The use of Cost-Benefit Analysis can be dated back to the mid-19th century. It was first used by a French engineer, Jules Dupuit who used the tool to analyze the bridge project which he was working on. Dupuis analysis and principles were first documented in 1848. Later on, a British economist known as Alfred Marshall popularized the analysis through his book ‘Principles of Economics 1890.’
A cost-benefit analysis is a tool that is used to evaluate the estimated costs versus the benefits reaped from a project.
Practically, the process entails tallying up all the costs a project will incur then subtracting the amount from the total estimated benefits associated with the projects or decision.
Importance of Cost-Benefit Analysis
The cost-benefit analysis helps you to choose a more rational decision from a list of potential or available options. Usually, organizations and companies use this tool to support their decisions before making an investment. When undertaking CBA, the organization looks at the consequences of each action or decision.
For instance, if the benefits outweigh the costs, then the decision to pursue the project is worthwhile. Otherwise, if the costs outweigh the benefits, then you can rethink again about venturing into the project.
At the same time, the benefits of each action are considered to reach the best and reasonable decision. This, therefore, helps in developing business strategies, evaluating new hires, or even allocating resources.
How to Do a Cost-Benefit Analysis?
Performing a cost-benefit analysis is always easy as there is no specific format to follow. Depending on your company’s preference, you can choose to do the whole process with the structure that works well for you. However, there are certain key elements you need to cover. If you are wondering how to perform your CBA, we will take you through a basic guideline that will make the work easier for you.
Outline the proposed project policy
First and foremost, you need to highlight the proposed policy in great detail. See to it that every variable is evaluated with the aim of addressing the existing problem. For example, if your company consistently records low sales, then the question to ask will be, “should we hire another sales manager:” otherwise, if you use a more programmatic question such as “How will we improve our sale,” your project policy won’t be outlined in detail, hence more room for assumptions.
Also, as you create your project policy, make sure you identify the goals and objectives you would want to meet. What do you need to accomplish at the end of the cost-benefit analysis? This information will help you interpret the results of your analysis.
List down the costs
Once you’ve outlines you’re working project policy, you need to create a list of possible costs that would be incurred during implementation. Some of the basic categories you would want to include the following:
Direct costs— are directly related to the production, development, or implementation of your proposal/decision. These include the cost of labor, manufacturing costs, raw material costs, and inventory costs, to mention a few.
Indirect costs— are fixed expenses that will help during the implementation of your project. These include utilities, rent, airtime, among others.
Tangible costs— are those costs that are easy to measure and quantify. They include payroll, rent, purchasing of tools or assets.
Intangible costs— are often difficult to measure or quantify. These include reduced customer satisfaction, decreased productivity levels, etcetera.
Real costs— are all expenses incurred when producing an offering. They include labor costs and raw materials.
Opportunity costs— are the loss of other possible alternatives when one alternative is chosen. These may include making alternative investments, such as purchasing a business versus starting one.
Cost of potential risks— includes all probable risks associated with regulation, competition, and environmental effects.
List down the benefits
After noting down the costs, you now need to list down all the benefits that will come from the prospected project or decision.
Some of the benefits are given below:
Revenue and sales increase— include all the incomes from sales or any other anticipated revenue.
Intangible benefits— are benefits that can’t be quantified, yet they can be felt. These include improved employee safety, morale, and customer satisfaction.
Competitive advantage— you will identify the competitive advantage the company uses to gain or dominate the market share.
Calculate costs and benefits
Once you have all your benefits and costs listed down, you need to develop a framework for calculation. Preferably, you can create an outline of costs and benefits and include them in a table for easy and accurate calculation. Also, bear in mind to consider both the long-term and short-term costs and benefits in your calculations. This will help give you reliable data and projection.
Here is an example of the diagram:
Cost-Benefit Analysis: Sports International Ltd Expansion
|Hardware & services||Computer monitors||4||$2,000||$8,000|
|Better customer retention and loyalty||$1,000|
Compare aggregate costs and benefits
Now, you have all your policies, expenses, and benefits listed down. That’s fine! But you now need to take things a little bit higher by comparing all these variables. You will quantitatively analyze and compare whether the benefits will outweigh the costs or vise versa. If the benefits exceed the costs, then that’s a green light for you to proceed with the project. If the costs exceed benefits, then you can seek other alternatives. Or, you can identify any possible cost reductions that will make you reach your goal.
Analyze the results and draw a conclusion
From the results received, you need to make solid decisions about your project. Some analysis methods you can use to arrive at your decision are described below:
Performing sensitivity analysis
Sensitivity analysis, also known as “what if” analysis, helps you to determine the future events should you proceed with the project implementation. According to analysts, this method of analysis is very effective when testing the robustness of the CBA.
Consider discount rates
Discount rates are part of your costs. Therefore, make sure you include them in your findings. Some of the common types of discounts you are likely to encounter are social discount rates, hurdle rates, and annual effective discount rates.
Use discount rates to determine your action
In order to get accurate findings on the feasibility of the project, you need to treat discounts as an important variable. If you keep getting positive results after increasing or decreasing the discount rate, then the project can be said to be financially viable.
On the other hand, if you keep getting negative results despite increasing or decreasing the discount rate, then the project isn’t viable. You can therefore decide to adjust your zero balance point or evaluate with new findings.
When Is the Cost-Benefit Analysis Performed?
Every company should always perform a cost-benefit analysis before engaging in any project due to its wide range of benefits. While its primary role is to test for the feasibility of a project, there are other scenarios where it can be useful.
