If you are like most people these days, you are trying to cut costs and get more for each dollar. However, the best way to do this is not always to simply buy the cheapest option. Instead, it is better to try to maximize the value you get for each purchase by utilizing a cost-benefit analysis. (To learn more about this and other fundamental economic principles, read our Economics Basics Tutorial.)
Reclaim Your Purchasing Behavior
Cost-benefit analysis is a method of outlining the cost and the benefits of a financial decision and weighing them against each other. The important thing about the cost-benefit analysis for your financial life is that it allows you to make more rational decisions about your spending. Sales and marketing efforts are often based on manipulating emotions to drive purchasing behavior. You can reclaim your financial independence against these emotional appeals by using the cost benefit analysis as a framework for making rational decisions with your money. (For more on controlling your spending, read 5 Ways To Control Emotional Spending.)

Real World Examples
Let us consider a simple case of cost-benefit analysis. In this case, we will assume you want to move to a smaller apartment to save costs, but you have four months left on a lease contract. You must pay a $1500 penalty to terminate the lease early. The current rent you are paying is $1000 per month and the new smaller apartment's rent would be $700 per month.

It is easy to see that you will save $300 per month for the next four months by moving, but you will have to pay $1,500. Since you will pay $1,500 and only save $1,200, moving before your lease is up will result in a $300 loss. This is not to mention that you will also be living in a smaller apartment for four months.

The example above was very simple, but in real life you would have many other things to consider. For instance, there might be differences in utility bills, differences in commuting costs, additional moving costs, fees for moving your cable, internet, and telephone subscriptions and many other things.

The most common problem with cost-benefit analyses is in not recognizing all of these factors in the first place. So it is best to give these things a good amount of thought if there is a large amount of money at stake.

Dealing with Uncertainty
Many cost-benefit problems are not this easy because they have important elements which are hard to quantify. Whenever this is the case it makes it much more difficult to make an objective financial decision.

One place where this problem comes up is when you are shopping for auto insurance. Let's suppose you are trying to decide between auto liability coverage of $50,000 versus $100,000. You can get quotes for each coverage level and find that $100,000 of coverage costs $5 extra per month. In this case, the cost is clear, but it is difficult to quantify the extra benefit you get from the $100,000 coverage. Is it worth the $5? It's hard to tell.

In cases like these, the best you can do is to rely on approximations. If the decision involves a lot of money, you can spend a good amount of time developing these approximations to make the best decision you can. In everyday decisions involving smaller amounts, you will often have to just use your best judgment. It is not always possible to make a perfect decision because estimations are often required.

The Bottom Line
Despite its imperfections, if you consistently employ this cost-benefit thought process you will come closer to maximizing the value you obtain for your money. As you become more experienced at employing cost-benefit analysis, you may find a lot more money left in your wallet without even noticing a decline in your standard of living. (Learn more in Standard of Living Vs. Quality Of Life.)

Related Articles
  1. Retirement

    Suddenly Pushed into Retirement, How to Handle the Transition

    Adjusting to retirement can be challenging, but when it happens unexpectedly it can be downright difficult. Thankfully there are ways to successfully transition.
  2. Savings

    How Parents Can Help Adult Children Buy a Home

    Owning a home isn't easy thanks to stringent lending standards. Thankfully, there's ways parents can help their kids buy a home.
  3. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  4. Stock Analysis

    The Biggest Risks of Investing in Sears Stock

    Learn about the factors that have led to Sears Holdings' underperformance the past several years and where the ailing retailer could be heading in the future.
  5. Stock Analysis

    4 Key Indicators That Move The Markets

    Educated investors need to keep their finger on the pulse of the economy, and watching certain indicators is a good way to do that.
  6. Retirement

    4 Ways to Boost the Amount You Save for Retirement

    Retirement can easily last more than twenty years, which means you have to save a lot. Thankfully, there are ways to enhance the amount you put away.
  7. Savings

    Craft Beer Clubs – Bargain or Not?

    If you're an aficionado of artisanal brews (or would like to be), a beer club can be a palate-pleasing, albeit pricey, way to expand your hops horizon.
  8. Credit & Loans

    Adjustable Rate Mortgage: What Happens When Interest Rates Go Up

    Adjustable rate mortgages can save borrowers money, but they can't go into it blind. In order to benefit from an ARM, you have to understand how it works.
  9. Retirement

    How to Stretch Your Retirement Savings

    What does "nest egg" mean for your personal situation? Will you deplete it, or will you nurture it to generate income that lasts throughout retirement?
  10. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  1. What are the pros and cons of a business temporarily closing once a shutdown point ...

    The first and primary benefit of a business stopping operations after crossing a shutdown point is that it won't run the ... Read Full Answer >>
  2. What are common use cases for marginal analysis?

    Marginal analysis can be applied to almost every part of life. Marginal analysis focuses on maximizing the value of scarce ... Read Full Answer >>
  3. What causes politicians or governments to begin "pork barrel" spending?

    Pork barrel spending occurs when the government taxes the general population to hand out concentrated benefits to special ... Read Full Answer >>
  4. Marginal propensity to Consume (MPC) Vs. Save (MPS)

    Historically, because people in the United States have shown a higher propensity to consume, this is likely the more important ... Read Full Answer >>
  5. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  6. Are Social Security payments included in the US GDP calculation?

    Social Security payments are not included in the U.S. definition of the gross domestic product (GDP). Transfer Payments For ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center