Cost-Benefit Analysis…Don’t panic! You’re not back at your Econ 102 class. All is well. Breathe deeply.
When deciding on the next tool to recommend adding to your FI tool chest, we decided upon a cost-benefit analysis introduction/refresher. Don’t worry, it’s not as difficult as it sounds. In fact, cost-benefit analysis by definition is designed to help you come up with a decision-making process that is mostly math-based, so you’ll feel better about the results you yield.
In essence, a cost-benefit analysis (CBA) helps you make the decisions you need to stay on your path to Financial Independence and helps you weed out the desire to “keep up with the Joneses,” if you will.
So we put all our heads together and came up with how we should be thinking in cost vs. benefit for every decision we may make – not to the “n”th degree – but thinking about how you weigh the real pros and cons. Therefore, not just hard fiat currency. And how we can psychologically break that cycle of trying to look good for people we don’t care about.
OK, that last sentence was harsh. But you know who you are, Karen.
- What is Cost-Benefit Analysis (CBA)?
- Advantages of a Cost-Benefit Analysis
- Disadvantages to Using Cost-Benefit Analysis
- Becoming a True Valuist
- A Real-Life Example of Cost-Benefit Analysis In FI
- The Bottom Line
What is Cost-Benefit Analysis (CBA)?
Please, don’t let us lose you in the terminology and some of the math (don’t click away, please)! We’ll go through each term and each step of the CBA process with you. And, as it should have been mentioned before, if you’ve never heard of Cost-Benefit Analysis or not seen an example of one: you’re one of the 6.99999 billion people in the world who haven’t. So don’t feel too bad.
We’re here to distill complex mathematical, economic, or “other” subject matter into digestible pieces. Don’t worry, that doesn’t make you out of the loop; it just means we are a little obsessed…just a little. Please join us, we have jackets.
So, what is the cost-benefit analysis definition? A CBA (Cost-Benefit Analysis) is a methodology for calculating the benefits and the costs of any decision. Simple enough, right? It truly isn’t that much different than your budget.
The formula is simple: benefits/costs.
You add up all your benefits and then all your costs, divide the benefits by the costs, and you get a nice, neat ratio (called the BCR, or Benefit-Cost Ratio).
Final formula: benefits/costs = BCR
Cost-Benefit Analysis Example As It Relates To Benefit-Cost Ratio
A calculation that has a ratio that’s larger than 1 means your benefits outweigh the costs. We want to have a much larger BCR than 1, but if you are stuck in a binary decision, this could sway your decision towards either buying or passing.
Having a BCR that equals 1, then your benefits equal your costs. It’s a wash.
A CBA takes all the tangible and intangible costs and benefits and then plugs the results into a very basic mathematical formula:
This is a BCR (or benefit-cost ratio).
- If Benefits = Cost, the BCR is 1. This is our benchmark
- If the BCR is lower than 1, your costs are exceeding your benefits
- If the BCR is higher than 1, your benefits exceed your costs
As previously stated, we want a ratio higher than 1. The higher the ratio, the better the benefits.
Cost-Benefit Analysis Example:
Carl has a discount card to get $.20 off per gallon (current market price = $2.99). For background, he owns a 2015 Honda Accord (4 cylinders), which scores him 30 mpg. He drives 45 miles out of the way to get this deal.
Benefits: $2.79/gallon x 33* gallons of gas = $92.07
Costs: $2.99/gallon x 30 gallons of gas = $89.70
*This includes the 3 gallons (45 miles one way = 1.5 gallons x 2 = 3 gallons). Carl has to drive round-trip.
Expected Value vs. Real Value
Carl is effectively breaking even when he travels a total of 90 miles to get $.20 off per gallon. Carl, in his mind, has an expected value of saving $6.00 ($.20)(30 per gallon). However, burning the gas to get there makes his return a wash. In reality, his BCR is so close to 1, it truly is break-even.
Result: BCR = $92.07/$89.70 = 1.03 (neither -EV or +EV)
Now, this is the “hard numbers” view of CBA. The goal is to get into a CBA mentality when it comes to decision-making. Using a CBA for all purchases will help you make the correct financial decisions. If your BCR is lower than 1, you are losing money. If your BCR is higher than 1, you are saving money.
This example is a classic, simple way of looking at your money and maximizing value. The pure “dollars on paper” doesn’t fit this model, because using CBA, you are considering all the variables of benefits and costs. He may “save” money by getting his gas 45 miles away, but he’s actually losing money. That’s why the exercise of cost-benefit analysis by example is so important.
Further, we didn’t even consider the wear-and-tear on his car, the time wasted on traveling 90 miles to save $6.00, and other variables that would certainly swing the BCR out of Carl’s favor. We’ll go into the cost-benefit analysis definition a bit more clearly in the next section to explain why these are important.
