Cost-Benefit analysis isn't just a concept from ECON 101. Believe it or not, you conduct cost-benefit analysis almost every day. When we think of financial analysis, we often assume that it only applies to finances in a business setting. Cost-benefit analysis can be just as helpful in deciding whether to buy a car as it is in deciding whether to buy a company.
What is cost-benefit analysis?
Cost-benefit analysis examines the strengths and weaknesses of alternatives to decide which option provides the more benefit relative to the cost.
Imagine you're at a grocery store, and you're deciding between two types of cereal. One is $4. The other is $5. You like the former better, but you'll need to decide if the difference between the cereal is worth more than a dollar to you in deciding which cereal to buy. In other words, you're analyzing whether the benefit is worth the cost.
For the most part, this is done by companies.
The benefits in a business setting are clear. Cost-Benefit analysis can help a company make major financial decisions, such as hiring, providing benefits to employees, and offering new products.
It can also help a company decide if they're getting enough bang for their buck.
For example, imagine an advertising campaign that costs $5,000 dollars gains a company ten customers a month, who buy the product twice. It may seem easy to see that this is not an effective campaign.
However, his is an oversimplification because there are benefits to advertising and gaining new customers beyond the increased revenue.
This is why cost-benefit analysis can look at the best alternative instead of the pure numbers.
For example, if you're spending $5,000 on an advertising campaign and garnering ten customers a month, but your previous campaign with a different platform spent the same and gained 50 new customers a month, the former is an unsuccessful campaign.
This type of analysis can also be said for personal finances.
How to Conduct Cost-Benefit Analysis for Personal Finances
Whether you're a business owner, the head of a household, or even a student looking at loans, cost-benefit analysis can be a game changer.
This type of analysis is especially useful when choosing between options.
Let's look at how to do cost benefit analysis when choosing whether to lease, rent, or buy a home. This is a personal finance decision that will affect your bank account years into the future. So how would you conduct cost benefit analysis for a situation like this?
Know your options
The difference between leasing and renting is in the time frame of the contract. With renting, the landlord may ask for a month's rent at a time. A lease tends to be for a set timeframe, such as 12 months or 24 months. Buying a home means that you will own it. You're your landlord, which changes some of the costs.
Identify your goal
In cost-benefit analysis, we can put a monetary value on things that are traditionally non-monetary. For example, how much is not answering to a landlord worth to you. For some, this would not be a factor that they care about. For others, it is a defining factor in their decision.
Identifying your goal is the second step. What are you hoping to gain from this decision?
Identify the Costs of each option
Pick a timeframe to analyze the total costs. Since this is a long-term decision, let choose five years while keeping in mind the benefits over a more extended period of time.
There are different types of costs:
These costs are the obvious, money out of your bank costs.
Your direct costs for renting are your rent per month, your utilities, your insurance, and any other expenses directly related to this form of housing. If you were to continue renting for five years, let's assume your cost would be $50,000.
Your direct costs for leasing may be similar to renting. It will be your total rent, insurance, utilities, and other direct expenses. Since a lease tends to be cheaper than month by month, let's assume your five-year cost is $40,000
Your direct costs for buying will be more expensive. These can include mortgage, cost of house or loan payments, and costs of repairs. Let's assume this is $700,000
If we were just looking at direct costs, leasing would be the clear winner.
Intangible costs don't have an obvious monetary value. It's up to you as the decision-maker to decide what each cost is worth.
For renting, dealing with a landlord who can change the terms of your rent every month creates instability. Is this a big deal? The cost of this will change depending on the person making the decision.
In leasing, you are unable to change aspects of the home. How much does this cost to you? Perhaps you can't have pets. Is this a cost?
For owning a home, you are liable for all damages. Is this a cost?
Opportunity cost is the cost of the lost benefits of the next best option. How much could you have saved if you had gone with another form of housing?
Identify the benefits
There may be direct benefits to each option. For example, there are tax incentives to being a homeowner.
Many of the benefits will be intangible.
- How much is the privacy and security of home owning worth to you
- How much is the opportunity to not be tied down in a lease worth to you in this stage of life?
- How much is having a stable place to live for the next year worth to you?
Will the housing market rise? If you buy a house now, will it increase in value? Would you lose out on this benefit as a renter or a leaser?
The biggest issue with this is that the cost-benefit analysis will look different in short-term versus long-term models. Causal knows this and will provide you with both. Also, the resale value of a house isn't liquid, but it is still an asset.
Causal will help you quantify all of this with our templates. Our buy versus rent template takes into account all of these factors and gives you total wealth from each option.
Our templates are perfect for cost-benefit analysis in personal finance, making sure that you know the numbers and can make an informed decision on all life choices, not just corporate ones.