How to Do a Cost-Benefit Analysis (FREE Templates)

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A Cost-Benefit Analysis (CBA) is a systematic approach used by businesses to analyze the benefits of implementing a particular decision, action, or project while also considering the tangible and intangible costs associated with the decision, action, or project.

The costs of undertaking an action are subtracted from the benefits that would be realized if the decision or action was implemented. A cost-benefit analysis utilizes measurable financial metrics such as revenue earned and costs saved as a result of implementing the action or decision. Tangible benefits and costs include acquisition of materials, profits, payment for services, etc., while intangible benefits and costs include employee morale, customer satisfaction, cost of time, etc.

Organizations use cost-benefit analysis when evaluating alternatives and decisions. CBA provides an evidence-based evaluation of the decision to be made without political and opinion influences and bias. By using analysis, a business can make sound informed decisions when developing business strategies, allocating resources, or making purchases or hiring decisions.

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Uses of a Cost-Benefit Analysis

CBA is primarily used in the decision-making process, which cuts across different sectors such as business, finance, government, including non-profit organizations.

All these sectors can use CBA when;

  1. Comparing projects– In most cases, an organization will have to weigh a number of projects to decide which project to implement. CBA helps management to determine the project with the most significant returns/benefits.
  2. Deciding whether to pursue– Sometimes, a proposed project may appear necessary, but its costs may outweigh its benefits. A CBA helps determine the feasibility and worthiness of carrying out a project.
  3. Evaluating new hires– A CBA can be used to determine whether the benefits of recruiting new employees would outweigh the financial implications.
  4. Weighing investment opportunities- CBA is used to compare the profitability of different investment ventures, therefore, assisting investors in making the best decision.
  5. Measuring social benefits– A CBA-based evaluation takes into consideration the intangible benefits and cost of selecting an alternative over the other. This way, a business can have insight into the intangible benefits, e.g., Social benefits of a project.  
  6. The desirability of suggested policies– The decision or project with the most benefits is often the most desired alternative.
  7. Assessing change initiatives– When implementing changes, an in-depth analysis of the financial implications is required. CBA offers such an approach, and management can choose the best course of action.
  8. Quantifying effects on stakeholders and participants– A cost-benefit analysis can give a quantifiable measurement of the effects of making decisions in an organization.

How to Do a Cost-Benefit Analysis

There is no standard/universal format for carrying out a cost-benefit analysis. The format will often depend on the situation, industry, or preference. However, there are basic elements that should be present regardless of the format used. Despite the difference in approach methods, the quality of the results of a CBA is not compromised. It is advised that a company should use a structure which is most suitable to them.

Below are detailed steps of performing a CBA.

Establish a framework

This is the first step of a CBA. It involves providing information that is relevant to a Cost-Benefit Analysis.

It can be broken down into the following steps:

Outline– A company first outlines the proposed decision, program, or policy change in detail. The outline should describe the opportunity or the problem.  The outline should relate what is being evaluated to the problem or opportunity being addressed.

Background– After the outline, background information about the problem or opportunity is then provided. This will sometimes involve extensive research as one has to consider the internal and external factors, for example, financial, economic, technology, social factors, etc.

Current Performance– An outline of the current nature of things should be provided. This will often determine where and what changes or improvements are needed.

Opportunities– After evaluating the existing conditions, positions where improvements can be made to increase benefits, are determined. These will often represent opportunities.

Projected Performance– After the opportunities have been identified, the company or business can then set objectives and goals to work towards. For example, hire a new administrative assistant or purchase a new copier.

Risks Involved– It is important to determine the risks of continuing with the way things are as opposed to what they could be. Sometimes the risks could be favorable and therefore meaning there is no need for change.

Approaching Cost Benefits– After assessing the risks, the best approach to carry out the CBA is analyzed. This includes determining which costs and benefits will be included in the analysis. Short and long-term unforeseen costs should be factored in; this would involve a lot of critical thinking.

Determine Feasibility of a Project– The last step of establishing the framework is determining the CBA feasibility of the project or initiative. This could involve determining if the necessary infrastructure, such as technology, is available. Feasibility can also be influenced by geographic parameters. For example, the involved stakeholders could be in different geographic regions, which means they will be impacted differently by an initiative.

Categorizing costs and benefits

The next step in a CBA is grouping the costs and benefits applicable to the project or initiative. This is sometimes dependent on the form in which they will be realized.

The different categories include;

Direct Costs– These are cost directly incurred with the implementation of the project in undertakings such as labour, manufacturing, raw materials, inventory, and production costs of products and services.

