as long as a new cable (probably questionable), then you should fix the cable if it cost less than $10 to fix it, including the time value of effort spent to fix it.
From a Price of Ownership viewpoint – The cable may be cheaper to fix than replace, but the owner may have an additional attachment to the product. If fixing the cord means covering it in tape, you might think that it might be functional, but it can look like you don’t have your act together. Perceptions of others can play a large role. For the purposes of this example, let’s assume that the owner wants to have items that look professional and not low quality. In this instance, it may pay to buy a new cable, even if fixing it is less costly.
From a Sunk Cost viewpoint – The price initially paid for the cable is irrelevant. The only comparison is whether the cable is cheaper to fix or buy new.
Decision: Spend $10 on a new cable.
“Your car engine broke down and it will cost $1500 to fix it, but you spent $1200 fixing the transmission one month ago. At the moment, the car will sell for $1000. Do you buy a new car?”
From a Total Cost of Ownership viewpoint – The TCO model would be most relevant when it comes to purchase the car initially. How expensive is the car? What mileage does it get compared to alternatives? How much is insurance? What will be the total cost of maintenance and repairs? How many miles per year will the vehicle be used? How many years will it be in service? What can the vehicle be expected be worth at the end of its life? By adding these costs and establishing the cost per mile of operating the vehicle over its life expectancy, different vehicle models can be compared to determine which is the most affordable option. Note, the lowest cost option will ignore many of the more aesthetic features of a vehicle, like its prestige, or a fancy brand name.
From a Price of Ownership viewpoint – Let’s say that this is your first car or you drove this car on a memorable road trip with your family or friends. In this case, you might think of the car as more than a product. If the car has a strong personal value and is not considered a commodity, then it might make sense to get it repaired, regardless of the value of the car. However, most businesses try to avoid having these attachments. There are instances in which a business may make such a decision. For example, if the Ford company had an original Model T that Henry Ford owned and it needed to be rebuilt, it might make sense so that the company employees and customers could share in the perceived value of his legacy.
From a Sunk Cost viewpoint – From this view we have two problems. First, you paid $1,200 last year to fix a vehicle that appears to be only worth $1,000. You should not have invested that money last year, and should not invest another $1,500. However, if it only costs $200 to fix and it will be worth $1,000, you should get it fixed, because the $1,200 you wasted last year is a sunk cost.
Decision: Sell the old car and invest in a newer car. However, while it is economically smarter to invest in a new car, monetary limitations may require you to pay for repairs, so take into account your personal situation.
“You inherited a rocking chair that has belonged to your family for generations. However, it needs a woodworm treatment and restoration for some cracks. The full restoration cost is $250. On the other hand, a new chair of similar quality would cost $150. Do you keep the old chair?”
From a Total Cost of Ownership viewpoint – The total cost of ownership for the rocking chair will be the price paid initially plus restoration costs and future maintenance. At this point in time, the TCO of the old chair is higher. Taking into account future restoration costs, the old chair will probably need more maintenance than the new one. Clearly, the new chair has the the lowest TCO.
From a Price of Ownership viewpoint – Since the chair has a strong personal value, you may prefer to pay $250 for restorations, even though a new chair is available for $150. The emotional attachment can cause decisions to be economically irrational, but that can be acceptable. In this instance, you could consider this as a discretionary expense. Businesses sometimes take personal attachment or historical respect into account; for example, paying maintenance costs for a statue of the founder that grew the company from a small shop to a multinational corporation.
From a Sunk Cost viewpoint – At this point there are no sunk costs, since the family chair was inherited and didn’t cost any money. Therefore, both options have a sunk cost of zero.
Decision: Keep the chair and pay the restoration cost for $250.
There is always a connection between pricing and personal value. Acknowledging this connection, businesses apply these techniques to make more economical assessments. There is no reason why individuals can’t take advantage of these same principles.
We hope that these tools we presented can help you make smarter, more well-rounded choices in your decision-making process.
Ariely, Dan. (2009). Chapter 8: The High Price of Ownership. Predictably Irrational: The Hidden Forces That Shape Our Decisions.167-182
Arkes, Hal R. & Blumer, Catherine. (1985). The Psychology of Sunk Cost. Organizational Behavior and Human Decision Processes. Vol. 35, Issue 1, 124-140.
Hill, Sonya D. & Drouillard, Jenai. (2012). The Total Cost of Ownership. Encyclopedia of Managament. 7, 1022-1024.
Investopedia. Total Cost of Ownership-TCO. Retrieved from https://www.investopedia.com/terms/t/totalcostofownership.asp