In my graduate-level business school class on pricing strategies, one recurring theme is the idea that when buying a product, any price that shoppers encounter or pay can be terribly misleading. Anytime you make a purchase decision, a product’s price should have little weight in whether you should buy it or not. In fact, more often than not, using price alone will lure you into buying things that are far more expensive for you than you think.
The main reasons for this misjudgment are two-fold. First, the actual cost of any product could be vastly different from, and usually much higher than, the product’s sticker price. Second, shoppers rarely translate the product’s price into a number that is more meaningful: how much money they would have to earn, and by implication, how many hours they would have to work to buy the item.
To understand this idea, let’s take the example of shoes, and then work out exactly how much our shoes really cost us. In the discussion that follows, I will use the best available statistics for an average American consumer. Depending on your own circumstances, you can easily use my method to do this calculation for yourself. This way you can figure out just how much your shoes (or anything else you own) are costing you.
As a starting point, we need to figure how many pairs of shoes does an average American consumer owns. There are many different surveys available, but they report numbers that are mostly in the same ballpark. For our exercise, let’s start with the finding that on average, American men own around 11 pairs of shoes and American women own around 17 pairs of shoes.
Based on these values, let’s split the difference and go with 14 pairs of shoes owned by an average American consumer. (Note this would include all shoes owned, from cheap flip-flops, and $10-20 shoes purchased in a big-box store, to the $100+ sneakers or designer shoes purchased in a fancy department or specialty shoe store.)
The surveys also vary about average prices consumers pay, but let’s assume that the average pair of men’s shoes has a price of $65 and the average pair of women’s shoes is priced at $85. Again, the average is $75 per pair of shoes.
Using these numbers, (and simplifying a little) we can conclude that the average American paid a total of $1,050 (=14* $75) for their shoes.
Or have they?
When most Americans buy shoes in a store or online, we end up paying sales tax to the state we live in. For instance, in Houston where I live, sales and local taxes add another 8.25% to my shoe bill. The national average in 2015 is 5.45%. When making buying decisions, studies have shown that most shoppers ignore this amount, an effect that consumer psychologists call “price partitioning”. Even though consumers ignore sales tax, in reality, the amount spent for a pair of shoes priced $75 will be $79 after factoring in sales tax.
The $1,050 paid for shoes actually cost the average American shopper $1,107.
But sadly, the story does not end here.
A vast majority of Americans buy their shoes with a credit card. And a majority will carry a credit card balance instead of paying off the full balance each month. For our exercise, this means that when buying a pair of shoes, you are not only paying the shoes’ sticker price, but you are also paying interest to your credit card company for borrowing money to buy the shoes.
Let’s assume your credit card has an interest rate of 15%. (This is an average; credit card interest rates could be as low as zero for a limited time period when the company runs a special offer for customers, or it could be as high as 29.99%.)
While data on how quickly Americans pay off credit cards on average is hard to find (if such a statistic indeed exists), for our exercise, let’s assume that the amount borrowed to buy the shoes will be paid off in 5 years.
Using an interest rate calculator, the $1,107 that the shopper spent for shoes (plus sales tax) will incur an additional $473 in interest before the borrowed amount is paid off.
The total amount spent for shoes after adding sales tax and interest payments is actually $1,580.
We are still not done.
In making buying decisions, the question to ask is not, “How much money did I pay for my shoes?” Instead, the correct question is: “How much money will I have to earn to pay for my shoes?” After all, we all need money coming in to pay for shoes (and everything else)!
Shoppers pay for shoes with their after-tax incomes, whereas their pay or salary is typically reported in before-tax dollars.
So to determine “how much they will need to earn to buy the shoes”, we need to calculate the pre-tax income that is equivalent to $1,580 in after-tax spending.
Let’s continue to stay with averages. According to the Social Security Administration, the average wages of an American person are $46,481. At this level, the income tax rate is 25%: they will pay 25% of this wage as income tax. (We are simplifying a little here; the 25% is really a marginal tax rate so the federal income tax bill will actually be less; however, most Americans will have to pay additional state income tax which I did not add; in my calculation, I am assuming these two factors cancel each other out).
For our calculation, every dollar the person spends for shoes, they would have to earn $1.25 in income. This means that to spend $1,580 on shoes (after tax), they would have to earn $1,975 in before tax income!
Now, we are ready to answer the question we started with: How much are your shoes really costing you?
Calculated in this way, the sticker price of a single pair of shoes alone suddenly seems too low and misleading, doesn’t it? And keep in mind, this is just shoes. Think of everything else you own and start doing the math for how much you have to work to pay for those things.
Some more interesting tidbits about shoes:
It was Oscar Wilde who said that a cynic is someone who knows the price of everything but the value of nothing. Even though we may not all be cynics, the same is true about many of us. We shop by considering the sticker prices of products, but we completely ignore our precious life force that we have to spend to acquire it.
It’s time we thought more carefully and looked beyond just sticker prices before buying things.