There Is One Spin
Every variable that you use to calculate the CBA must be translated into monetary value. This means you must assign intangible variables (e.g., time, comfort making the decision, your perceived value of a variable) a dollar amount. Yeah, we know that can be tricky, but stick with us, and we’ll break it down.
The Devil Is In The Details
When you decide to make a purchase, spin the wheel on Bitcoin, or take a family trip, we’re pretty sure you add up all the costs and try to talk yourself out of the decision unless you truly value it! And we are so proud of all the results of the gamification of our Travel Rewards, cutting back on discretionary spending, and simply trying to increase our FI number. But, we are also guilty of FOMO and impulse buying. Tell us that you didn’t see all the new 70” OLED TVs on sale every week because Christmas is now an entire Q4 holiday. However, in this case, you talk yourself into it. You’ve been doing so well in saving and investing you want to pull the trigger on a treat. Now you have the “envy of the neighborhood” living room, but you’re $799.99 (plus tax) poorer.
OK, so when we say the devil is in the details, we mean those details. That everyone is different, yet we all fall into a predictable set of actions. That’s especially true with those on the path to FI – the steps are clear, the results are hard fashioned, but we are still human.
So, when you are deciding to make a financial move, creating a cost-benefit analysis will give you hard numbers to look back to (i.e. like your budget). Except the resulting ratio is up for your interpretation.
As Brad says, think of CBA/BCR as a tool in your FI toolbox.
The Importance of Weights
When we say weights, we mean the weight you assign to variables. The above example does not express weights because there are no intangible variables. “Intangible” means that it cannot be observed physically and/or doesn’t have physical properties. Time. How much do you like or dislike something? Those, as we stated previously, need dollar amounts assigned to them.
So how do we assign dollar amounts to things that we usually do not? It takes some time. Not the answer you were looking for, was it? But, to utilize and define cost-benefit analysis effectively, it’s a practice worth taking.
A good way for you to start is how you value your time. Do you work all the time and have little need for a social life? Then you may want to take your dollars earned per hour and assign that to your time variable. If you enjoy your free time much more than you do your time at work, you may want to assign double the amount you make per hour to your time variable.
Again, we want to give you a tool, not a rule. If you feel confident enough in your decision-making not to use CBA, the FI Police will not come knocking at your door. But, many of us find comfort in math. This is a mathematical methodology to assist you on your journey towards financial independence.
Advantages of a Cost-Benefit Analysis
Since the genesis of cost-benefit analysis, it has been a staple in every discipline that concerns risk vs. reward. Why? Because it is straightforward and predictable – two tenants you want to have when using a decision-making methodology.
Every decision that has to do with time vs. money or risk vs. reward starts with a question: do the benefits outweigh the costs? This naturally leads to the next question: what is my course of action to ensure they do? Most of us consider our ROI (return on investment) at face value and choose what swings in our favor.
The cost-benefit analysis goes one significant step further. It includes the intangible costs – costs that are often overlooked. To truly maximize your benefits, you must include these costs. Otherwise, you are missing opportunities to capitalize on because you didn’t consider all the variables. Or take opportunities that have a large intangible variable time-sink. Both inhibit your path to FI.
The Benefit-Cost Ratio (BCR) Compared and Explained
Some mathematical models like cost-benefit analysis equations/examples rely upon ratios as a way of expressing, in one value, how advantageous or disadvantageous a decision is. It’s about making life simpler.
Compare ratio-based models to similar models, such as multi-criteria analysis, holistic cost vs. benefit, fixed targets, and cost-effectiveness analysis (among others). You’ll find that they often reflect nearly the same results without the complexity.
So, the BCR considers all necessary information for us to determine if decisions are financially worthwhile or not in one ratio. By nature, we think that simpler “isn’t enough information.” But, by the nature of the methodology itself, it truly is, and that’s why it’s been used for decades.
Disadvantages to Using Cost-Benefit Analysis
Admittedly, there are some disadvantages to using a CBA. Some of us like to include much more information about a decision, especially if it’s a crucial one. A CBA gives us the costs and benefits and guides us with the BCR. If you want to include information such as sunk costs, depreciation, variables that have multiple possible outcomes, and decisions that must be made over time – a CBA isn’t adequate.
Quantifying the Qualitative
Probably the most challenging part of using a CBA is assigning a dollar value to something that does not have one. That applies to any qualitative variable you may use, but this is especially true of time. Those just starting out using CBA have difficulty assigning a dollar value to time because they fear under-or-overestimating can lead to errors in courses of action, which should be a real fear. But, like most all other useful tools, practice and refining is the only way to get better at assigning the correct value.
Leaving Variables Out Can Lead to Inaccurate Projected Costs
Say you have a cost-benefit analysis example, and you feel you’ve recorded all the possible costs. Then, when you execute your plan, you’ve failed to consider “X” or “Y.” Since a CBA doesn’t have a set amount of variables, nor does it have a structure to double-check to ensure all variables are accounted for, this is a real danger. Because if you are in the execution phase and you’ve unfortunately left out a “make-or-break” variable, it can lead to an incorrect BCR.
