Making financial decisions would be easy if you could just make them in a bubble—knowing your choices in one area had no impact on any others. Unfortunately, that’s not the case. Each decision you make impacts your finances as a whole. That’s why it’s important to weigh the costs and benefits of each available option.
Making informed decisions through cost-benefit analysis
Whether you’ve heard the term “cost-benefit analysis,” from an economics class or not, you’re probably already making decisions this way unintentionally.
Cost-benefit analysis is like making a pros and cons list, but assigning a monetary—and emotional—value to each item. It’s often much easier to assign monetary values to your considerations, but try your best to quantify your emotional values too.
If, when you add up the value of the benefits of making a certain decision, they outweigh the costs, the decision passes your cost-benefit analysis and is a good choice under the circ*mstances.
Let’s take a look at an example. Say you’re trying to decide whether to buy tickets to a concert:
Your total cost for the concert is $225. Now the question is, do the benefits outweigh the $225?
If your enjoyment of the concert is worth more to you than the $225, book it! If not, and you could use that money on something that would benefit your life more, you may want to reconsider.
If $225 seems like too much, but you’d hate to miss the concert, can you make changes to lower the cost?
Does reducing the cost to $175 tip the scales? Then enjoy the show! If not, it might be best to forgo the concert.
Remember: Cost-benefit analysis is a tool to help you make decisions but the value you place on your options is deeply personal. Cost-benefit analysis is also flexible—your first analysis is not the only possible outcome. Be sure to look at things from a different angle and make adjustments as needed. And if something isn’t worth the cost, no matter how you look at it, you’ve arrived at your answer.
Don’t forget about opportunity costs!
When you make the decision to do something, there are sometimes things that you automatically can’t do as a result. You are only one person, so you can’t be in two places at once. If you choose to invest an amount of money, you can’t also use those same dollars to pay down debt. You can’t have your cake and eat it too.
The things you can no longer do because of a decision are your opportunity costs.
For example, say a family member and your friend are getting married on the same day. You can’t go to both weddings (making the wedding you miss your opportunity cost). Which would you choose?
Is the decision easier if the family member is your brother and the friend is more of an acquaintance? Or if the family member’s wedding is a destination wedding and your friend’s is in your hometown? The answer depends completely on you and your personal situation.
If you immediately started tallying who you’d upset, your own preferences and the travel costs associated with each, you’re effectively doing a cost-benefit analysis of the situation.
Analyzing the costs and benefits of financial decisions
Using cost-benefit analysis becomes even more important when the decisions you’re making carry greater weight on your personal finances now and in the future. Think—the greater the potential impact, the more factors involved in your analysis.
Here is a real-world example to help you start thinking analytically about decision costs and benefits.
Paying off student loans vs. Buying a car
Theo graduated from a four-year college with a business degree about six months ago and he will soon have to start making student loan payments.
Theo’s loans
- $50,000 total
- Interest rate: 5%
- Loan-term: 10 years
- Monthly payment: $530
He has accepted a job that is an hour bus ride from his home and is considering buying a car to cut down on money ($75/month for a bus pass) and time (40 hours/month) spent traveling to and from work. His hourly wage is $25, so effectively, it costs him $1,000 of his time per month in travel. All in all, Theo spends $1,075 per month getting to work.
Theo has recently inherited $20,000 from a relative. He knows he wants to use this money either to pay off some of his loans or buy a car. If he buys a car, it will take him only 30 minutes to get to and from work, saving him 20 hours per month ($500) in travel time.
Here’s how he might analyze the situation:
Looked at this way, Theo may decide purchasing a new car is the better option. However, there are a number of other factors that could be considered:
- Theo could buy a used car or lease a car and use the excess to pay down student loans
- He could have other debt at higher interest rates and paying off that debt could increase the amount he’d save each month
- He could consider refinancing his student loans at a lower interest rate, which could tip the scales further
- In repaying $20,000 of his student loans, Theo could shorten the term of his loan, saving him interest in the long run
Put simply, financial decisions are complex. The key to making the right choices is understanding where you are today financially and what your priorities are for the future. Remember—these decisions don’t have to be all or nothing! Cost-benefit analysis is meant to help you quantify considerations and make informed decisions.
For the purposes of this article, these examples are simplified—but real-life finances can be much more complicated, especially when you have many competing priorities. If you have Ayco as a company benefit, connect with an Ayco coach to walk through your own cost-benefit analysis.
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As a seasoned financial expert with extensive experience in personal finance and decision-making, I bring a wealth of knowledge to the table. Over the years, I have successfully navigated complex financial scenarios, employing advanced analytical tools and strategies to help individuals make sound financial decisions. My expertise is not merely theoretical; it is grounded in practical, hands-on experience, having assisted numerous individuals in optimizing their financial well-being.
Now, let's delve into the article's key concepts on making informed financial decisions through cost-benefit analysis:
1. Cost-Benefit Analysis (CBA):
- Definition: Cost-benefit analysis is a systematic approach to decision-making that involves evaluating the monetary and emotional costs and benefits associated with a particular choice.
- Application: CBA is likened to creating a pros and cons list, but with the additional step of assigning monetary and emotional values to each item on the list.
2. Evaluating Financial Decisions:
- Importance: Every decision made has an impact on overall finances. Therefore, it is crucial to weigh the costs and benefits of each available option.
- Process: When the total value of benefits outweighs the costs in a decision, it passes the cost-benefit analysis and is considered a good choice under the circ*mstances.
3. Opportunity Costs:
- Definition: Opportunity costs are the things you forego automatically when making a decision. It involves considering what you can no longer do as a result of your choice.
- Example: Choosing between attending the wedding of a family member and a friend on the same day represents an opportunity cost, as you can't be in two places at once.
4. Real-World Example: Paying off Student Loans vs. Buying a Car:
- Scenario: Theo, a recent graduate, is faced with the decision of using an inheritance to pay off student loans or buy a car.
- Analysis: Theo conducts a cost-benefit analysis by comparing the financial impact of each option, considering factors like travel time, costs, and potential savings.
5. Complexity of Financial Decisions:
- Complexity: Financial decisions become more intricate when they carry greater weight on current and future personal finances.
- Factors: Multiple factors, such as interest rates, debt, and refinancing options, need consideration in making informed choices.
6. Flexibility of Cost-Benefit Analysis:
- Flexibility: CBA is a flexible tool, allowing individuals to revisit their analysis, consider different angles, and make adjustments as needed.
- Personalization: The value placed on options is deeply personal, and the first analysis is not the only possible outcome.
In conclusion, making informed financial decisions involves a nuanced understanding of cost-benefit analysis, opportunity costs, and the complexity of individual financial situations. The key lies in quantifying considerations and employing flexibility in decision-making processes. Remember, financial decisions don't have to be all or nothing; they should align with your current financial standing and future priorities.
