Question

Why do you think so many approaches exist in cost-benefits analysis, and how would you determine which to use?

Answer 1

Cost-Benefit Analysis defination and introduction

A cost-benefit analysis is a process businesses use to analyze decisions. The business or analyst sums the benefits of a situation or action and then subtracts the 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.

Jules Dupuit, a French engineer and economist, introduced the concepts behind CBA in the 1840s. It became popular in the 1950s as a simple way of weighing up project costs and benefits, to determine whether to go ahead with a project.

As its name suggests, Cost-Benefit Analysis involves adding up the benefits of a course of action, and then comparing these with the costs associated with it.

The results of the analysis are often expressed as a payback period – this is the time it takes for benefits to repay costs. Many people who use it look for payback in less than a specific period – for example, three years.

You can use the technique in a wide variety of situations. For example, when you are:

• Deciding whether to hire new team members.
• Evaluating a new project or change initiative.
• Determining the feasibility of a capital purchase.

However, bear in mind that it is best for making quick and simple financial decisions. More robust approaches are commonly used for more complex, business-critical or high cost decisions.

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.

KEY TAKEAWAYS

• A cost-benefit analysis (CBA) is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action.
• A CBA involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
• A CBA can also include intangible benefits and costs or effects from a decision such as employee morale and customer satisfaction.

The Cost-Benefit Analysis Process

A cost-benefit analysis (CBA) should begin with compiling a comprehensive list of all the costs and benefits associated with the project or decision.

The costs involved in a CBA might include the following:

• Direct costs would be direct labor involved in manufacturing, inventory, raw materials, manufacturing expenses.
• Indirect costs might include electricity, overhead costs from management, rent, utilities.
• Intangible costs of a decision, such as the impact on customers, employees, or delivery times.
• Opportunity costs such as alternative investments, or buying a plant versus building one.
• Cost of potential risks such as regulatory risks, competition, and environmental impacts.

Benefits might include the following:

• Revenue and sales increases from increased production or new product.
• Intangible benefits, such as improved employee safety and morale, as well as customer satisfaction due to enhanced product offerings or faster delivery.
• 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.

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.

Important -With cost-benefit analysis, there are a number of forecasts built into the process, and if any of the forecasts are inaccurate, the results may be called into question.

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.

Alternative capital budgeting analysis methods, including net present value, could be more appropriate for these situations. The concept of present value states that an amount of money or cash in the present day is worth more than receiving the amount in the future since today's money could be invested and earn income.

One of the benefits of using net present value for deciding on a project is that it uses an alternative rate of return that could be earned if the project had never been done. That return is discounted from the results. In other words, the project needs to earn at least more than the rate of return that could be earned elsewhere or the discount rate.

However, with any type of model used in performing a cost-benefit analysis, there are a significant amount of forecasts built into the models. The forecasts used in any CBA might include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If one or two of the forecasts are off, the CBA results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis.

We can determine the suitable cost benefit analysis process by following methods

Key Points

Cost-benefit analysis is a relatively straightforward tool for deciding whether to pursue a project.

To use the tool, first list all the anticipated costs associated with the project, and then estimate the benefits that you'll receive from it.

Where benefits are received over time, work out the time it will take for the benefits to repay the costs.

You can carry out an analysis using only financial costs and benefits. However, you may decide to include intangible items within the analysis. As you must estimate a value for these items, this inevitably brings more subjectivity into the process.

To Use the cost benefit analysis tools

Follow these steps to do a Cost-Benefit Analysis.

Step One: Brainstorm Costs and Benefits

First, take time to brainstorm  all of the costs associated with the project, and make a list of these. Then, do the same for all of the benefits of the project. Can you think of any unexpected costs? And are there benefits that you may not initially have anticipated?

When you come up with the costs and benefits, think about the lifetime of the project. What are the costs and benefits likely to be over time?

Step Two: Assign a Monetary Value to the Costs

Costs include the costs of physical resources needed, as well as the cost of the human effort involved in all phases of a project. Costs are often relatively easy to estimate (compared with revenues).

It's important that you think about as many related costs as you can. For example, what will any training cost? Will there be a decrease in productivity while people are learning a new system or technology, and how much will this cost?

Remember to think about costs that will continue to be incurred once the project is finished. For example, consider whether you will need additional staff, if your team will need ongoing training, or if you'll have increased overheads.

Step Three: Assign a Monetary Value to the Benefits

This step is less straightforward than step two! Firstly, it's often very difficult to predict revenues accurately, especially for new products. Secondly, along with the financial benefits that you anticipate, there are often intangible, or soft, benefits that are important outcomes of the project.

For instance, what is the impact on the environment, employee satisfaction, or health and safety? What is the monetary value of that impact?

As an example, is preserving an ancient monument worth $500,000, or is it worth $5,000,000 because of its historical importance? Or, what is the value of stress-free travel to work in the morning? Here, it's important to consult with other stakeholders and decide how you'll value these intangible items.

Step Four: Compare Costs and Benefits

Finally, compare the value of your costs to the value of your benefits, and use this analysis to decide your course of action.

To do this, calculate your total costs and your total benefits, and compare the two values to determine whether your benefits outweigh your costs. At this stage it's important to consider the payback time, to find out how long it will take for you to reach the break even point – the point in time at which the benefits have just repaid the costs.

For simple examples, where the same benefits are received each period, you can calculate the payback period by dividing the projected total cost of the project by the projected total revenues:

Total cost / total revenue (or benefits) = length of time (payback period).

Example

Custom Graphic Works has been operating for just over a year, and sales are exceeding targets. Currently, two designers are working full-time, and the owner is considering increasing capacity to meet demand. (This would involve leasing more space and hiring two new designers.)

He decides to complete a Cost-Benefit Analysis to explore his choices.

Assumptions

• Currently, the owner of the company has more work than he can cope with, and he is outsourcing to other design firms at a cost of $50 an hour. The company outsources an average of 100 hours of work each month.
• He estimates that revenue will increase by 50 percent with increased capacity.
• Per-person production will increase by 10 percent with more working space.
• The analysis horizon is one year: that is, he expects benefits to accrue within the year.

Costs

Category	Details	Cost in First Year
Lease.	750 square feet available next door at $18 per square foot	$13,500
Leasehold improvements.	Knock out walls and reconfigure office space	$15,000
Hire two more designers.	Salary, including benefits Recruitment costs Orientation and training	$75,000 $11,250 $3,000
Two additional workstations.	Furniture and hardware Software licenses	$6,000 $1,000
Construction downtime.	Two weeks at approximately $7,500 revenue per week	$15,000
Total	$139,750

Benefits

Benefit	Benefit Within 12 Months
50 percent revenue increase.	$195,000
Paying in-house designers $15 an hour, versus $50 an hour outsourcing (100 hours per month, on average: savings equals $3,500 a month.)	$42,000
10 percent improved productivity per designer ($7,500 + $3,750 = $11,250 revenue per week with a 10 percent increase = $1,125/week.)	$58,500
Improved customer service and retention as a result of 100 percent in-house design.	$10,000
Total	$305,500

He calculates the payback time as shown below:

$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows that come in over a number of periods of time, particularly where returns vary from period to period. In these cases, use Net Present Value  (NPV) and Internal Rate of Return  (IRR) calculations together to evaluate the project, rather than using Cost-Benefit Analysis. (These also have the advantage of bringing "time value of money" into the calculation.)

Also, the revenue that will be generated by a project can be very hard to predict, and the value that people place on intangible benefits can be very subjective. This can often make the assessment of possible revenues unreliable (this is a flaw in many approaches to financial evaluation).