You have often herd the term cost benefit analysis. The business leaders, top management and policy makers has to take certain crucial decisions related to a business case, project or policy. Some examples of these instances are as follows:
Whether a project is feasible or not?
Is it profitable to invest in a particular business?
Will this policy will be beneficial to the public or not?
Which alternative solution regarding a business issue is more suitable?
These crucial decisions require evaluation and analysis of the particular business case, project or the policy and based on that analysis, crucial decisions regarding acceptance or rejection of a proposal or selection of the most cost effective alternative is taken. Cost Benefit analysis is such a process to evaluate and analyze the business proposals, projects or policies so that best decision regarding a particular business problem or project proposal can be made. We will learn more about the cost benefit analysis in this article.
What is Cost Benefit Analysis?
The cost benefit analysis is a process to estimate the cost and benefits of a project or proposal to make the most cost effective decision. In other words, a cost benefit analysis is the process of comparing the projected or estimated costs and benefits of a project or business proposal to arrive at whether it makes any sense to go ahead with the business or project proposal! The cost benefit analysis (also called CBA) is a common method used by businesses, project authorities and policy makers to make the appropriate decision.
Generally, the cost benefit analysis is adding up all the projected costs associated with a project or business proposal and subtracting all the potential benefits to be derived from that project or business proposal.
If the potential benefits are more than the project or business proposal costs, it means that the particular project or the business proposal is good and it makes sense to go ahead with that project or business proposal.
Cost benefit analysis is basically a data driven decision making which is widely used by decision makers in companies, project managers, policy makers, etc.
Steps Followed in Cost Benefit Analysis
Step 1: Identify The Project Scope
The first step of cost benefit analysis is to determine the objectives of the analysis and establish a framework within which you are conducting the analysis. The identification of the purpose of cost benefit analysis is utmost important.
At this stage, the planning takes place which includes the timeline, resources needed, constraints, personnel required, or evaluation techniques. The assessment of the resources needed for the analysis is crucial at this stage.
The key stakeholders are identified and their input is secured at this stage only.
Step 2: Identify The Costs
The second step of the analysis is cost identification of the project or business proposal. The costs may have following components:
Direct costs: These costs are directly associated with the project like manufacturing, inventory, raw materials, manufacturing expenses.
Indirect Costs: Indirect costs are not directly associated with a project but they impact the project indirectly. These costs include various overhead costs like electricity, rent, utilities, back office support costs, etc.
Intangible Costs: These costs are difficult to measure in monitory terms. Few example of these costs are decrease in productivity of the current business due to new business processes, reduced customer satisfaction due to change in customer service processes after new business, etc.
Opportunity Costs: These costs are related to lost benefit that would have arrived when the resources being considered in the current business were utilized somewhere else, such as other investments, other alternative business, etc.
Other Costs: Costs arise from potential risk such as environmental aspects, competition, regulatory risks, etc. come under other costs.
Step 3: Determine the Benefits
The benefits from the business or the project are determined in this step. Every business has potential benefits, such as:
Direct: Increased revenue and sales due to new business.
Indirect: Such as increased employee morale due to increase in business, increased customer satisfaction, enhancement in brand value, etc.
Competitive: Increase in market share, gain in competitive advantage due to new business decision.
Step 4: Assign a Value to Costs and Benefits
After compilation of all the costs and benefits of the new project or business proposal, now it’s time to assign monitory value to these costs and benefits. Assigning monitory value to the costs and benefits is mandatory to compare these with each other.
It is important to note here that although the direct costs and benefits can be easily quantified, it is difficult to quantify the indirect costs and benefits. However, there are many software and methodologies available now a day, by which you can quantify these indirect costs and benefits.
Once the monitory values are assigned to these costs and benefits, you can tally up each list for the next step.
Step 5: Compare the Benefits with Costs and
Now you can compare the costs and benefits for making the conclusion. If the total benefits outweigh the total costs, it means that it makes sense to proceed with the business case or the project proposal. If the total cost outnumbers the total benefits, it means, that the proposed project or the business case is not cost effective and you may reconsider it. You can also look at the framework of analysis as established in the step 1 to ascertain whether the analysis is fulfilling its objective or is there any shortfall.
Step 6: Arrive at Conclusion and Implement the Recommendation
Finally, the findings of the analysis are summarized and compiled in a report. concisely summarizes the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis. It also incorporated the recommendation on the basis of the outcome of the analysis. That report is presented to the management or the decision making authorities for further action. The management then implements the recommendations of the analysis in the interest of the organization.
Advantages and Disadvantages of Cost Benefit Analysis
Advantages of Cost Benefit Analysis
The cost benefit analysis relies on data driven decision making and the outcome of the data is based on the quantifiable information that has been collected for a specific problem. The analysis requires substantial research regarding all the projected costs and benefits of the proposed project or business case. It also requires quantification of intangible costs and benefits. The cost benefit analysis helps decision makers in taking informed decisions which are based on substantial research and quantitative analysis.
Disadvantages of Cost Benefit Analysis
There are some limitations of the cost benefit analysis also. It is suitable for the projects involving short to medium capital expenditure and having small time of completion. For very large projects having longer duration, the cost benefit analysis might not give the accurate results due to important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money.
Another limitation of this analysis is that it is based on various forecasts which may include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If any of these forecasts are not accurate, then the outcome of the analysis may not be correct.
The pros and cons of the cost benefit analysis are summarized in the table below:
|Based on the data driven analysis
|May not be suitable for projects involving high capital expenditure and having long period of completion
|Makes decision making process simple
|Difficult to predict all variables
|Considers hidden costs and benefits
|May give incorrect results, if any of the forecasts is inaccurate
|Quantify intangible costs and benefits
|Removes the human elements
Cost benefit analysis is an excellent tool which can help in simplifying the decision making process. It compares the projected costs and benefits of a project or business proposal to determine whether it is a cost effective alternate or not. It is based on a data driven analysis and reveals hidden costs and benefits also. However, there are some limitations of this method also such as it is not suitable for projects involving high capital expenditure and having long period of completion, it may give incorrect results, if any of the forecasts is inaccurate, it’s difficult to predict all variables, it removes human element, etc. It is widely used by decision makers in companies, project managers, policy makers, etc.