How do you compare two different financial courses of action?
Comparing Financial Options
by Gary Foreman
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Editor's note: Your finances may be very disimiliar to this reader's but the process outlined in this article can be applied whenever you need to compare two different financial courses of action.
I work at the local school. I can walk to work and have little in the way of work related expenses. I have two children heading for a local college, one next year, one in five years. If I can get a job with the college, they will waive $5,000 of the college tuition per child per year. If that happens, I will have to buy a car and pay work related expenses. I am stretching my brain to tell which is the better deal. Can you please help?
We've all been in Ronnie's position at least once in our lives. How do you compare two different financial courses of action?
Each situation we face is unique. So often it's hard to find an online calculator or other tool to help. Is it possible to learn how to create your own formula to compare two different options?
The good news is that it is possible. And it's really not as difficult as it might seem. We'll work through Ronnie's question, but we'll also explore how you can create formulas for different situations that you might face.
The first step is to define the question. In this case, Ronnie has two job offers. Her present job keeps her expenses low, but doesn't provide any help for tuition. A different job would reduce the cost of college for her two children, but it also increases other expenses. Simply defining the two alternatives helps us to begin thinking about what might be included in our formula.
Next take a sheet of paper. Write one choice on the left side, another on the right. The top half of the page is for income. The bottom half for expenses. Listing the various components will help you see and understand how each impacts the potential answers.
Then we'll work on each situation to develop a formula to describe it. Let's begin with Ronnie's current job. Since she has a child entering college in five years, we'll probably need to do a plan that will last for nine years (5 years plus 4 years of college).
Ronnie didn't provide complete figures so we'll need to make some assumptions. For instance, let's assume that her present job pays $40,000 per year and the job at the college would pay $37,000 per year. We'll also assume that the extra "work related expenses" would amount to $1,200 per year. Finally, let's assume that the auto expenses would be $6,000 per year.
Sometimes, you'll know all of the different inputs (like salary and expenses). Other times, you'll need to estimate. In this case, Ronnie will likely estimate the college's salary and the other job and auto expenses.
She may need to do a little research to make reasonable estimates. It would be smart to price some cars and call to find out what insurance and operation costs might be. Getting a useful comparison is dependent upon good estimates. So don't shortcut this step.
Let's start with her current job. We'll project income and expenses for 9 years. Ronnie's total income would be 9 times $40,000 or $360,000. She doesn't have auto or work-related expenses, so we won't have anything on the expense portion.
Now, we'll compare a job with the college. Her salary would be 9 times $37,000 or $333,000, but she'd save $5,000 per year in reduced college costs for her kids. So it's the same as if she added $40,000 to her income (4 years X $5,000 X 2 kids). So her total income would be $373,000.
But, she has some added expenses. We estimated the work and auto related expenses would total $7,200 per year or $64,800 over nine years. So we need to subtract that from the income figure. That works out to income after expenses at $308,200 ($373,000 minus $64,800).
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Based on those assumptions Ronnie would be better off in her current job ($360,000 vs. $308,200).
Can this model be used for other questions? Sure! Can you do it yourself? Yep! Most problems require you to set up two different formulas. Each should include income and expenses.
One secret is in ignoring the things that stay the same and focusing on the things that change. In Ronnie's case, there were differences in both income and expenses, but most of the action was in the expenses.
Another trick is to keep it simple. For instance, we didn't include income taxes on Ronnie's extra income from her current job (probably about $400 depending on filing status and deductions). Nor did we include the value of her car at the end of the nine years (probably about $2,000).
That was done for a reason. It needlessly complicates the formula and makes it really hard to focus on the key differences. Also, these tweaks to the formula are less important than the initial assumptions that you make. For instance, in Ronnie's case, a change in the cost estimate to own and operate a car would make a bigger difference.
Remember that this isn't a math exercise. Nor will it give you an exact answer. Rather it's a tool to help you see the choices clearly and to identify any significant financial differences.
You can do a similar analysis on any financial question you have. Some are harder than others, but don't be afraid to take a piece of paper and begin to break down the problem. In many cases, you'll be able to create your own formula. But, even if you can't, you've still put yourself in a better position to understand the key parts of the decision.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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