Making a tradeoff between current and future needs

Jan 25 2013, 08:57 IST
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SummaryMost of us have a peculiar habit of saving hard for a number of months and spending the accumulated savings at the end of the year in options of our choice.

Most of us have a peculiar habit of saving hard for a number of months and spending the accumulated savings at the end of the year in options of our choice. For instance, Mr Kumar, a software engineer, has been saving R20,000 per month for 12 months, thereby accumulating R2,40,000 for the year. Now, he plans to spend these R2,40,000 in some manner.

Possible options

Here are a few options:

* Buy a brand-new car by taking a loan for the additional amount required;

* Go on a family vacation;

* Buy a piece of land;

* Invest in equity shares directly;

* Invest in markets through mutual funds;

* Invest in a fixed deposit for 3-5 years;

* Buy gold or gold ETFs;

* Take an insurance policy — either an endowment policy or a moneyback policy, or a unit-linked insurance policy

* Spend on buying costly clothing, replacing durables, mobile phone, computer or laptop , and so on.

Present vs future needs

Everyone needs to take a call on whether to fulfill our current requirements or save for future needs. Though we would like to save for the future requirements, for instance, to meet the post-retirement life-cycle requirements, often, we settle with consumption alternatives available in front of us. So, Mr Kumar may prefer to spend his accumulated savings on alternatives of going on family vacation or spending on costly clothings, replacement of durables, computer or mobile or a combination of these two alternatives. Why should he sacrifice the future requirements (which are necessities) to his present luxuries? That’s where the accounting concept of “Just One Fallacy” may hold true.

The Just One Fallacy

When companies manufacture or trade a product or render a service, every extra unit required to be produced/traded/serviced does not give additional fixed cost to the company as long as the extra unit is in the relevant volume range. What such an extra unit of sales adds to the total cost is it’s per unit variable cost only. So, there is a natural tendency for the business unit to ignore the impact of such additional unit of sales under the premise that the fixed cost is a irrelevant for the decision of whether to sell that extra unit or not.

But the problem comes only when the business unit started selling “N” number of additional units, assuming that these additional units do not add additional fixed costs, which is certainly fallacious.

As the company keeps on adding additional units in its operations, these units put together cross the relevant volume range and, thereby, start giving additional fixed cost to the company, which is ignored by decision-makers. This phenomenon of ignoring additional fixed costs for additional small volume of sales is known as “The Just One Fallacy”.

If Mr Kumar decides to spend his accumulated savings on present luxuries than on avenues that would cater to meeting the future necessities, the better explanation for such the decision may perhaps be that he is in the just one fallacy, i.e, he may feel that he is spending the hard-earned savings on luxuries, but doing so only for this year and it does not impact his long-term fortune in any way. So, he keeps spending his savings on luxuries year after year, assuming that such spendings do not impact his future prospects. Assuming that he spends like that for next 20 years, then he realises he had wasted his hard-earned money on luxuries, which are not contributing to his post-retirement needs.

The takeaway of the discussion is that we need to examine whether the expense is required at all. If yes, then the next question is to find out the impact of the expense on the future requirements. If the expense is not required, then it has to be used for meeting the future requirements as one rupee saved is equal to one rupee earned. But it does not mean that one has to tighten as much as possible on his current requirements. As long as one is able to have a trade-off between his present and future requirements, he is not into the ‘just one fallacy’.

The author teaches accounting and finance courses at IIM Ranchi

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