Indirect Costs– These are costs indirectly incurred when implementing a project. This could be through utilities and overhead costs—for example, electricity, rent, etc.

Tangible Costs– They are associated with identifiable assets and activities such as payroll, rent, or purchase of items. They are easily quantifiable.

Intangible Costs– They are difficult to measure and quantify as they represent virtual costs such as customer satisfaction, delivery times, etc.

Real Costs– These are costs incurred with producing an offering, for example, labour costs.

Opportunity Costs– These are costs of alternative initiatives that were not undertaken.

Cost of Potential Risks– They include the representative value of risks projected, such as regulatory risks, environmental impacts, and competition.

Calculate total costs and benefits

This step looks into the projected costs and benefits of the project. As earlier stated, they should be both short and long-term. The life of the project should be put into consideration and should be reflective of how they are to evolve with time.

To get the total costs and benefits, the following steps can be adopted:

Outlining overall costs and benefits– All the aspects of the project should be assigned a monetary value. Much care must be taken to avoid overestimating benefits while underestimating costs. The analyst should use a conservative approach while assigning a value to items in the costs and benefits list.

Making Projections based on the life of the program– Some costs and benefits will only be realized later in the life cycle of the project; therefore, forecasting is part and parcel of a CBA. Much keenness should be observed when making these forecasts to avoid inaccurate estimates.

Evolving costs and benefits– The next step should be to determine the evolving costs and benefits. These are costs and benefits that will be incurred as the initiative progresses, such as maintenance, staffing, market reach, etc. Once the future costs and benefits have been projected, these values should be adjusted to the present value. Present value is the current value of a cost or benefit that will be realized in the future; for example, the value of 1 dollar in the future is not the same as 1 dollar in hand today. Determining the present value of costs and benefits improves the accuracy of the figures.

Compare cost and benefits

To determine the benefits to be gained, there is a need to compare the amount of resources consumed and the benefits gained from the project. This is preceded by determining the net present value of the costs and benefits.

Subtracting costs from benefits– The first step of comparison involves subtracting the cost of resources from the cost of benefits gained. The result represents the net benefits gained, and they can be compared to the total costs of the project. If the benefits exceed the costs, the initiative is worth implementing and vice versa.

Return on Investment (ROI)– ROI is the benefit gained by the organization, company, or business from an investment of their resources. It is taken as the final value obtained from subtracting the costs from benefits.

With/Without comparison– The company can choose to incorporate a “with/without” comparison. This process involves analyzing the impact of the project, which is the difference between how the situation in the study area would be with project or initiative and without the project or initiative. This helps in looking at the situation from both perspectives.

Analyze results and final recommendation

The final step in a cost-benefit analysis will normally be an interpretation of the findings and results, which form the basis of one’s decision.

Perform sensitivity analysis

Also known as a “what-if,” it is used to predict how outcomes determined by a CBA are affected by changes in certain variables such as risks and costs. These variables cannot be determined with certainty hence the need for sensitivity analysis, especially the forecast variables. It is used to show the impact of the variation of one aspect of the project on the benefits or costs projected.

Consider discount rates

As earlier stated, a conservative approach is used in a CBA; therefore, discount rates should be considered when analyzing the findings of the process.

Some of these discounts include;

Social discount rate– Used to determine the present value of costs and benefits that will be realized in the future, which is common with government projects such as education and transportation.
Hurdle rates– This is the minimum rate that the business or company expects to earn from investing in a project.
Annual effective discount rates– Represents the actual return expected at the end of the year, the amount of interest earned or paid.

Course of action

Once the analyst has determined the discount rate, it can be increased or decreased to see how the results will vary. This is used to determine the project’s suitability. The changes might be positive or negative.

Positive– If both an increase and decrease of the rate results in a positive result, the project or initiative is financially viable. 
Negative– If by increasing and decreasing the rate gives a negative result, one can re-examine their calculations while adjusting the calculations to a zero-balance point and finally evaluate the project’s viability using the new findings.

After the CBA has been completed, a recommendation and decision can be made from realistic and informed data projections.

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    Risks and Uncertainties

    Despite the effectiveness of cost-benefit analysis in decision-making, it is associated with certain risks and uncertainties which can stem from inaccuracies and human agenda.

    Know the risks

    Risks in a cost-benefit analysis are primarily human-associated. Risks can stem from stakeholder influence or interested parties trying to influence the outcome by manipulating the results, for example, by over or understating the costs, revenue, sales, expected costs, alternative rates of return, and future cash flows. In the event that one of these is wrongly predicted, the results/findings are compromised regardless of whether everything else was correctly predicted. Sometimes, the project or initiative supporters may tend to have a personal or organizational bias when doing the analysis.

