What is cost-benefit analysis? How is it used? What are its pros and cons?

A cost-benefit analysis is a systematic process that businesses use to analyze which decisions to make and which to forgo. The cost-benefit analyst sums the potential rewards expected from a situation or action and then subtracts the total costs associated with taking that action. Some consultants or analysts also build models to assign a dollar value on intangible items, such as the benefits and costs associated with living in a certain town.

Understanding cost-benefit analysis
 

Before building a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs and revenues that a company might generate from the project.
 

The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.
 

In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-making process.
 

Opportunity costs are alternative benefits that could have been realized when choosing one alternative over another. In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision.

Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis.
 

By considering all options and the potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.

Finally, the results of the aggregate costs and benefits should be compared quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company should likely avoid the project.
 

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.
 

The first step of a cost-benefit analysis is to understand your situation, identify your goals, and create a framework to mold your scope.
 

The project scope is kicked off by identifying the purpose of the cost-benefit analysis. An example of a cost-benefit analysis purpose could be "to determine whether to expand to increase market share" or "to decide whether to renovate a company's website".

This initial stage is where the project planning takes place, including the timeline, resources needed, constraints, personnel required, or evaluation techniques.

The second step of a cost-benefit analysis is to determine the project costs. Costs may include the direct costs would be direct labor involved in manufacturing, inventory, raw materials, manufacturing expenses, as well as indirect costs might include electricity, overhead costs from management, rent and utilities.
 

When determining costs, it's important to consider whether the expenses are reoccurring or a one-time cost. It's also important to evaluate whether costs are variable or fixed; if they are fixed, consider what step costs and relevant range will impact those costs.
 

Determine the benefits
 

Every project will have different underlying principles; benefits might include higher revenue and sales from increased production or new product, as well as intangible benefits, such as improved employee safety and morale, as well as customer satisfaction due to enhanced product offerings or faster delivery. This also includes competitive advantage or market share gained as a result of the decision.
 

An analyst or project manager should apply a monetary measurement to all of the items on the cost-benefit list, taking special care not to underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning a value to both costs and benefits for a cost-benefit analysis.
 

Analysts should also be aware of the challenges in determining both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales quantities, customer demands, and product expectations. Implicit costs, on the other hand, may be difficult to calculate as there may be no simple formula. For example, consider the example above about increasing employee satisfaction; there is no formula to calculate the financial impact of happier workers.
 

Compute analysis calculations
 

With the cost and benefit figures in hand, it's time to perform the analysis. Depending on the timeframe of the project, this may be as simple as subtracting one from another; if the benefits are higher than the cost, the project has a net benefit to the company.
 

Some cost-benefit analysis requires more in-depth critiquing. This may include applying discount rates to determine the net present value of cashflows, as well as utilizing various discount rates depending on various situations, in addition to calculating cost-benefit analysis for multiple options. Each option may have a different cost and different benefit. This also includes level-setting different options by calculating the cost-benefit ratio, as well as performing sensitivity analysis to understand how slight changes in estimates may impact outcomes.
 

Advantages of cost-benefit analysis
 

There's plenty of reasons to perform cost-benefit analysis. The technique relies on data-driven decision-making; any outcome that is recommended relies on quantifiable information that has been gathered specific to a single problem.
 

A cost-benefit analysis requires substantial research across all types of costs. This means considering unpredictable costs and understanding expense types and characteristics. This level of analysis only strengthens the findings as more research is performed on the state of outcome for the project that provides better support for strategic planning endeavors.
 

A cost-benefit analysis also requires quantifying non-financial metrics (i.e. what is the financial benefit of increased employee satisfaction?). Although this may be difficult to assess, it forces the analyst to consider aspects of the project that are more difficult to measure. The ultimate result of a cost-benefit analysis is to deliver a simple report that makes it easier to make decisions.
 

Limitations of cost-benefit analysis
 

For projects that involve small- to mid-level capital expenditures and are short to intermediate in terms of time to completion, an in-depth cost-benefit analysis may be sufficient enough to make a well-informed, rational decision. For very large projects with a long-term time horizon, a cost-benefit analysis might fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money.

 

Source: Investopedia