What is a cost-benefit analysis, how is it used, what are its advantages and disadvantages? (2023)

What is a cost benefit analysis?

A cost-benefit analysis is a systematic process that companies use to analyze which decisions to make and which not to make. The cost-benefit analyst adds up the potential rewards expected from a situation or action, and then subtracts the total costs involved in taking that action. Some consultantsAnalystAlso create models to assign a dollar value to intangibles, e.g. B. the benefits and costs associated with living in a particular city.

Understand cost benefit analysis

Before building a new facility or undertaking a new project, prudent managers conduct a cost-benefit analysis to assess all the potential costs and revenues that a company could generate from the project. The result of the analysis determines whether the project is financially feasible or whether the company should undertake another project.

In many models, a cost-benefit analysis is also taken into accountOpportunity costsin the decision-making process. Opportunity cost is alternative benefits that could have been gained by choosing one alternative over another. In other words, opportunity cost is the lost or missed opportunity as a result of a choice or decision.

Considering opportunity costs allows project managers to weigh the merits of alternative courses of action, rather than just the current path or choice being considered in the cost-benefit analysis. By considering all options and potential missed opportunities, the cost-benefit analysis is more complete and allows for better decision-making.

Finally, the results of the additional costs and benefits must be compared quantitatively to determine whether the benefits outweigh the costs. If so, then the rational decision is to proceed with the project. If not, the company should review the project to see if it can make adjustments to increase benefits or reduce costs to make the project viable. If not, the company should probably avoid the project.

The process of cost benefit analysis

There is no single, universally accepted method for conducting a cost-benefit analysis. However, each process usually has some variations of the following five steps.

Identify the scope of the project

The first step in a cost-benefit analysis is to understand your situation, identify your goals, and create a framework to frame your scope. The scope of the project begins with determining the purpose of the cost-benefit analysis. An example of the purpose of a cost-benefit analysis might be “to determine whether to expand in order to growmarket share" or "to decide whether to renew a company's website".

In this initial phase, the planning of the project takes place, including the schedule, required resources, constraints, required personnel, or evaluation techniques. At this point, a company must assess whether it is equipped to perform the analysis. For example, a company may find that it does not have the necessary technical staff to conduct a proper analysis.

During the scoping phase of the project, the key stakeholders should be identified, notified and given the opportunity to contribute throughout the process. It may be appropriate to involve those most affected based on the results of the analysis (ie if the result is a company's website overhaul, IT may need to hire additional staff and should be consulted).

determine costs

With the framework behind us, it's time to get down to numbers. The second step in a cost-benefit analysis is to determine the cost of the project. The costs may include the following.

• Direct costs would be the direct labor costs of manufacturing, warehousing,raw material, production costs.
• Indirect costs can include electricity, general administration costs, rent, utilities.
• intangible costsa decision, such as the impact on customers, employees or delivery times.
• Opportunity costs such as alternative investments or buying a facility versus building a facility.
• Cost of potential risks, such as B. Regulatory risks, competition and environmental impacts.

When determining the costs, it is important to consider whether they are recurring or one-off costs. It is also important to assess whether costs are variable or fixed; If they are fixed, consider what step cost and relevant rank will affect that cost.

determine benefits

Each project will have different basic principles; Benefits can include:

• Higherrevenueand sales due to increased production or a new product.
• Intangible benefits such as increased employee safety and morale, and customer satisfaction through better product offerings or faster delivery.
• Competitive advantageor market shares gained by the decision.

An analyst or project manager must apply a monetary measure to all items on the cost-benefit list, being particularly careful not to underestimate the costs or overestimate the benefits. A conservative approach, deliberately trying to avoid subjective bias in calculating estimates, is more appropriate when assessing both costs and benefits for a cost-benefit analysis.

Analysts also need to be aware of the challenges in determining explicit and implicit utility. Explicit benefits require future assumptions about market conditions, sales volumes, customer needs, and product expectations. Implicit costs, on the other hand, can be difficult to calculate because there may not be a simple formula. For example, consider the above example of increasing employee satisfaction; There is no formula for calculating the financial impact of happy employees.

Calculate analysis calculations

With the numbers on the costs and benefits, it's time to do the analysis. Depending on the project timeline, this can be as simple as subtracting one from the other; If the benefit is greater than the cost, the project has a net benefit to the company.

Some cost-benefit analyzes deserve further criticism. This can include:

• Usediscountsto determine the present value of cash flows.
• Using different discount rates depending on different situations.
• Calculation of the cost-benefit analysis for several options. Each option may have different costs and benefits.
• Leveling of different options by calculating the cost-benefit ratio.
• Perform a sensitivity analysis to understand how small changes in estimates can affect results.

Make and implement recommendations

The analyst performing the cost-benefit analysis is then often required to summarize the findings for presentation to management. This includes a concise summary of costs, benefits, net impacts, and how the results ultimately support the original purpose of the analysis.

In general, if the cost-benefit analysis is positive, the project has more benefits than costs. A company must consider limited resources, which can lead to mutually exclusive decisions. For example, a company may have a limited amount of capital to invest; Although a cost-benefit analysis of upgrading its warehouse, website, and equipment is positive, the company may not have enough money for all three.

Benefits of cost-benefit analysis

There are many reasons to conduct a cost-benefit analysis. The technique is based on data-driven decision-making; All recommended results are based on quantifiable information collected specifically for a single problem.

A cost-benefit analysis requires extensive research into all types of costs. This means considering unpredictable costs and understanding the types and characteristics of expenses. This level of analysis only strengthens the results as more research is conducted on the status of the project result, which provides better supportstrategic planningefforts

A cost-benefit analysis also requires quantifying non-financial metrics (ie what is the financial benefit of increased employee satisfaction?). While this can be difficult to assess, it forces the analyst to consider aspects of the project that are more difficult to measure. The end result of a cost benefit analysis is the provision of a simple report that facilitates decision making.

Limits of cost-benefit analysis

For projects with small to medium capital expenditures and short to medium completion times, a thorough cost-benefit analysis can be enough to make a rational and informed decision. For very large projects with a long time horizon, a cost benefit analysis may not take into account important financial concerns such as inflation, interest rates, variable cash flows, etcexisting valueof money.

One of the advantages of using NPV to decide on a project is that it uses an alternative rate of return that could be achieved if the project had never been undertaken. This power will be subtracted from the results. In other words, the project must generate at least more than the rate of return or discount rate obtainable elsewhere.

However, any type of model used to perform cost-benefit analysis has a significant amount of forecasting built into the models. Forecasts used in a cost-benefit analysis may include future revenue or sales, alternative returns, expected costs, and expected future cash flows. If one or two of the forecasts are wrong, the results of the cost-benefit analysis are likely to be called into question, thus highlighting the limitations of conducting a cost-benefit analysis.

The final result

Some complex issues require further analysis, and a business may use a cost-benefit analysis when it is unclear whether or not to undertake a task. By determining the costs and identifying what is cheap, a company can simplify the decision-making process by creating a cost-benefit analysis.