Cost-Benefit Analysis: How It's Used, Pros and Cons

What Is a Cost-Benefit Analysis?

A cost-benefit analysis (CBA) is a process of comparing the projected costs and benefits of a decision to determine its feasibility. Businesses can determine whether a decision is worthwhile by summing up the potential rewards expected from an action and subtracting the associated costs. Consultants or analysts may also create models to assign a dollar value to intangible factors, such as the benefits and costs of living in a particular town.

Understanding Cost-Benefit Analysis

Cost-benefit analysis (CBA) estimates and assesses the value of a project's benefits and costs to determine whether or not its worth pursuing. Originating from the work of Jules Dupuit and Alfred Marshall and developed further by the U.S. Corps of Engineers in the 1930s, CBA involves comparing all current and future monetary costs and benefits of a project.

Before taking on a new project, prudent managers perform a CBA to evaluate all the potential costs and revenues it might generate. The analysis's outcome determines whether the project is financially viable or whether a company should consider other alternatives.

Many CBA models also factor opportunity cost into the decision-making process. Opportunity cost represents the potential benefits a business misses out on when choosing one alternative over another. It accounts for the value of the next best option that isn't selected, highlighting the trade-offs involved in any decision. Opportunity cost can make the decision-making process more comprehensive and effective.

Finally, a manager will quantitatively compare the aggregate costs and benefits to determine if the benefits outweigh the costs. If they do, the rational decision is to proceed with the project. If not, the business reviews the project to see if adjustments can be made to increase benefits or decrease costs to make it viable. Otherwise, the project should likely be avoided.

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 the Project's Scope

The first step in a cost-benefit analysis is understanding the current situation, identifying goals, and establishing a framework to define the project scope. Begin by determining the purpose of the cost-benefit analysis. For example, the purpose might be "to decide whether to expand to increase market share" or "to evaluate the benefits of renovating the company website."

In this initial stage, the project planning takes place, including setting the timeline, identifying necessary resources, understanding constraints, determining required personnel, and selecting evaluation techniques. At this point, a company should assess whether it's equipped to perform the analysis, such as having the technical staff needed for an adequate assessment.

During the project scope development phase, key stakeholders should be identified, notified, and given a chance to provide their input. Depending on the findings, it may be wise to include those most impacted by the analysis's outcome (e.g., 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 you, it's time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs. These costs can be categorized as follows:

• Direct costs: Include labor, inventory, raw materials, and manufacturing expenses
• Indirect costs: Might include electricity, overhead costs from management, rent, and utilities
• Intangible costs: Refer to the decision's impact on customers, employees, or delivery times
• Opportunity costs: The potential benefits lost when choosing one alternative over another. For example, investing in a new plant rather than building one falls under this category.
• Cost of potential risks: Such as regulatory risks, competition, and environmental impacts

When determining costs, consider if they're recurring or one-time expenses. Additionally, evaluate whether costs are variable or fixed. For fixed costs, consider step costs and relevant ranges that could impact those expenses.

Determine the Benefits

Every project will have different underlying principles; benefits might include the following:

• Higher revenue and sales from increased production or new products.
• Intangible benefits, such as improved employee safety and morale and greater customer satisfaction due to enhanced product offerings or faster delivery times.
• Competitive advantage or market share gained as a result of the decision.

Analysts or project managers should assign a monetary value to all items on the cost-benefit list, and be careful not to underestimate costs or overestimate benefits. A conservative approach that avoids subjective tendencies when calculating estimates is best for assigning value to costs and benefits in a cost-benefit analysis.

Analysts should also know the challenges in determining explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales volumes, customer demand, and product expectations. Implicit costs, such as the impact of increased employee satisfaction, may be difficult to quantify as there's no straightforward formula to calculate the financial effect of happier workers.

Compute Analysis Calculations

With the cost and benefit figures in hand, it's time to perform the analysis. This involves concisely summarizing the costs, benefits, net impact, and how the findings support the original purpose of the analysis.

However, some cost-benefit analyses require more detailed examination. This may include:

• Applying discount rates to determine the net present value of cash flows.
• Using various discount rates depending on different scenarios.
• Conducting cost-benefit analysis for multiple options, each with different costs and benefits.
• Comparing 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

If a cost-benefit analysis is positive, the project offers more benefits than costs. However, a company must consider its limited resources, which may force it to make mutually exclusive decisions. For example, a company with limited capital might find positive cost-benefit analyses for upgrading its warehouse, website, and equipment, but it may not have enough funds to pursue all three projects at the same time.

Advantages of Cost-Benefit Analysis

There are many reasons to perform a cost-benefit analysis. The technique relies on data-driven decision-making, with recommendations based on quantifiable information specific to a single problem.

A cost-benefit analysis requires substantial research across all costs, including unpredictable ones, and a thorough understanding of expense types and characteristics. This extensive research strengthens the findings and supports strategic planning efforts.

A cost-benefit analysis also requires quantifying non-financial metrics, such as the financial benefit of increased employee satisfaction. Although challenging to assess, this process forces the analyst to consider aspects of the project that are harder to measure. The ultimate goal is to deliver a straightforward report that simplifies decision-making.

Limitations of Cost-Benefit Analysis

An in-depth cost-benefit analysis may suffice for making a well-informed, rational decision for projects that involve small- to mid-level capital expenditures and short to intermediate completion times. However, for large projects with a long-term time horizon, a cost-benefit analysis might overlook critical factors, such as inflation, interest rates, varying cash flows, and the present value of money.

Using net present value (NPV) in project decisions offers the benefit of considering an alternative rate of return that could be earned if the project weren't undertaken. A positive NPV indicates that the projected earnings exceed the anticipated costs, making the project a worthwhile investment, while a negative NPV suggests the opposite.

However, any cost-benefit analysis model includes numerous forecasts, such as future revenue, alternative rates of return, expected costs, and future cash flows. If one or two forecasts are inaccurate, the cost-benefit analysis results could be questioned, highlighting the limitations of this approach.

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 decision-making by synthesizing a cost-benefit analysis.

However, it's crucial to be aware of the limitations and challenges of CBA. Although it provides a structured method for decision-making, its accuracy relies heavily on the precision of forecasts and assumptions. Incorrect estimates of future costs or benefits can result in faulty conclusions. Despite these challenges, when performed with careful consideration and accurate data, CBA is a valuable tool for strategic planning and resource allocation.