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January 12, 2013, Bedford, NY
By Jonathan Winter
One of the most empowering actions you can engage in financially is knowing how to calculate the breakeven point on a spending choice. This is because the “obvious” choice is rarely obvious. There are a lot of reasons for this: overselling of the benefits by marketers, complicated cash flows, wasted product if bought in quantity, etc. Confusion is everywhere, and with it, a hard time separating savings from wishful thinking . . . Your ability to calculate breakeven is directly related to your ability to really save money. This article will show you how to calculate a back of the envelope (i.e. in the field) break even point. If you want more, subscribe to our free newsletter (in the form below) and we’ll send you an excel spreadsheet for more complicated situations.
Let’s start with two simple examples: in the the first my friend Jeff thinks he’s saving a lot of money but he’s really not; in the second the consumer thinks she’s losing money but she’s really saving a ton!
Jeff the NYC businessman
If you’ve read several of my posts, you may have read about a friend of mine, Jeff, the New York City businessman. Jeff lives in a town close to mine, White Plains, NY. When he’s in the country he’ll usually take the train into the city to work (he subscribes to an automatic monthly train pass to save money). When he’s not, he is usually someplace like India, Vietnam or Manila, doing something in the import/export business, I’m not sure what. Some months he’s here the entire month and others he’s gone three out of four weeks.
Recently I asked Jeff “how many weeks per month he’s in town, on average.” His response was “I don’t know, I guess I’m here three weeks per month, on average.” “Interesting. Do me a favor,” I asked, “will you look at your calendar and see how many weeks you were out of town last year? If I’m right, I’m going to astound you!” “huh? okaaay,” said Jeff.
The next day Jeff called, “it was a busy year, I was actually on the road 22 weeks,” he said. “And how many days do you think you worked from home?” I asked. “About one day a week, when I was here,” said Jeff. “Vacation?” I asked? “Two weeks, what are you getting at Winter???” The conversation continued as follows:
me: “Wait for it… What do you pay for your monthly train pass?”
me: “How much is a ten ride ticket (10 anytime one way trips).”
Jeff: “$105 per 10 one way trips.”
me: “Why are you buying a monthly ticket?”
Jeff: “It’s automatically charged to my credit card every month, and I do it to save money. A month of 10 trips is 40 trips at $105 per 10. That is $420 dollars, a monthly pass is $229 . . .”
Here comes the ah hah
“Have you calculated the break even on your two options?” I said. Jeff replied, “No, I don’t need to-to know I’m saving money. Even if I don’t use a lot of trips, the monthly is so much less money.” Let me help you Jeff. You’re in the country 26 weeks a year. You work from home 26 days a year. You vacation two weeks a year. Your total number of trips to and from the city is 26 weeks less 2 weeks vacation, or 24 weeks X 4 days per week (remember he works from home once a week) X 2 trips per day: 24 weeks X 4 days X 2 trips per day = 192 trips or about 19 ten ride tickets. At $105 each, you’d pay: $1995. Compare that to 12 monthly ride train tickets at $229 each. You are paying $2748. If for whatever reason you could no longer work from home one day a week the math is 24 weeks X 5 days X 2 trips per day or 240 trips or about 24 ten ride tickets. At $105 each, you still pay less, $2520. Your break even on the monthly ticket occurs at just over 26 weeks (26 10 ride tickets = 26 x $105 = $2730).
In this case, because the savings on a monthly pass is soooo significant when compared to 4 ten rides tickets, it appeared that when buying a monthly pass Jeff could not lose, even if he didn’t use it a lot of the time. Clearly he was wrong. He needs to spend 27 weeks a year commuting into the city to break even . . .
How about the other way – Home Insulation 101
There are also times when a purchase v. savings decision looks like “why bother,” the savings looks tiny for the cash outlay.
What if you could cut your utility bill by 9% by insulating your attic at a cost of about $2350??? Hmm. Does not get the blood pumping, “it’s okay I guess. The saving sounds small and the cash out the door not small”. . . Let’s dig.
If the average house utility bill (summer and winter) is about $450 per month (and it is in the United States), then, at 9%, your savings is $40.50 per month. You say “Jonathan, it still does not jump out at me – $2350 out the door and $40.50/month back in???”
How about this, what if I said if you spend $2350 now, you will save $486 per year, for as long as you own your home? This means that you will completely recover your investment in 4.84 years (your break-even point). Your return on your investment is $486/$2350 or 21% per year, and the savings is certain! If you had a stock that paid you a 21 percent dividend a year forever, would you buy it? You are in affect “getting paid” $486 per year on a $2350 investment. You don’t need to turn down the thermostat, you do not need to wear sweaters in the winter, you don’t need to buy a new air conditioner and/or heater. Your comfort is exactly the same, you just pay less for it.
Your ability to calculate break-even is critical to your everyday financial life. There are all sort of breakeven calculations: choosing between two different purchase options (the train ticket example); the return on the money spent-where the benefit ends when you decide to stop using the purchase (the insulation example); on return on the money spent-where the benefit has a finite period of time, (such as a car that will eventually break down). We’ll use the most common break even calculation for this article.
Cost of Purchase / Savings Per Year From that Purchase = recover time (in years)
Using the Insulation example:
$2350/$486 = 4.84 years
This formula can be used for simple spending outlays such as a food vacuum sealer.
Cost of Food Vacuum Sealer Unit/Savings on Spoiled Food Per Year
and even bigger savings items such as refinancing a mortgage
Refinance Costs / Reduction in Payment Per Year*
This calculation ignores the fact that what you spend your money on may change in price over time (i.e. train tickets), breaks down at some point in the future (i.e. the food sealer) or goes away when your life situation changes (attic insulation – you most likely will not sell your house for more if you have insulated the attic, no matter what anyone tells you, unless your utility bill was outrageous before hand) – so keep this in mind.
If you’d like a spreadsheet calculating more advanced break even scenarios, simply subscribe to 101MoneyTalk.com below (don’t worry, it’s fast, free and most importantly, safe). Once subscribed we’ll send the spreadsheet to you right away.
Until next time,
* Be careful that you are comparing the same/very similar number of years. If for example you have 15 years left on your mortgage, and you refinance with a 30 year mortgage, you will very likely end up with a lower payment, but this is not the goal. Your goal is to save money, so compare your current payment with a 15 year mortgage.