According to green car report, most internal combustion engines are incredibly inefficient at turning fuel into usable energy. On average, most gasoline combustion engines average around 20% thermal efficiency where diesels are closer to 40%. I can still remember sitting in physical chemistry discussing thermodynamics and this example of thermal efficiency was mentioned.
So, how does this relate to financial effectiveness?
If there is a way to calculate the efficiency of an engine, then there surely is a way to calculate the efficiency of income. Since my education and earlier part of my career is science-engineering based, I try to relate things to my background because it is what I feel most comfortable with. I want to have financial concepts that I can grasp and that make sense to me. I am intending to estimate efficiency of income based on the total salary you earn on an annual basis and unavoidable expenditures [required to live].
Here are a few items that would not be included in unavoidable expenditures:
Anything you can truly live without would be considered avoidable expenditures. As always, there may be some expenditures that may be avoidable to someone else and unavoidable to you or vice versa. These would need to be looked at case by case.
So, why is efficiency of income important and what does it tell us?
First of all, in setting financial goals we need a key performance indicator (KPI) we can use to identify how well we are doing. If you calculate your efficiency of income to be 50% in 2018, then you will focus on reducing avoidable expenditures in 2019 to increase this KPI. Year over year, you will continue to monitor this KPI and put efforts into increasing it. The higher your efficiency of income, the better opportunity for you to grow financially.
Similar to thermal efficiency, efficiency of income will take into account any money losses due to poor investments, interest paid for mortgage/loans, fees that could have been avoided, and so on. As you pay off mortgages, get your finances in better working order, and learn to invest properly, your efficiency of income should rise.
The last point I want to mention about efficiency of income is that it standardizes all individuals based on how well they manage their money and not how much money they make. Too often, you have individuals who bring in large sums of money, yet they are still poor. How does this happen? They are simply awful at managing their money for the most part. If they were properly managing their money, they should in theory be better off than someone making less money than them. Think about it this way, just because a hockey team has great offense, does not mean they will be a great team when their defense is horrible. They may get a lot of goals, but they are probably going to give up a lot of goals too.
More to come on this concept later.