Comparing Costs with Different Time Periods

How do you compare costs with different time periods?

To answer the above question, people who have no background in Economics or Finance will just ignore the difference in the time periods of costs. So the analysis becomes simple, it is a matter of comparing the cost items. The resulting comparison while theoretically is wrong is practical especially under three (3) conditions:

1. The time period involved is too short, say 2 years;
2. The amount is too small, say a few hundred pesos; and
3. The interest rate is too low, say less than 1%.

Whoa! interest rate? What has interest rate got to do with comparing costs? Well, interest rate is the cost differences between the two periods. Say if you got P1.00 now and you place it in a bank for 2 years and your deposit registered P1.20, the P1.00 now can be said to be equal to P1.20 after two years. The differences between now and the future value is the interest rate earned or foregone. Economists refer to this as the "opportunity cost of capital".

In most investments situations, you will be faced with decisions involving costs at difference time periods. So it is best that you know how much is the interest rate. In the above example, the interest rate is 10% per year.

So when comparing costs at different time periods, know the interest rate. Use it as a gauge in deciding which costs are higher or lower. In investment decision-making, if the yield from an investment is say 20% and the interest rate is 10%, then you gain by 10% if you decide to invest. Assuming all other things to be equal.

If however the investment yield is only 5%, and the interest rate is 10%, then the investment is not attractive since you will actually be losing 5% have you decided to put your money in the bank that yields 10%.

In short, faced with an investment decision problem, don't just compare costs without regard to its time period. You may lose money in the process. But if it does not involve much money, then perhaps, it is just practical to compare costs without regard to its time period.