A cost-benefit analysis is a process a business can use to analyze decisions according to the costs associated with making that decision. For a cost analysis to be effective it’s important to articulate the project in the simplest terms possible, identify the costs, determine the benefits of project implementation, assess the alternatives.
- Understanding a cost-benefit analysis
- Performing a cost-benefit analysis
- Cost-benefit analysis best practices
- Key takeaways
Understanding a cost-benefit analysis
Before undertaking any new project, a business must conduct a cost-benefit analysis (CBA) to determine whether the project is financially viable. In other words, does the forecast revenue exceed the forecast costs?
A cost-benefit analysis is also important in guiding the decisions that are made within a project. This gives project managers a systematic approach to determining the worthiness of various transactions, tasks, investments, and other business requirements.
Ultimately, the cost-benefit analysis gives project managers objective guidance on the approach that will best minimize costs. It also prevents businesses from falling in love with ideas that sound good on paper but which do not generate any return on investment.
Performing a cost-benefit analysis
There is no universal approach to performing a cost-benefit analysis, but certain steps will apply to most businesses and industries:
1 – Articulate the project in the simplest terms possible
First, the project must be clearly articulated and defined in simple terms. This step is important because clarity in defining the problem leads to less clarification work later on.
For example, a farm machinery company looking to add new models to its fleet should assess each model based on whether or not consumers would buy it. It should not, on the other hand, look to increase its fleet based on unpredictable future climate cycles or commodity prices.
2 – Identify the costs
When identifying the costs, it’s crucial that businesses think laterally and include:
- Direct costs – manufacturing, inventory, and raw materials.
- Indirect costs – rent, electricity, and other utilities.
- Intangible costs – or impacts a decision will have on relevant stakeholders.
- Opportunity costs – for example, the costs associated with hiring new staff members versus outsourcing the work temporarily.
- Risk costs – or the costs associated with risks related to environment, compliance, or competition.
3 – Determine the benefits of project implementation
Are real or perceived benefits worthy of investment? That is, do the benefits align with broader company goals or objectives?
Benefits might encompass:
- Revenue and sales.
- Enhanced employee safety or morale.
- Customer satisfaction through faster delivery or valuable product offerings.
- Competitive advantage and attainment of market share.
4 – Assess the alternatives
Does there exist a more economical way of achieving the aforementioned benefits? This process is called the opportunity cost, defined as the benefits that are realized when choosing one alternative over another.
Regardless of whether an alternative course of action exists, compare the total costs against the total benefits to make the most informed decision. Businesses can do this by considering the payback period, or the period required for the business to recoup costs and break even.
Cost-benefit analysis best practices
- The CBA is best suited to projects involving policy development, capital expenditure, asset usage, and protocol establishment. Each will require a robust economic analysis that may require the external consultation of an experienced evaluator.
- The most effective cost-benefit analyses consider a broad and holistic view of costs and benefits over the short and long term. By ensuring that the analysis is comprehensive, there is more chance that every affected stakeholder will be included.
- Much of the risk involved with this analysis lies in subjectivity. Stakeholders or other interested parties can sometimes exaggerate benefits while understating costs. There can also be a reliance on historical data to predict future trends. In this situation, businesses must perform a rigorous initial analysis to counteract any pre-existing biases
- A cost-benefit analysis provides an objective assessment of the costs and benefits of taking a particular action.
- A cost-benefit analysis begins with clearly defining a simple problem and identifying the costs and benefits in the context of company objectives. Then, alternatives are assessed according to the time required to realize profitability.
- A cost-benefit analysis is a broad and holistic analysis that should include all relevant stakeholders. But it does require that businesses maintain objectiveness without reliance on historical data or pre-existing biases.