Loading the player...

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.

  1. Shadow Pricing

    1. The actual market value of one share of a money market fund. ...
  2. Shadowing

    The process of creating values for variables that don't rely ...
  3. Capital Investment Analysis

    Capital investment analysis is a budgeting procedure that companies ...
  4. Marginal Analysis

    An examination of the additional benefits of an activity compared ...
  5. Capital Project

    A long-term investment made in order to build upon, add or improve ...
  6. Financial Analysis

    The process of evaluating businesses, projects, budgets and other ...
Related Articles
  1. Personal Finance

    Cost-Benefit Analysis: The Key To Your Financial Life

    Using cost-benefit analysis can leave you with a lot more money in your wallet without a decline in your standard of living.
  2. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  3. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
  4. Investing

    The Most Important Factors for Investing in Real Estate

    It's a little more complicated than "location, location, location."
  5. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  6. Investing

    Style Matters In Financial Modeling

    If you're looking to get a job as an analyst, you'll need to know how to work it.
  7. Personal Finance

    A project manager's qualifications and career path

    Learn about a project manager's job, the qualifications necessary for the position, and the most common careers for these professionals.
  8. Managing Wealth

    How to Calculate Your Tangible Net Worth

    You can calculate your tangible net worth with a simple equation.
  9. Investing

    Explaining Amortization In The Balance Sheet

    Read to find out more about amortization, an important way to account for the value of intangible assets.
  1. How do companies use marginal analysis?

    Find out how and why companies rely on marginal analysis, particularly when developing a cost-benefit approach for future ... Read Answer >>
  2. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  3. How do you calculate costs of capital when budgeting new projects?

    Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
  4. How do you use internal rate of return to calculate a capital budget?

    Learn about how the internal rate of return is used in the creation of a capital budget along with net present value and ... Read Answer >>
  5. What are the different types of costs in cost accounting?

    Cost accounting aids in decision-making processes by allowing a company to evaluate its costs. Some types of costs in cost ... Read Answer >>
  6. What is the difference between a spot rate and a forward rate?

    Understand the concept of intangible assets and learn how they are handled in the purchase agreement when a company is bought ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  3. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  4. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  5. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  6. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
Trading Center