What Is Cost-Benefit Analysis?
April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.
Today's term: cost-benefit analysis.
Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.
Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.
The Most Bang for the Buck in Business
In the business world, companies' managers might think in terms of costs and benefits if they have several possible actions they can take. For example, a cost-benefit analysis can help them determine whether to build another factory, buy a certain company, issue more stock, or expand their employee retirement benefits.
Economists apply cost-benefit analysis when they want to estimate the effect of various actions, such as government incentive programs to support the housing market, or subsidies for certain industries, or changes in tax rates, or spending on infrastructure.
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The analysis can take various forms, and can involve varying degrees of complexity and precision, everything from considering opportunity costs (i.e., what is given up by making a given choice) to applying probability estimates to outcomes, to calculating the net present value of various options (which involves translating future costs and benefits into current dollars).
Assessing the costs and benefits helps zero in on the action that offers the most bang for the buck. It's good to remember, though, that these analyses are not necessarily precise, as they often include estimates, especially for qualitative factors.
Cost-Benefit Analysisin Our Lives
When pondering big decisions (or even some small ones), using cost-benefit analysis can help you be a bit more rigorous in your decision making process and more confident in the final decision you make. It comes in handy in all sorts of situations, such as when you're:
Weighing different career or job options. In this case, you might factor in any costs associated with getting the required training, the amount you'll expect to earn, the degree of enjoyment you'll get, the location, the commute, the wardrobe, the hours, the employee benefits, and so on.
Deciding whether to rent or buy a home, and what kind of home, too. You might consider costs such as the down payment, mortgage, insurance, monthly rent, along with the cost of commuting from various spots, the satisfaction provided by each location and home type, the expected cost of repairs and upkeep over time, insurance and tax costs, and resale or equity values.
Deciding whether to attend a particular function. Think about how much enjoyment you'll get, or how you might be able to network, versus how comfortable you'll be and what you'll give up to attend, such as an alternative activity, or $40 for gas and parking.
Making financial decisions: Thinking in a detailed way about the big picture can help you in such choices as how much to contribute to a retirement account, when to start collecting Social Security, whether to buy an annuity or CDs, or perhaps even which stocks to buy.
It can be applied, too, when thinking about your cellphone contract or your cable bill or whether you should hire someone to fix a leaky faucet versus tackling the job yourself. Even if you can't quantify all the factors involved in a decision, you might still include them on a list to help you come up with a final decision.
Learning about some simple economic concepts can make you a better financial thinker and decision maker.
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More money terms:
Supply and Demand
Asset allocation
Sunk cost
See all money terms to know
