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What is a Cost-Benefit Analysis?

definition

Cost-benefit analysis (CBA) is a decision-making process many businesses use to determine the expected pros and cons of particular business decisions.

🤔 Understanding cost-benefit analysis

When companies are making important decisions about the future of their products or operations, they want to know if an action is going to make them money in the long-run. They use a tool called cost-benefit analysis (CBA) to weigh the financial pros and cons of any decision. They calculate the costs and benefits of the decision they’re considering, as well as the opportunity costs of any alternatives they would be forgoing. This process helps companies to determine whether the choices they’re making are in the financial best interest of the company’s future. Despite the advantages of using cost-benefit analysis, it sometimes fails to take into account relevant information for long-term decisions.

example

Suppose Donna owns a small boutique downtown. Business is doing well, and Donna wants to expand her operations. She is weighing the options of either renovating her current shop to make it bigger or buying a larger building in a different part of town. Donna weighs the financial pros and cons of each option using cost-benefit analysis. Using this tool, Donna can determine which option should be more profitable in the long-run.

Takeaway

Cost-benefit analysis is like trying to see into a crystal ball…

It allows you to see into the future (or, at least a reasonable set of guesses about the future) to determine the financial consequences of your actions. Anytime businesses are considering a big decision, they want to use this crystal ball to make sure that whatever choice they make is expected to result in more money for the company in the long-run.

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How does a cost-benefit analysis work?
What are the benefits of cost-benefit analysis?
What are the limitations of cost-benefit analysis?

How does a cost-benefit analysis work?

Many companies use cost-benefit analysis to help them make important short-term and long-term business decisions. While the process likely looks a little different for every company, the steps are roughly the same.

Step 1: Make a list of all costs and benefits

The first thing you’ll need to do to start your cost-benefit analysis is to brainstorm a list of every cost and benefit you expect to come as a result of the project you’re considering.

For the costs, first consider the direct costs. These are the actual costs involved with moving forward with your project or product. The direct costs would include raw materials, labor costs, and manufacturing costs. Be thorough. Will you have to hire more people as a result of a particular project? Will it require equipment you don’t currently have? These are the tangible costs of the project. If we’re talking about a company considering producing a new product, these tangible costs are the cost of goods sold.

Next, consider the indirect costs. Indirect costs are those the company will incur, but that aren’t directly related to production. These costs would include overhead such as rent, utilities, and management. These are tangible costs, but there isn’t a direct correlation between production and these costs.

Finally, you’ll want to look at the intangible costs. Intangible costs are more difficult to pinpoint, but they’re still relevant. Your intangible expenses could include the impact on your employees or the effect on your customers and the way they see your company. Intangible costs could also include the social and environmental impact of a particular decision.

After you’ve compiled a list of the costs, it’s time to list the benefits. The benefits of any given project might include tangible benefits, such as additional revenue and profit. You should also consider intangible benefits such as increased customer satisfaction and public awareness or increased employee productivity.

Step 2: Give each cost and benefit a monetary value

Once you’ve listed all of your expenses and benefits, you have to give them an actual monetary value. This part can be difficult, especially given that many of the items on your list are likely intangible. It can also be tough to guess just how much of an impact a particular project will have on your future revenues. But you still have to quantify everything.

Other costs and benefits will be easier to put a number on. You can probably accurately estimate how much it will cost to produce a product or go forward with a project.

Step 3: Calculate the benefit-cost ratio

Once you have a list of all of your costs and benefits and you know what the expected price tag is for those items, it’s time to run your benefit-cost analysis. What we’re looking for here is the benefit-to-cost ratio.

First, add up the monetary value of each (meaning the sum of all of your costs and the sum of all of your benefits). Then, you’re going to take the total dollar value of your benefits and divide it by the total dollar value of your costs.

The resulting number is your benefit-to-cost ratio. If the number is more than one, your benefits outweigh your costs. The higher the number, the more your benefits outweigh your costs. If the number is less than one, your costs exceed your benefits.

To determine whether a project is the best business decision, you want to see a ratio above one — The higher the number, the better.

Example of a cost-benefit analysis

Now that we’ve covered the technicalities of how to do a cost-benefit analysis, let’s put what we know into practice. To do this, let’s return to our example of Donna and her boutique. Remember, Donna’s business is doing well, and she is weighing her options of either moving to a larger location or renovating her current space. To determine which option will be more profitable for Donna, we’ll run a cost-benefit analysis on each option.

Let’s start with the option of moving to a larger space. Donna estimates this plan would have the following costs:

  • Cost of a new building: $100,000
  • Cost of new staff: $50,000
  • Cost of inventory to fill the larger space: $25,000
  • Moving expenses: $10,000
  • Increased utility costs: $5,000
  • Marketing costs to let her customers know about the move: $5,000

Donna’s total costs to move to a new space would be $195,000.

