Cost-Benefit Analysis: The Key To Your Financial Life
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.)