I have many times found myself in the position of being asked by people to help them evaluate some options they have from a financial perspective. In reality, people will often arrive with a preferred alternative in mind and will be looking for justification or rationalisation of their preferred alternative. What often happens is they ignore better alternatives altogether and only bring forward the options that seem desirable to them. So how should one look at alternatives from a financial perspective? Here are the things that are important to consider.
Firstly let’s talk about sunk costs. I see many people ignore these but they form part of the financial decision for anything. Sunk costs are costs you are already incurring and will continue to incur. A viable example is someone who plans to buy a car. Assuming the same person already pays daily for transport to work as well as transport of their children to school, both transport costs would be considered sunk costs. That is to say, the question is not whether or not they can afford the full car payment but rather if they can afford the difference between the car payment (plus running costs) and their existing transport cost.
With the above example, I mentioned the running costs of the car. This includes consumable costs such as the cost of fuel for the vehicle. Other incidental costs must be considered. Maintenance costs are a good example that is often ignored. Also, consider costs such as registration and insurance which are necessary legal requirements for car ownership. Incidental costs tend to be ignored and as such hit people very hard when they rear their heads. Make sure you consider all costs that are associated with ownership or participation with the alternative you choose.
Incidental costs as mentioned may sometimes be in the form of costs that endure, such as registration and insurance. That is an ongoing cost that you will have to part with for as long you are involved with the alternative. So even if you buy the car for cash, meaning a one-off expense to buy the car, you will still have ongoing costs associated with the car. Another good example of ongoing costs is repairs and maintenance. You will pay for maintenance, repairs or both at some point. It’s unavoidable and worth considering.
The value of time
Ile the conversation is about considering the financial perspective when it comes to alternatives we cannot underestimate the importance of time. I’ve said before that we should manage our money like we manage our time and I’m sure you’ve heard it said that time is money. Saving time is just as important as saving money. Perhaps more important all things considered. It may not always be easy to attach value to time but I have an idea of how to do it that I often advise people to try. You can establish an hourly rate by dividing your net income from all sources of income by the number of productive hours spent in generating that income. This is not to say that you will be making money during that time but it does attach a monetary value to time and if the alternative saves you the time you can work out a value of the time-saving.
Ultimate financial impact
The ultimate financial impact is simply put in the total of all financial factors. To organise this properly you have to balance between upfront costs and ongoing costs. So comparing how much you part with upfront is not enough, also look at what is to come. This works best when you compare several alternatives and not just look at the preferred alternative. One thing I would like to stress here is the opportunity cost of money. For example, where an alternative saves you money upfront or in ongoing costs the value there is what else you can do with the money and not just the money saved. This only counts if you direct the money to this purpose and not if it’s a fanciful idea.
The important thing is to first consider all alternatives, even the ones that seem absurd upfront. Secondly, consider all things about all alternatives. Finally, learn to consider all aspects even those that may be hard to quantify or relate financially to the decision to be made.