Hey guys, it’s Finance Fridays and I’m going to talk to you about the Value Cost Ratio (VCR).
I alluded to this concept a little bit in my prior post Trimming the Fat.
Stock Photo from: Pexels
What is a Value Cost Ratio (VCR)?
Well.. it’s not this:
Stock Photo from: Pixabay
For those who don’t know, that’s a Videocassette recorder (VCR). I’m showing my age here because for some of you, VCRs were before your time….
Ok let’s refocus now:
Value Cost Ratio is mostly just a mental exercise when evaluating what an item or experience is “worth” to you.
In my prior post, I used Starbucks as an example, so I will expand on that here.
A Venti Pike from Starbucks is my drink of choice. I actually drank one yesterday despite saying I was giving it up in my prior post Trimming the Fat. This was because I was running a little late for work and didn’t have time to make my coffee at home. Interestingly, the caffeine content from that one Venti Pike kept me up for my whole 10 hour shift… and then I had trouble sleeping that night. I guess in this short time period, my caffeine tolerance has either declined significantly or I drank too much of the coffee too late in my shift. Either way, mistakes were made.
Note, there is something called the Benefit Cost Ratio (BCR),which is used in assessing a project.
Ok back to the Value Cost Ratio.
So in this particular instance, let’s give my Venti Pike an arbitrary value of “3” and the cost of $3 (to round up). So for me, the Value Cost Ratio is 3/$3. This ratio doesn’t mean anything by itself. Now let’s consider the alternative Value Cost Ratio of bringing coffee from home.
Is it as good as my Venti Pike from Starbucks?
Probably not. So let’s say it’s a 2 on the arbitrary value scale, whereas the Venti Pike is 3.
Does it cost less than the Venti Pike?
Definitely. How much less? I’m not sure, but I think it’s reasonable to consider it <$1 a cup.
So what is the Value Cost Ratio of Coffee from home?
Well, it’s 2/$1. Like I said, this is an arbitrary value and only matters when compared to something else.
So 3/$3 (Starbucks Venti Pike) versus 2/$1 (Home Coffee)
I think you can tell that the Home Coffee wins out in terms of efficiency for me.
What do you mean “for me“?
Like I said before, this concept is relative. It’s relative as a comparison to other things and also relative to the person.
For example, I also discussed that my wife drinks Starbucks everyday. We’ve tried multiple types of coffees from home and none of them work for her.
We’ll use the same arbitrary value of 3 for Starbucks and $3 for the cost.
However, for her, Home Coffee would receive an arbitrary value of 0.1 or maybe even 0, because it basically just doesn’t work for her.
So her Value Cost Ratio for Home Coffee is 0.1/$1 or 0/$1.
If you flip the concept on its head, then Starbucks provides infinite value to her because nothing can reproduce it.
C’mon Sensei, nothing works -at all-?
Well, like I said. Everything is relative.
If the value of Home Coffee to her was at least 1, then her Value Cost Ratio would be 1/$1 and Venti Pike would be 3/$3 so they would be essentially the same. However, for her, the relative value of Home Coffee is not 1, it’s barely above zero… in fact it may even be zero.
Wait, couldn’t you “fix” this?
Potentially. It is feasible that she has developed a tolerance for caffeine and if we tapered her caffeine intake then Home Coffee might increase in relative value. However, I don’t think it’s worth it. The margin was already pretty small (for me), so it is unlikely to be beneficial for my wife.
Additionally, she is pretty frugal like me and I think it’s ok to allow this tiny indulgence. For her, it’s Starbucks and ice cream.
Yes. My wife is an ice cream lover. Remember I said that value is relative. However, for certain things, the relative value could be infinite.
For example, if you consider an Oreo Cookie to have a relative value of 1, then to my wife, ice cream would have a relative value of 99 billion. Essentially, the value to her is infinite because she likes it that much. As such, there are very few things that can compare to it, regardless of price.
However, within the relative value between different ice creams, you can still apply the same concept.