Becoming a True Valuist
If you are a regular listener to the Choose FI podcast or a reader of our blog (kudos!), then you know what we mean by being a valuist. But, for the uninitiated:
A valuist is someone who places importance and spends money on experiences or products they truly love and place a high value on. Like, using less discretionary income on stuff you don’t need and saving it towards an awesome vacation. Or delaying gratification by saving your money over time and buying a quality 3rd vehicle for your family instead of the one that “looks cool” and you want now. It is a mindset (like frugalism and minimalism are mindsets).
Best Bang-For-Your-Buck Utility
We don’t mean the water bill you pay every month as “utility.” Utility is economic terminology for the enjoyment you get from the consumption of a good or service. Valuists look for the best bang-for-your-buck utility when they consume. Just settling with the “next best” thing because they don’t have the discipline to wait and get what they really want is a foreign idea to us.
We want the most we can get out of our money when it comes to quality. Quantity doesn’t matter. We want the best experiences, the best products, the best [insert here] we know we can afford and still be well on our path to FI.
A Real-Life Example of Cost-Benefit Analysis In FI
Let’s look at a real-world cost-benefit analysis example: a Choose FI Community Member who is pursuing FI gave us some time to tell us how he uses CBA in his small business (company employee count: 1).
Our FI Community member (Lew) is a rare vinyl records dealer. He was a furniture store owner for 28 years. He operated out of a small town and, after increasing overhead and competition, was barely making enough to get by – much less pursue Financial Independence. So, he took up the rare vinyl side-hustle, which then became his main source of income; shifting from collector to dealer.
He found that if he measured all the variables that he could (just like a one long, ever-evolving cost-benefit analysis example) he could make money. He didn’t feel comfortable disclosing figures, but he said he was easily making 5-10 times more than he ever did with his furniture business.
Not only is he further along his path to FI than he ever thought possible, but he’s also passionate about music (high utility). And that’s what we want to see – loving what you do and making good money doing it.
Lew attributes preparation, discipline, and product knowledge to his success. He doesn’t buy records unless he can make money. He comes across vinyl he’d love to have himself, but passes on them because they aren’t marketable.
His main sources of records are collectors and other dealers he knows up and down the east coast. They are found either through networking or simply word of mouth. Lew lives in North Carolina, so his “region” of business is NC, VA, SC, TN, AL (in that order), and occasionally MD, PA, and NY.
He already applies cost-benefit analysis to his approach to decision-making. He gave us his thought process plus the numbers prior to and then after his last buying trip, which was to Danville, VA.
Thought Process Prior to Buying
“I source [buy products] and then I sell them on eBay. I accept PayPal as a payment method. eBay Store fees in the music category run about 10% and PP fees are about 4%. To be safe, I round these costs up to 15%. Packaging (tape, mailers) costs $1.75 per record.
Always rent a car when you travel to buy, as I’ve “run” the long-run numbers against the wear-and-tear on my car against renting each time. Therefore, I always encourage the younger guys to sign up for Enterprise+ — your mileage is unlimited and you get the occasional upgrade too. I pay for the rental and the gas.
Records need a climate-friendly place. I store them in my home. Because I have a large bonus room, I’ve calculated that each record costs roughly $.02 each to store.
My time value of money is what I would consider paying myself to achieve my desired salary as a buyer [low utility], not a seller. Each hour I’m “on the road” costs $25. That isn’t money I pay myself. That’s money I would pay someone else to buy for me.
This method has kept me about 2 years ahead of other dealers.”
“In the collectibles market, prices can swing wildly. There are also staples of the industry that you know you can make a buck on. On this trip, I bought 50 copies of a 60’s Soul record for $20 each. I know I can easily sell them on eBay for $80 – giving me a high rate of return – I may just have to ‘work’ [hold on to them for and sell slowly] them over some time.”
Let’s take a look at the costs first.
Consider that this is a one-day trip. He eats twice (Food =2), spends about 9 hours (Time = 9 hours) going through the records to find the ones he wants, and purchases 50 copies.
Now the benefit.
Result: $4,000.00/$1,621.39 = 2.47 (+EV)
Because the BCR is comfortably above 1, we know that this trip has a positive “expected” value (+EV).
The Bottom Line
We hope you can see that using cost-benefit analysis in decision-making is a powerful, yet relatively simple tool to learn and use in your everyday life. And remember, it is just that: a tool. You’ll be surprised how much you spend (cost) to purchase a product or service (benefit). Once you get the hang of it, CBAs may become second nature to you. You’ll know ahead of time all of the variables you’ll need to consider before making a commitment to move ahead with a purchase.
We all have the same goal in mind: reach Financial Independence and enjoy the life we want without the worry of money. Using a cost-benefit analysis formula/example is another powerful tool to help you reach that goal.
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