- When developing benchmarks for comparing projects
- Evaluating new hires
- Assessing charge initiatives
- Deciding whether to pursue a proposed project
- Weighing investment opportunities
- Appraising desirability of suggested policies
- Quantifying effects of stakeholder and participants
- When measuring social benefits
Limitations of Cost-Benefit Analysis
If you are operating a small or medium-sized project with a short completion time, you need to conduct an in-depth cost-benefit analysis. This will provide you with sufficient information necessary for rational decision-making.
If you are operating a large-scale project with a longer completion time, then a CBA may not provide you with the necessary information. This is because other factors such as price inflations, interest rates, and varying cash flows may come into play as your project is underway. For such projects, alternative capital budgeting analysis methods such as net present value (NPV) may suffice.
According to economists, NPV is beneficial for projects with long deadlines as it uses an alternative concept of calculation that is based on the present value. However, whichever model you use to calculate the CBA, there is often room for forecasts such as future revenues, future rates of returns, and expects costs. Now, if one of these forecasts fails to realize, it can compromise on the accuracy of the CBA, hence its limitation.
Risks and Uncertainties of Cost-Benefit Analysis
In as much as it’s beneficial for every company, the cost-benefit analysis does have certain risks and uncertainties. More often, these risks do come as a result of human errors or inaccuracies. That’s said, here are some common risks and uncertainties associated with CBA.
While it is an important undertaking, companies need to know that cost-benefit analysis has some associated risks. Usually, the majority of risks are associated with human elements.
A company should not over-rely on data. People sometimes tend to rely too much on the previously acquired data while compiling new projects. This may lead to a collection of results that don’t necessarily relate to the project in question. Therefore, the overall outcome may be inconsistent with the situation at hand.
Secondly, using heuristics to access dollar value may provide an inappropriate reading. This can lead to errors hence invalid finding
Some unavoidable uncertainties associated with CBA include:
Money isn’t everything: There are certain benefits that can’t be described in terms of dollar value. Therefore, you should only concentrate on money-related benefits alone.
Cash in unpredictable: Usually, revenues and cash flows depend on seasons. One day they will be at their peak, and the other day they will low. Hence creating concrete data can be difficult.
Don’t rely on intuition: It is often advised that you do proper research on benefits and costs to get real information. Even if you are an expert, you shouldn’t always generalize from your expertise.
Income influences decisions: The more income, the more decisions you will make. That is to say, if your business generates more revenue, you will look for better ways to make good use of it.
Accuracy affects value: The accuracy of data determines the value of your project. If you use inaccurate data, the value of your project will surely diminish.
Value is subjective: The value of immeasurable costs and benefits can always be misinterpreted or interpreted differently by various individuals.
Don’t automatically double up: One common mistake people are fond of is doubling benefits and costs values. However, be warned that this can cause inconsistency or inaccuracy.
Real Example of Cost-Benefit Analysis
After being in operation for a period of 8 years, Sports International Limited is planning to expand its business. In order to achieve this, it will require hiring new employees to support this move. According to its plan, the company intends to hire four new employees within the first year. By this, the benefit will increase to $200,000. Also, the new hiring of the company will make additional revenue collection of $25,000. The salary of the new hires is estimated to be $150,000. Also, the additional cost of hiring will be $10,000. The amount spent to hire additional software and computer hardware will be $20, 000.
Analyze the company’s new expansion strategy using cost-benefit analysis.
The total benefit accrued will = benefits + additional revenue.
Total benefits = $200,000 + $ 25,000 = 225,000
Total cost accrued = salary of employees + cost of hiring + cost of hardware and software.
Total cost accrued= $150, 000+$10,000 + $20,000 = $ 180, 000
Cost Benefits Ratio = total benefits/ total costs
Cost benefit ratio = $225,000/ $180,000
Cost benefit ratio = 1.25
Since the outcome is a positive value, we can comfortably say that the company’s decision to make expansion is worthy.
Usually, the controversial aspects in a CBA do fall under intangibles variables. This is because they are difficult to measure or quantify.
They may include human life, customer satisfaction, and loyalty among others.
However, when thinking of things that value in a CBA, the intangibles will definitely play a significant role. According to experts, CBA does assume that monetary value can be put in every cost and benefit associated with a project.
Therefore, it’s advantageous that people explicitly and systematically consider every factor that can affect the implementation of that particular project.
Download Free Templates
Cost-benefit analysis is very important for your business. If you are looking for ways to create an effective cost-benefit analysis, you can download our free CBA templates. Our templates are not only user-friendly but easy to customize as per the preference of your company.
Frequently Asked Questions
What are the tools used in CBA?
The tools used in CBA vary with the type of project you want to pursue. That’s said, some of the tools you can use include benefit-cost ratio, regression modeling, valuation, and forecasting techniques.
What are the costs and benefits of cost-benefit analysis?
Usually, performing CBA is a cost on its own. This is because you require time and resources to understand the benefits and costs associated with the project. Another variable that adds to its costs is the amount paid for analysis or consultants.
However, if done properly, CBA can be beneficial in that it will provide you with the necessary information for rational decision-making. Before doing CBA, you need to determine whether its benefits will outweigh costs.
How does one weigh cost versus benefits?
One can weigh the cost associated with a project versus the benefits of using a CBA tool. The CBA quantifies and compares both the cost and benefits to determine the worth of undertaking a project. If you find your benefits exceeding the costs, then this is an indication that the project is worth performing.
Regardless of your return on investment, performing a cost-benefit analysis is often recommended before doing any project. It helps provide you with useful information about the project you are about to undertake.