What Is a Cost-Benefit Analysis?
A cost-benefit analysis is a systematic process that businesses use to analyze which decisions to make and which to forgo. The cost-benefit analyst sums the potential rewards expected from a situation or action and then subtracts the total costs associated with taking that action. Some consultants or analysts also build models to assign a dollar value on intangible items, such as the benefits and costs associated with living in a certain town.
- A cost-benefit analysis is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action.
- A cost-benefit analysis involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
- A cost-benefit analysis can also include intangible benefits and costs or effects from a decision such as employees morale and customer satisfaction.
- More complex cost-benefit analysis may incorporate sensitivity analysis, discounting of cashflows, and what-if scenario analysis for multiple options.
- All else being equal, an analysis that results in more benefits than costs will generally be a favorable project for the company to undertake.
Cost-Benefit Analysis (CBA)
Understanding Cost-Benefit Analysis
Before building a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs and revenues that a company might generate from the project. The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.
In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-making process. Opportunity costs are alternative benefits that could have been realized when choosing one alternative over another. In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision.
Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis. By considering all options and the potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.
Finally, the results of the aggregate costs and benefits should be compared quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company should likely avoid the project.
With cost-benefit analysis, there are a number of forecasts built into the process, and if any of the forecasts are inaccurate, the results may be called into question.
The Cost-Benefit Analysis Process
There is no single universally accepted method of performing a cost-benefit analysis. However, every process usually has some variation of the following five steps.
Identify Project Scope
The first step of a cost-benefit analysis is to understand your situation, identify your goals, and create a framework to mold your scope. The project scope is kicked off by identifying the purpose of the cost-benefit analysis. An example of a cost-benefit analysis purpose could be "to determine whether to expand to increase market share" or "to decide whether to renovate a company's website".
This initial stage is where the project planning takes place, including the timeline, resources needed, constraints, personnel required, or evaluation techniques. It is at this point that a company should assess whether it is equipped to perform the analysis. For example, a company may realize it does not have the technical staff required to perform an adequate analysis.
During the project scope development phase, key stakeholders should be identified, notified, and given a chance to provide their input along the process. It may be wise to include those most impacted by the outcome of the analysis depending on the findings (i.e. if the outcome is to renovate a company's website, IT may be required to hire multiple additional staff and should be consulted).
Determine the Costs
With the framework behind us, it's time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs. Costs may include the following.
- Direct costs would be direct labor involved in manufacturing, inventory, raw materials, manufacturing expenses.
- Indirect costs might include electricity, overhead costs from management, rent, utilities.
- Intangible costs of a decision, such as the impact on customers, employees, or delivery times.
- Opportunity costs such as alternative investments, or buying a plant versus building one.
- Cost of potential risks such as regulatory risks, competition, and environmental impacts.
When determining costs, it's important to consider whether the expenses are reoccurring or a one-time cost. It's also important to evaluate whether costs are variable or fixed; if they are fixed, consider what step costs and relevant range will impact those costs.
"Costs" can be financial (i.e. expenses recorded on an income statement) or non-financial (i.e. negative repercussions on the community).
Determine the Benefits
Every project will have different underlying principles; benefits might include the following:
- Higher revenue and sales from increased production or new product.
- Intangible benefits, such as improved employee safety and morale, as well as customer satisfaction due to enhanced product offerings or faster delivery.
- Competitive advantage or market share gained as a result of the decision.
An analyst or project manager should apply a monetary measurement to all of the items on the cost-benefit list, taking special care not to 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 a value to both costs and benefits for a cost-benefit analysis.
Analysts should also be aware of the challenges in determining both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales quantities, customer demands, and product expectations. Implicit costs, on the other hand, may be difficult to calculate as there may be no simple formula. For example, consider the example above about increasing employee satisfaction; there is no formula to calculate the financial impact of happier workers.
Compute Analysis Calculations
With the cost and benefit figures in hand, it's time to perform the analysis. Depending on the timeframe of the project, this may be as simple as subtracting one from another; if the benefits are higher than the cost, the project has a net benefit to the company.
Some cost-benefit analysis require more in-depth critiquing. This may include:
- Applying discount rates to determine the net present value of cashflows.
- Utilizing various discount rates depending on various situations.
- Calculating cost-benefit analysis for multiple options. Each option may have a different cost and different benefit.
- Level-setting different options by calculating the cost-benefit ratio.
- Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes.
Make Recommendation and Implement
The analyst that performs the cost-benefit analysis must often then synthesize findings to present to management. This includes concisely summarizes the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis.
Broadly speaking, if a cost-benefit analysis is positive, the project has more benefits than costs. A company must be mindful of limited resources that might result in mutually-exclusive decisions. For example, a company may have a limited amount of capital to invest; although a cost-benefit analysis of an upgrade to its warehouse, website, and equipment are all positive, the company may not have enough money for all three.
Not all cost-benefit analysis that result in net benefit should be accepted. For example, a company must consider the project's risk, coherence to its company imagine, or capital limitations,
Advantages of Cost-Benefit Analysis
There's plenty of reasons to perform cost-benefit analysis. The technique relies on data-driven decision-making; any outcome that is recommended relies on quantifiable information that has been gathered specific to a single problem.
A cost-benefit analysis requires substantial research across all types of costs. This means considering unpredictable costs and understanding expense types and characteristics. This level of analysis only strengthens the findings as more research is performed on the state of outcome for the project that provides better support for strategic planning endeavors.
A cost-benefit analysis also requires quantifying non-financial metrics (i.e. what is the financial benefit of increased employee satisfaction?). Although this may be difficult to assess, it forces the analyst to consider aspects of the project that are more difficult to measure. The ultimate result of a cost-benefit analysis is to deliver a simple report that makes it easier to make decisions.
Limitations of the 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, a cost-benefit analysis might fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money.
One of the benefits of using the net present value for deciding on a project is that it uses an alternative rate of return that could be earned if the project had never been done. That return is discounted from the results. In other words, the project needs to earn at least more than the rate of return that could be earned elsewhere or the discount rate.
However, with any type of model used in performing a cost-benefit analysis, there are a significant amount of forecasts built into the models. The forecasts used in any cost-benefit analysis might include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If one or two of the forecasts are off, the cost-benefit analysis results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis.
Requires data-driven analysis
Limits analysis to only the purpose determined in the initial step of the process
Results in deeper, potentially more reliable findings
Delivers insights to financial and non-financial outcomes
May be unnecessary for smaller projects
Requires capital and resources to gather data and make analysis
Relies heavily on forecasted figures; if any single critical forecast is off, estimated findings will likely be wrong.
What Are the Five Steps of Cost-Benefit Analysis?
The broad process for a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform analysis of both costs and benefits, and to make a final recommendation. These steps may vary from one process to another.
What Is the Main Goal of Using a Cost-Benefit Analysis?
The main goal of cost-benefit analysis is to determine whether it is worth undertaking a project or task. This decision is made by gathering information on the costs and benefits of that project. Management leverages the findings of a cost-benefit analysis to support whether there are more benefits to a project or if it is more detrimental to a company.
How Do You Weigh Costs vs. Benefits?
Cost-benefit analysis is a systematic method for quantifying and then comparing the total costs to the total expected rewards of undertaking a project or making an investment. If the benefits greatly outweigh the costs, the decision should go ahead; otherwise, it should probably not. Cost-benefit analysis will also include the opportunity costs of missed or skipped projects.
What Are Some Tools or Methods Used in Cost-Benefit Analysis?
Depending on the specific investment or project being evaluated, one may need to discount the time value of cash flows using net present value calculations. A benefit-cost ratio (BCR) may also be computed to summarize the overall relationship between the relative costs and benefits of a proposed project. Other tools may include regression modeling, valuation, and forecasting techniques.
What Are the Costs and Benefits of Doing a Cost-Benefit Analysis?
The process of doing a cost-benefit analysis itself has its own inherent costs and benefits. The costs involve the time needed to carefully understand and estimate all of the potential rewards and costs. This may also involve money paid to an analyst or consultant to carry out the work. One other potential downside is that various estimates and forecasts are required to build the cost-benefit analysis, and these assumptions may prove to be wrong or even biased.
The benefits of a cost-benefit analysis, if done correctly and with accurate assumptions, are to provide a good guide for decision-making that can be standardized and quantified. If the cost-benefit analysis of doing a cost-benefit analysis is positive, you should do it!
The Bottom Line
Some complex problems require deeper analysis, and a company can use cost-benefit analysis when it isn't abundantly clear whether or not to pursue an undertaking. By determining the expenses and identifying what will be favorable, a company can simplify the decision-making process by synthesizing a cost-benefit analysis.