Cost Benefit Analysis
What Is a Cost-Benefit Analysis ?
A cost-benefit analysis (CBA) is a process of comparing the projected costs and benefits of a decision to determine its feasibility. Businesses can determine whether a decision is worthwhile by summing up the potential rewards expected from an action and subtracting the associated costs. If the benefits outweigh the costs, the decision is likely worthwhile for the business.
Cost Benefit Analysis
A cost-benefit analysis doesn't always involve concrete numbers or measurements. Consultants or analysts, for example, could create models to assign a dollar value to intangible factors, such as the benefits and costs of living in a particular town.
- A cost-benefit analysis measures the benefits of a decision or action by subtracting the associated costs.
- It involves measurable financial metrics such as revenue earned or costs saved from pursuing a project.
- The analysis can also consider intangible benefits and costs, like employee morale and customer satisfaction.
- More complex analyses may include sensitivity analysis, discounting cash flows, and what-if scenarios for various options.
- Generally, if the benefits outweigh the costs, the project is favorable for a company
Understanding Cost-Benefit Analysis
Cost-benefit analysis (CBA) estimates and assesses the value of a project's benefits and costs to determine whether or not it's worth pursuing. Originating from the work of Jules Dupuit and Alfred Marshall and developed further by the U.S. Corps of Engineers in the 1930s, CBA involves comparing all current and projected costs and benefits of a project, both monetary and intangible.2
Before taking on a new project, prudent managers perform a CBA to evaluate all the potential costs and revenues it might generate. The analysis's outcome determines whether the project is financially viable or whether a company should consider other alternatives.
Many CBA models also factor opportunity cost into the decision-making process. Opportunity cost represents the potential benefits a business misses out on when choosing one alternative over another. It accounts for the value of the next best option that isn't selected, highlighting the trade-offs involved in any decision.Evaluating opportunity cost can make the decision-making process more comprehensive and effective.
Finally, a manager will compare the total costs and benefits to determine if the benefits outweigh the costs. If they do, the rational decision is to proceed with the project. If not, the business reviews the project to see if adjustments can be made to increase benefits or decrease costs to make it viable. Otherwise, the project should likely be avoided.
Using Net Present Value (NPV) in project decisions offers the benefit of considering an alternative rate of return that could be earned if the project weren't undertaken. A positive NPV indicates that the projected earnings exceed the anticipated costs, making the project a worthwhile investment, while a negative NPV suggests the opposite.
Determine the Benefits
Every project will have different underlying principles, and the benefits might be tangible or intangible. These could include:
- Higher revenue and sales from increased production or new products
- Improved employee safety and morale
- Greater customer satisfaction
- Increased customer retention
- Competitive advantage
- Expanded market share
In this stage, the project manager or analyst performing the cost-benefit analysis will need to determine both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales volumes, customer demand, and product expectations. Implicit benefits, such as the impact of increased employee satisfaction, may be difficult to quantify as there's no straightforward formula to calculate the financial effect of happier workers.
For the analysis to work, each type of benefit will need a monetary value assigned to it.
Compute Analysis Calculations
With the cost and benefit figures in hand, it's time to perform the analysis. This involves concisely summarizing the costs, benefits, net impact, and how the findings support the original purpose of the analysis.
However, some cost-benefit analyses require more detailed examination. This may include:
- Applying discount rates to determine the net present value of cash flows
- Running the analysis with different discount rates
- Conducting cost-benefit analysis for multiple options, each with different costs and benefits
- Comparing different options by calculating a cost-benefit ratio
- Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes
Make Recommendation and Implement
If a cost-benefit analysis is positive, the project offers more benefits than costs. However, a company must consider its limited resources, which may force it to make mutually exclusive decisions. For example, a company with limited capital might find positive cost-benefit analyses for upgrading its warehouse, website, and equipment, but it may not have enough funds to pursue all three projects at the same time.
Not all cost-benefit analyses that result in net benefit should be accepted. For example, a company must consider the project's risk, alignment with its company image, and capital limitations.
What Are the Five Steps of Cost-Benefit Analysis?
The broad process of a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform an analysis of both costs and benefits, and make a final recommendation. These steps may vary from one project to another.
Depending on the specific investment or project being evaluated, a cost-benefit analysis may require discounting the time value of cash flows using net present value calculations
What are the cost-benefit analysis methods?
Various methods are employed in cost-benefit analysis, including:
- Net Present Value (NPV): Calculates the present value of future cash flows minus the initial investment.
- Benefit-Cost Ratio (BCR): Represents the ratio of the benefits to the costs.
- Internal Rate of Return (IRR): The discount rate at which NPV becomes zero.
- Payback Period: Time taken for the benefits to repay the costs.
- Sensitivity analyses are also conducted to account for uncertainties and variables in estimates.
Cost Benefit Analysis Video