Hello gentle readers and welcome to my first post of this (or any other) year, my name is Benjamin Frankbling. My aim is to provide you all with unique content and opinions that you wont find anywhere else. Personal finance advice can be found all over the web, so as editor in chief of AFR I’m going to do my best to keep you all entertained and coming back for more. (I’ll let William spit the cold hard facts and drop the heavy math articles on you all). I will try to steer clear of the most common financial articles and offer some alternative reading that should put a smile on your face and some dollar signs over your eyes.

Who: This article is for anyone who is considering making a change and needs to objectively compare options.
What: I will present an introduction to the appraisal technique known as Cost-Benefit Analysis. The majority of the ideas expressed below should seem somewhat intuitive and retroactively, even a little bit obvious.

I will begin with a small case study. Since this is AFR, we are going to examine the financial impact of the decisions we make. Since this is AFR, we will also simplify our examples like crazy.

The Situation:

You run a popular amusement park near the grand canyon called Ben’s Funtown. Your most popular ride, the Crazy Cliff Crawler has recently come under public scrutiny due to the large number of plummet related toddler deaths. You are losing business and the lawsuits are piling up. Perhaps a change in the way you run your park is in order?

The Proposal:

Install a guard rail. This nifty piece of technology promises to reduce deadly falls by 80%

The Analysis:

Your right-hand man suggests that some Cost-Benefit Analysis is in order. Give that guy a raise, promotion or whatever else he needs to be happy because he is on the ball. (Also, he suggests that you add seat belts to the FearSphere, but let’s not get ahead of ourselves…)

Cost-benefit Analysis is a monetary comparison of the initial and ongoing expenses related to making a change versus the expected return. Simply, is what you put in worth what you will get out? While simple in concept, the potential difficulty arises when we have to assign plausible equivalent monetary costs to non-monetary decisions. How much does bad publicity hurt the bottom line? How many more tickets will we sell if we advertise on AFinancialRevolution.com? Market research and surveying techniques are really beyond the scope of this example, so for now assume that any cost estimates mentioned were left under your pillow for you by the finance fairy.

Before we begin our analysis we need a few more bits of information. Your elite squad of super-nerds provide to you a dossier detailing the Crazy Cliff Crawler. Here is what you know:

1. Each year 100 customers die on your ride.
2. Every dead customer costs you $5,000 (in legal fees and lost business).

The first thing we need to do is compute the…wait for it…Costs and Benefits of our proposal.

Costs:

-A one time cost of $500,000 for the design of the guard rail
-A one time cost of $1,000,000 for materials and labor
-Recurring costs of $100,000/yr in maintenance

Total cost: $1,500,000 + $100,000/yr

Benefits:
-Savings of $400,000/yr in the reduction of legal fees and lost business (the 80 customers who will now live x $5,000)

Total benefit: $400,000/yr

We now have the total cost and total benefit of the proposal. The next step is to calculate the payback time, or break even point. These terms are synonymous and refer to the amount of time required in order for the benefits to repay the costs. At times, the break even point is even more valuable than the total benefit. If you planned on closing down the Crazy Cliff Crawler in 2 years, wouldn’t you want to know if your costs would be paid off by then? Well lucky for you, that calculation is fairly simple.

Set the total cost: 1,500,000+100,000X equal to the total benefit: 400,000X and simply solve for X. In our example we see that after 5 years (1,500,000 + 5×100,000 = 5×400,000) our benefit will match our cost. This means that if we plan to have this guard rail in place for more than 5 years, it will save us money. Anything less than 5 years, we will have lost money. To keep things simple, I will not go into any more detail here, but be sure to read William’s posts on the time value of money and opportunity cost if you haven’t already, as these two concepts should really be applied at this point to see how much your long term costs and benefits are actually worth.

The Conclusion:

As it turns out, you planned on selling Ben’s Funtown in a year and liquidating your assets to invest in a speculative oil drilling partnership on the moon. (Good investment!) For you it turns out that the guard rail wasn’t a good option, but at least you added a valuable toy to your bag of tricks: Cost Benefit analysis.

The Epilogue:

Cost-Benefit analysis can also be used to compare multiple options. You can look for the solution that provides the lowest cost, greatest long term benefit, or even the shortest payback time. It all depends on the situation. Remember, the hardest part of using Cost-Benefit analysis will be assigning value to non-monetary items (like happiness, free time, etc), but doing so can can also give you a fresh perspective on things. Hopefully you already use this kind of problem solving methodology when faced with a possible change, but just in case your care-free nature doesn’t permit a rational decision making process I am going to force a few more (realistic) examples down your throat.

Right now I take the train to work every day. Should I switch to the bus?

I really want to get a PS3. Should I sell my XBox to buy one now, or wait a few months and keep both?

I can buy a used car that will get 20mpg or a more expensive new car that gets 30mpg. I drive around 3,000 miles a month for work and I’m moving to Antarctica to study nitrogen levels in ice cores in 3 years…what should I do?

This is my first post, so as William Wallets says, sound off in the comments! and let me know what you think.

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