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. If the benefits outweigh the costs, the decision is likely worthwhile for the business.

A cost-benefit analysis doesn't always involve concrete numbers or measurements. Consultants or analysts, for example, could 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 it's 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 projected costs and benefits of a project, both monetary and intangible.

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. Evaluating opportunity cost can make the decision-making process more comprehensive and effective.

Finally, a manager will compare the total 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, the process usually has some variation of the following five steps.

Define 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 overhauling the company website."

In this initial stage, the project planning takes place. This includes:

• Setting a timeline
• Identifying necessary resources
• Understanding constraints
• Determining required personnel
• Selecting evaluation techniques

During this phase, the business should identify key stakeholders who will be impacted by the analysis and give them a chance to provide input on the process. For example, if the outcome would be to renovate a company's website, the IT department may be required to hire multiple additional staff or take on extra work. They should be consulted about the impact this will have on their department, workflow, and other projects.

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.

"Costs" can be financial, such as expenses recorded on an income statement, or non-financial, such as negative repercussions on the community. These costs can be categorized as follows:

• Direct costs: Created by the project, such as labor, inventory, raw materials, and manufacturing expenses
• Indirect costs: Associated or partially associated with the project, such as electricity, overhead costs from management, rent, and utilities
• Intangible costs: Impact that can't be measured directly, such as the impact on customers, employees, or delivery times
• Opportunity costs: Potential benefits lost from choosing this alternative instead of another
• Cost of potential risks: 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, and the benefits might be tangible or intangible. These could include:

• Higher revenue and sales from increased production or new products
• Improved employee safety and morale
• Greater customer satisfaction
• Increased customer retention
• Competitive advantage
• Expanded market share
  

In this stage, the project manager or analyst performing the cost-benefit analysis will need to determine both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales volumes, customer demand, and product expectations. Implicit benefits, 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.

For the analysis to work, each type of benefit will need a monetary value assigned to it.

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
• Running the analysis with different discount rates
• Conducting cost-benefit analysis for multiple options, each with different costs and benefits
• Comparing different options by calculating a 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. It also keeps that information specific to a single problem, rather than over-complicating the decision that needs to be made by considering too many factors at once.

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

Accurately performing a detailed cost-benefit analysis requires capital and resources, such as personnel and dedicated time. For smaller decisions, this may be more expensive than is worthwhile for the project.

A cost-benefit analysis relies heavily on estimates and forecasts. It may be possible to make accurate forecasts for mid-level capital expenditures over short or intermediate periods of time. 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.

If these factors are either over- or underestimated, the entire cost-benefit analysis becomes unreliable.

The Bottom Line

Some complex problems require deeper analysis, and a company can use cost-benefit analysis when it isn't immediately clear whether or not to pursue a new project, expansion, or other 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.