Last time, we looked at the two most common ways to analyze a potential project. We focused on the money side which works great for business decisions because the cost of time is included implicitly.
But if you’re a business owner, do you include the value of your time in your calculations? How about when you’re making a personal decision? It’s important to add time into the equation.
To do that, follow this process:
- Step 1: Estimate project hours. How much time will you spend if you do this project?
- Step 2: Select your alternative activity. What would you do if you weren’t working on this project?
- Step 3: Calculate your opportunity cost per hour. Your opportunity cost per hour is the amount of money you could earn (or not spend) per hour on the alternative activity you chose in Step 2.
For example, if you would watch TV instead of working on this project, then that time wouldn’t be valued at much. Maybe, instead of watching TV, you would clean your house. Now that’s worth something!
How much would you pay somebody to clean your house? How many hours would it take you to do it yourself? Divide the amount you would pay someone to do the work by the number of hours it would take you to do it yourself to get your opportunity cost per hour.
- Step 4: Determine the total cost of your invested time. Multiply the number of project hours (Step 1) by your opportunity cost per hour (Step 3). That’s the value of the time you will invest in this project. This should be added to the money you will invest to find your total investment.
Example – Getting certified (Part II)
Let’s look at the same project we considered yesterday – you decide to go back to school and get certified for some specialty. Here are the details:
Incremental income: $2,000 in Years 1 through 3 (then you retire)
Opportunity cost of your capital: 6%
Now let’s add in the time component. Assume that, if you put the same time into another activity instead of this certification program, you would expect to earn $2,000. That’s the opportunity cost of your time. So instead of an investment of $2,000 (as mentioned above), your investment is really $4,000.
Payback period doubles
We see that your payback period is two years. You’ll be fully compensated for your invested time and money by the end of the second year. But remember, when we didn’t factor the value of your time into the equation, your payback period was only one year. So it doubles in this case.
Net Present Value falls
We said yesterday that calculating the Net Present Value (NPV) was a better way to determine whether or not you should do a project. In this case, with the value of your time factored in, the NPV is about $1,300 as shown in this screenshot from Microsoft Excel:
As you may recall – if our NPV is greater than $0, then we take on the project. That’s the case here so we would want to do this project. In fact, even factoring in our time, this project – under the assumptions we’ve made – would return 23%. That’s a pretty good return on our time and our money!
But not nearly as good as the 84% we thought it was when we weren’t placing any value on our time. That’s why it’s so important to include our time. As we said, businesses do this implicitly because they have to pay people to do projects. But when we’re taking them on ourselves, we have to be sure to place the appropriate value on our time. We forget this too often … to our own detriment.
Now you have the ammunition you need to determine whether or not you should take on that project you’re considering!
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(Image in today's post by egiprime)