For example, “regular” Breyer’s/Dreyer’s ice cream would be assigned a relative value of 1 and maybe a cost of $5.
However, Coldstone (my wife’s favorite) would have a relative value of 10 and a cost of maybe $10.
As such, despite the higher price, Coldstone has a better Value Cost Ratio for her.
Unfortunately, Coldstone has closed all Oahu locations, except the one at the airport. Sadness.
Who created this concept?
Um, no one important, just me. It’s just something I use to evaluate things. I would imagine there are other definitions and similar exercises that exist, but this is just how I see it and define it.
In medicine we try to weigh anything we do as a risk against its potential benefits. So I am applying the same concept for financial decisions.
Should it be Cost to Value Ratio or Value Cost Ratio? To be honest, it probably doesn’t matter.
My rationale for using Value Cost Ratio is mathematical. I think everything will have some small cost, so the denominator can never be zero in Value Cost Ratio. However, I think Value can be zero, which would be undefined (dividing by zero) if it was the Cost to Value Ratio. As such, I use the Value Cost Ratio.
So this concept is also person specific then?
Yes, very much so.
So for me, the Value Cost Ratio of buying a BMW 340i isn’t favorable. However, for some the relative value of a BMW is high enough to offset its high price.
Different strokes for different folks.
However, the Value Cost Ratio still applies.
Whereas a BMW 3 series might have a relative value of 10 for $60k, does an M3 have a high enough relative value to offset its higher price tag? What about a Ferrari? What about a Bugatti?
It’s all relative.
Anything else to consider?
Yes. There is also the idea of continued value through repetition.
For example, I bought my daughter Moana on Blu-Ray. She’s only had it a few days, but she’s already watched it 3 times and pretty much sings all the songs by heart. Additionally, my son loves it too. The Blu-Ray itself costs $22. If we consider the relative value of it to be “10” then its Value Cost Ratio is 10/$22.
Comparatively, going to the movie may cost $10 and have a relative value ratio of 10 as well, for a Value Cost Ratio of 10/$10. As such, going to a movie technically has a better Value Cost Ratio, right?
However, going to a movie is a one time event. If I estimate how many times they will watch the Blu-Ray over the next few years, then you can see its Value Cost Ratio increases.
It may not continue to be a relative value of 10 forever, but maybe 10+10+10+10+10+9+9+9+9+… or something to that effect.
As such, the ability to get continued value out of something also has an effect on its Value Cost Ratio and should be taken into account.
This can also be taken into account for my car example above.
If having a nice car gets repeated value to you day in and day out, that may increase its Value Cost Ratio over the long term. For example, someone who truly enjoys getting behind the wheel of his/her BMW every morning for their daily commute and maybe takes it to the track a few times a month.
My example for this would be a friend of mine who has a Porsche GT3 RS. For those interested, I’m talking about the 997 GT3 RS. Now he’s a real car guy, meaning he even has his own car lift in his garage. He truly enjoys driving that car and takes it to the track once in awhile. So, for him, the Value Cost Ratio is high enough.
However, for me, I think the luxury/fun will wear off pretty quickly and would not be enough to offset the high cost. I’m not a car guy.
Why does this concept matter?
Unless you are independently wealthy, you will come out of medical school with a significant loan burden and be behind in saving for retirement. I touched upon this in my prior posts The New Meta of Medicine and I Wouldn’t Choose Medicine Again.
As such, this new generation of doctors (including me) can not afford to spend without thinking.
I advise you to give thought to every purchase you make. The analogy that best fits this is when you go into the grocery store and actually look at the nutritional facts to make informed purchases about what you are buying. Just this one simple extra step will save you from making too large of purchases and overextending yourself too much. Impulse buys are the worst buys.
Value Cost Ratio (VCR) is a mental exercise I made up for making financial decisions. (different from Benefit Cost Ratio [BCR])
It helps compare things to one another with relative values.
Relative values are different for different people. Different strokes for different folks.
Remember that repetition can have an effect on the Value Cost Ratio in the long term.
Make informed decisions. Don’t impulse buy.