Have you ever been on the verge of deciding between a couple of alternatives and felt you lack a relevant, comparative benchmark? Maybe if you could use one final metric to compare Alternative A to Alternative B, it would make the decision easier? The good news is one such benchmark exists, and the better news is it’s nearly universally applicable—it’s the cost per unit.
What is it?
In the context of this article, cost per unit is a simple way to calculate the monetary cost per unit of consumption. It represents how much we must give up to receive a given quantity or return.
Why is it useful?
This concept is useful because it can reveal hidden insights to enable clearer and more informed decision making. Typically it’s an easy calculation, although you can make it as complex as you wish to achieve the desired level of clarity.
How do I calculate it?
There are many applications for this type of calculation, and I’ll cover a few different ones below. My aim is to make these examples more applicable and less theoretical so it helps everyone understand how these might function in real world circumstances.
Vehicle Purchases – This is a prime example of where using the cost per unit is beneficial. Not only that, but vehicles are some of the costliest purchases you’ll make in a lifetime. The stakes are high, so making an informed, logical, and cost-effective decision is critical to your overall financial success. We’ll assume you have already whittled your decision down to two vehicles for simplicity.
- Vehicle A is the one you really want. It has all the fancy features, it’s the right color, and it has a clean title history. You’ve waited months for one to become available and because it’s in high-demand, the price is a little more than you’re comfortable paying. But you’re tempted to pay it anyway because it’s the vehicle you’ve always dreamed of driving. The price tag is $30,000, and the vehicle has 70,000 miles on the odometer.
- Vehicle B is the same make and model as Vehicle A but is a lower trim level. Because of that, it has fewer features; it also isn’t the ideal color. The title history is clean, and it’s in the price range you’re comfortable paying. While it’s not the exact vehicle you’ve always dreamed about, it has a price tag of $25,000 and only 30,000 miles on the odometer.
Now let’s talk about how to calculate the cost per unit. Because both vehicles are the same make and model, it’s reasonable to expect them to have the same lifespan (short of one being a lemon, but that’s another story for another article). Let’s assume, based on your research, this vehicle has an average lifespan of 200,000 miles if properly maintained. That means Vehicle A has about 130,000 miles left in its lifespan, and Vehicle B has about 170,000 miles left it its lifespan. Therefore, Vehicle A’s cost per unit (in this case, cost per mile), is about $0.231/mile ($30,000 / 130,000 remaining miles = $0.231/mile) while Vehicle B’s cost per unit is $0.147/mile ($25,000 / 170,000 remaining miles = $0.147/mile) for a cost premium of $0.084/mile to drive Vehicle A.
Those two benchmarks assume you pay cash for the vehicle and ignore the impact of other dealer costs—if you finance the vehicle, those costs would be even further apart! Using a 72-month loan (average car loan term in 2020 is 69 months) at 4.49% (average APR on a 72-month car loan in 2020), assuming $2,000 of other dealer/loan fees, Vehicle A’s cost per mile would be $0.282/mile and Vehicle B at $0.181/mile for a cost premium of $0.101/mile to drive Vehicle B.
What does this exercise tell us? Using our two data points, assuming we will finance the vehicle with a 72-month car loan at 4.49%, it costs $0.101/mile EXTRA to drive Vehicle A as compared to Vehicle B. Through the lenses of financial responsibility and frugality, this benchmark tells us to pursue Vehicle B. It will save $0.101/mile or $5,713 over the life of the vehicle, including interest and fees. What a savings!
Grocery Purchases – Here’s another good example of where the cost per unit analysis is useful. Visualize the last time you visited the grocery store. For example, think about the cereal aisle—how many alternatives are there for this type of food? 50? 100? 200? There’s fruity cereal, hearty cereal, sugar-filled, sugar-free, granola, oatmeal, bran, brand name, store brand, and the list goes on and on. To simplify this example, pretend you are shopping for oatmeal. Your household eats one container of steel cut oats per month. Further, let’s assume you’re deciding between the brand name and the store brand.
- The brand name steel cut oats come in a 30-ounce container priced at $10.99.
- The store brand steel cut oats come in a 30-ounce container priced at $7.99.
The cost per unit for the brand name steel cut oats is $0.366/ounce ($10.99 / 30 ounces = $0.366/ounce) while the store brand is $0.266/ounce ($7.99 / 30 ounces = $0.266/ounce) for a cost premium of $0.100/ounce to eat the brand name versus the store brand steel cut oats. Seems insignificant, right? Yes, for a single purchase $0.100/ounce seems like an insignificant premium to pay. But the question is: does the $0.100/ounce premium to enjoy brand name steel cut oats give you $0.100/ounce of incremental satisfaction or nutrition? My guess is no, but it’s up to you to decide how much incremental value you’re deriving from paying the price premium for brand name.
Not sold yet? Try this—imagine if we applied this simple framework to ALL purchases. If we train ourselves to be satisfied with a cheaper home that still meets our basic needs or a cheaper vehicle that gets us from Point A to Point B safely, store brand groceries instead of brand name, store brand clothes instead of brand name, etc., we could realize savings totaling tens of thousands, possibly hundreds of thousands of dollars, across a lifetime. As a frame of reference, in a lifetime the average person buys three houses and nine vehicles. On those twelve transactions alone, you could easily save $100,000 or more by going with the “good enough” option rather than the “ideal” option. And all this can happen by using the simple benchmark of cost per unit to help us better understand the costs of various alternatives!