Cost-Benefit Analysis

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What is a 'Cost-Benefit Analysis'

A cost-benefit analysis is a process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed, and then the costs associated with taking that action are subtracted. Some consultants or analysts also build the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town, and most analysts will also factor opportunity cost into such equations.

BREAKING DOWN 'Cost-Benefit Analysis'

Prior to erecting a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis as a means of evaluating all the potential costs and revenues that may be generated if the project is completed. The outcome of the analysis will determine whether the project is financially feasible or if another project should be pursued.

The Cost-Benefit Analysis Process

The first step in the process is to compile a comprehensive list of all the costs and benefits associated with the project or decision. Costs should include direct and indirect costs, intangible costs, opportunity costs and the cost of potential risks. Benefits should include all direct and indirect revenues and intangible benefits, such as increased production from improved employee safety and morale, or increased sales from customer goodwill. A common unit of monetary measurement should then be applied to all items on the list. Care should be taken to not underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning value to both costs and benefits for the purpose of a cost-benefit analysis.

The final step is to quantitatively compare the results of the aggregate costs and benefits to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with project. In not, a review of the project is warranted to see if adjustments can be made to either increase benefits and/or decrease costs to make the project viable. If not, the project may be abandoned.

Limitation of Cost-Benefit Analysis

For projects that involve small to mid-level capital expenditures and are short to intermediate in terms of time to completion, an in-depth cost-benefit analysis may be sufficient enough to make a well-informed rational decision. For very large projects with a long-term time horizon, cost-benefit analysis typically fails to effectively take into account important financial concerns such as inflation, interest rates, varying cash flows and the present value of money. Alternative capital budgeting analysis methods including net present value (NPV) or internal rate of return (IRR) are more appropriate for these situations.

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