Would you be willing to use a little math if it meant evaluating your financial decisions like a professional financial analyst? The only difference between you and the experts are a few concepts and a calculator. Using these financial tools will alleviate some of the difficulty in decision making, while at the same time, improving your decisions.
After all that talk about math and calculators, I let you down by leading off the topics with one that does not require much math. However, opportunity cost can be useful in any financial decision.
An opportunity cost is an implicit cost of foregoing one option to go with another option. A good example of a decision where this is useful is whether or not you should go to college. If your salary with only a high school diploma is $25,000, but you’d make $35,000 with a college degree; the $25,000 is an implicit cost for going to college.
It may not seem useful at first, but taking the $25,000 as a cost and adding the explicit expenses of college, like tuition; you begin to peel back just how much a college education is really worth.
Cost benefit analysis isn’t hard to understand. You find all the costs of an option and add them up, find all the benefits of an option and add them up and then compare to see if the benefits are worth more than the costs. However, the difficulty is often figuring out and quantifying all the costs and benefits.
A good example of Cost-Benefit Analysis would be my couponing. Last Sunday, I purchased my newspaper to obtain the coupon offers. The newspaper cost me $2. I have since used only one of the coupons, which saved me $1. Unless I find a use for the other coupons, I risk losing $1 on my purchase.
As a response, I’m trying to do a cost benefit analysis of couponing with only online coupons. I’ve since found a few excellent coupon websites that offer many of http://www.smartfamilyfinance.com/wp-admin/post.php?post=280&action=editthe coupons I clipped from the newspaper. These sites are free. It would be easy to simply conclude the analysis with a cost of $0 and overlook many of the costs of couponing online. Couponing online means printing my own coupons which will cost me money in printer ink and computer paper. Since I’m not sure how many coupons I’ll be able to print and use, I only know the cost portion and need to wait and see what the benefits are before making a decision.
With some decisions, you want to be sure you include the opportunity cost in your analysis.
If you get any benefit for a cost, you can figure out the break-even point. This is where your use of the benefit finally equals the costs you paid. In doing this, you can see if you would reasonably use your benefit enough to cover the costs. I used break-even analysis in my recent decision to forgo the health care plan with co-pays.
In this scenario, I had two different health plans that were identical, except one plan offered a $25 co-pay for primary care and specialist visits. The other plan had no coverage for these visits, which meant a cost of $120 out-of-pocket. The savings for a visit would equal $95 and it sounds like a nice deal. However, to obtain the co-pay plan, my bi-weekly premium payments were twice as much. Over the course of a year, I’d pay $1,800 more for the co-pay plan.
So, using break-even analysis, I can now calculate how many visits to the doctor my family needs to make before we overcome the costs of the co-pay plan; that’s $95/visit for $1,800 annual extra cost or $1,800/$95. It works out that my family would need to visit the doctor about 19 times before we overcame the extra cost. I’ve been to the doctor maybe 3 times in the last ten years. It’s simply not reasonable to spend the extra money on the co-pay plan, because my family would never visit the doctor enough.
(notice that I use the non-co-pay plan as an opportunity cost?)
There are other tools that I’m sure I’m overlooking and when I think of them I’ll post more on them. But, these are the tools I turn to most often and they’ve helped me immensely in making wise financial decisions.