    CBA suffices the benefits-cost analyses for short-term projects; however, for large and long term projects, it might fail to accurately represent the financial implications due to unprecedented factors such as inflation, varying cash flows, interest rates, and the present value of money.

    Referring to case study data may be a risk in that they may not accurately represent the circumstances at hand, which would lead to inconsistency in the results. The use of heuristics to assign a monetary value to intangibles may result in errors and results that are not reflective of the actual costs of a project or initiative, which to a great extent influences the validity of the findings. The use of probability theory can be helpful to identify and examine patterns that would influence the outcome/findings.

    Uncertainties

    There are distinct aspects of the analysis that, despite taking extra precaution, cannot be ascertained. They will often vary from one project to the other. As they influence the results, they should be taken into consideration.

    • Accuracy affects value– Accuracy can greatly affect the value of findings which and in some cases cannot be guaranteed to be a hundred percent.
    • Don’t rely on intuition– Use of intuition can result in false information, yet sometimes one has to make educated assumptions; it is advised enough research is done regardless of the analyst’s level of expertise.
    • Cash is unpredictable– Cash value and flow are vulnerable to time and other factors. As this is unpredictable, translating revenue and cash flow into meaningful data can be difficult to achieve accurately.
    • Income influences decisions– Customer’s income will greatly influence their willingness and ability to purchase, and this is a factor that is hard to ascertain.
    • Money isn’t everything– Some of the benefits cannot be directly translated to money.
    • Value is subjective- in most cases, the value of intangibles will be dependent on the analyst’s interpretation which differs from one person to the other.
    • Don’t automatically double up– Doubling up of costs and benefits can result in inconsistent results. Not every increment in cost equates to an increment in benefits.

    Controversial aspects

    Intangibles make up the most controversial aspects of a CBA. This is because concepts and things such as human life, environment, customer loyalty, and brand equity can be hard to quantify and attach a monetary value to. As a monetary value has to be assigned to all the aspects of a CBA, the value might differ from one person to another. Determining the value requires critical thinking, meaning it is based on an individual’s perception, which might be a point of contention.

    Benefits of a Cost-Benefit Analysis

    Utilizing a CBA can prove to be advantageous to a company when making investment and other major decisions. There are several common outcomes of employing a CBA in the management of a business or company.

    These include:

    • Increase in Revenue and Sales- A CBA helps project how increased production or introduction of a new product would increase sales and revenue generation.
    • Intangible benefits- A CBA helps to include the impacts of intangible costs and benefits while evaluating the viability of a project.
    • Competitive Advantages- Using a CBA takes into account competitive advantage or market share gained from running a campaign/advert or introducing a product.

    Cost-Benefit Analysis in the Real World

    An example of a real-life application of CBA can be illustrated when deciding if to extend transport options in a city. A CBA will involve determining the total costs of constructing and maintaining the mode of transport, discounted costs included. From this, the discount rate can be determined and used to discount the operating cost for the entire life of the transport system. Some of the intangible benefits for a railroad include; value of travel time savings, parking, reliability, road capacity, reduction in bus-related and auto-related accidents. A monetary value is attached to it, and the total benefits are calculated. Both costs and benefits are given in the present value of the planning year. The difference between benefits and costs is determined, and if positive, the railroad is a viable idea. A benefit-cost ratio can be used if greater than 1, the project is viable. A sensitivity analysis can then be performed.

    Frequently Asked Questions (FAQs)

    How does one weigh costs versus benefits?

    In CBA, after the costs and benefits of undertaking a project or initiative have been quantified, they are compared. The decision to proceed or decline the project is purely based on this comparison. If the benefits outweigh the costs, the project should be implemented, and if not, the project should not be implemented.

    What are some methods or tools used in CBA?

    Depending on the situation and type of decision to be made, some of the tools that can be used in CBA include; time value of money/cashflows, e.g., Net Present Value, benefit-cost ratio (BCR), regression modelling, valuation, and forecasting techniques/methods.

    What are the costs and benefits/gains of doing a cost-benefit analysis?

    Well, this will vary from one situation to another. However, common costs include time taken to carefully understand and evaluate the potential costs and rewards, the money paid to analysts/consultants, and wrong or biased forecasts when carrying out predictions.

    If well done, CBA can be used as a guide for making standardized and quantified decisions during investment.

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