Next, let’s make a list of the benefits Donna will see from moving to a new space:

  • Sale of her current building: $75,000
  • Increase in revenue as a result of the new location, more extensive inventory, and added marketing: $150,000.

Donna’s total benefit from the move would be $225,000.

To find the benefit-to-cost ratio of moving to a new location, we can use the following formula:

Benefit-cost ratio = total benefits Ă· total costs

The benefit-to-cost ratio for Donna moving her business to a new location is 1.15. Because the number is higher than one, the benefits of the move, as estimated look to outweigh the costs. But we can’t determine if it’s the right option for Donna until we run the analysis on the option of Donna renovating her current space.

Donna estimates she’ll have the following costs if she renovates her current space:

  • Renovation costs: $25,000
  • Cost to close her shop for two weeks for renovations: $10,000
  • Cost of inventory to fill the larger space: $10,000

Donna’s total costs to renovate her new space are $45,000

Next, Donna estimates the following benefits of renovating her current space:

  • Increase in revenue as a result of the larger shop and larger inventory: $75,000

Donna’s total benefits from the renovation would be $75,000.

Taking those numbers into account, we can determine that the benefit-to-cost ratio for renovating her current space is 1.67. This number is higher than one, so we know the benefits outweigh the costs. The number is also higher than the benefit-to-cost ratio for moving to a larger space. Using this information, Donna would probably decide to stay in her current location.

What are the benefits of cost-benefit analysis?

A cost-benefit analysis can be a valuable tool for businesses to use to determine the impact and profitability of specific business decisions. First, this analysis can help firms to analyze the pros and cons of a single business decision. By putting a monetary value on all tangible and intangible costs and benefits, companies can ensure that a project should create a positive return on investment in the long run.

Cost-benefit analysis is also incredibly beneficial when it comes to comparing the outcomes of alternate business decisions. Companies have to weigh various options all the time. Should they produce Product A or Product B? Should they hire Project Manager Y or Project Manager Z? By using a cost-benefit analysis, they not only find out if their decisions should result in a profit, but if their choices are expected to result in more profit than the alternatives.

Additionally, every decision has an opportunity cost. When you choose to spend $5,000 on vacation instead of investing that $5,000 in the stock market, your opportunity cost is the returns you would have gotten from your investment. It works the same way with business decisions. With every significant business decision, the opportunity cost is the profit they could have made from a different choice. With a cost-benefit analysis, companies can look at all of those factors at once.

What are the limitations of cost-benefit analysis?

Despite the benefits of using the cost-benefit analysis tool, it’s not perfect. There are flaws in a cost-benefit analysis that can lead to inaccuracies in the results.

Inaccurate data

A cost-benefit analysis is only as good as the data you use. Unfortunately, there’s typically quite a bit of guesswork involved in a cost-benefit analysis, which means you have imperfect information.

Specific components of the cost-benefit analysis are particularly tricky to predict. For example, adding a monetary value to your increased revenues from a new product is generally just a guessing game. You might have a product you think will slightly increase revenues, and it becomes your most popular product. You also might put out a new product you think people will love, and instead, it falls flat.

It can also be challenging to estimate the monetary value of intangible costs. For example, a particular business decision might have a significant impact on employee satisfaction. You couldn’t have predicted it, but it ends up having a substantial effect on your bottom line.

Ultimately, there’s a lot of room for human error and inaccurate guesswork.

Market uncertainty

As a business owner, you have very little control over what happens to the market. And unfortunately, it can be challenging to predict significant changes in the market.

Going back to our example of Donna’s boutique, a change in the market could have a significant impact on her numbers. She can estimate how much she expects revenue to increase if she moves her store to a larger location. But what happens if the market takes a turn for the worse?

During a recession, people might spend less money at trendy local boutiques, since they don’t see them as a necessity. If Donna had spent a lot of money buying her new shop, and then a recession hit, she would likely see her profit margins decline unexpectedly. Her cost-benefit analysis couldn’t have predicted that.

Other movements in the market could also make the results of the cost-benefit analysis inaccurate. For example, what if Donna had decided to renovate her current space, and then a competing boutique opened next door? While Donna’s shop closes for renovations, her customers instead visit the new boutique. Some of them become regular customers of that shop instead of hers, and she’s lost that business. That’s another example of a market event that Donna likely couldn’t have included in her cost-benefit analysis.

Not the best tool for long-term projects

A cost-benefit analysis can be very valuable for short-term results but isn’t necessarily accurate for long-term effects. There are many factors such as inflation and interest rates that vary over many years that the cost-benefit analysis doesn’t take into account.

For these long-term projections, it might be better to turn to net present value, which is a tool that investors and businesses can use to determine the profitability of different investments over many years.

The purpose of the net present value is to evaluate the current value of future dollars. It’s based on the principle that money today is worth more than the same amount of money in the future. The tool uses a discount rate to take into account certain factors like inflation and risk to compare different investment options.

Because it is specifically meant to analyze long-term values, it is often better suited to that purpose than the cost-benefit analysis.

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