What Is A Cost-Benefit Analysis?

The projects a company decides to take on can play a significant part in its growth or decline. As a result, it’s vital that you have a good idea of what a project will cost you and what it will gain you before you begin. One of the best ways to do this is through a cost-benefit analysis.

In this article, we’ll explain what a cost-benefit analysis is, how to conduct one, and the benefits and limitations of this process.

Key Takeaways

• A cost-benefit analysis helps you see whether the benefits of a project will outweight the cost, and vice versa.

• To conduct acost-benefit analysis, first identify all of the potential costs and benefits associated with the project, and assign a value to them.

• Cost-benefit analysis isn’t foolproof or exhaustive, but it is a valuable decision-making tool.

What Is Cost-Benefit Analysis?

Cost-benefit analysis is defined as a systemic process to analyze which decisions to make and which to do without. The process estimates the strengths and weaknesses of any alternatives that can be used to determine the best approach to achieving benefits, while still maintaining financial savings.

Cost-benefit analysis, sometimes referred to as a CBA, will typically involve measurable financial metrics like revenue earned as a result of the decision to pursue a specific project, idea, or investment.

Sometimes, the cost-benefit analysis will include intangible benefits and costs from a decision or idea acted upon, such as employee satisfaction.

The cost-benefit analysis typically has two applications:

1. Determining if an investment is sound by deciding if the benefits outweigh the costs, or if the costs outweigh the benefits.

2. Providing some basis for comparing decisions such as comparing the total expected cost of each option with total expected benefits.

The Cost-Benefit Analysis Process

Now that we understand what a cost-benefit analysis process is, let’s take a look at how to do one. The cost-benefit analysis can be completed in a few steps:

1. Take time to brainstorm all of the costs and benefits you assume are associated with your project. Make a list. These could be things like direct labor, indirect costs such as electricity, rent, or utilities, intangible costs, opportunity costs, or cost of potential risks.

   Then, do the same thing for the benefit of the project. This could include revenue and sales increases, intangible benefits, or competitive advantage.

   Be sure that you think of any unexpected costs that might be associated with the project as well as any unexpected benefits. It’s best to run this by your team or a colleague, as they might think differently than you do.

   Once you’re done with your list, think about how these costs and benefits will impact the project over its entire lifetime.

2. Now, it’s time to assign a value to the costs you’re evaluating. This can include costs of physical resources as well as human effort that might need to be involved in the projects. Think of as many related costs as you can to come up with the most accurate monetary value.

   For example, think about what training might cost. Your employees may be less productive as they develop and learn a new tool or process are a specific project.

   Don’t forget to also think about any costs that might continue once the workload of the project is completed. Will you need additional staff to maintain this project? Will training need to be added quarterly?

3. Now that we’ve assigned value to the costs, it’s time to do the same thing for the benefits. It’s a bit less straightforward, mainly because it’s very difficult to predict the revenue for new products or projects.

   Additionally, some of your benefits might be intangible benefits that are important, but difficult to assign a price to.

   For example, you might see a benefit as a positive impact on the environment, employee or customer satisfaction, or health and safety. To accurately assign value to these things, it’s a good idea to sit down with some stakeholders to decide how they should be valued.

4. The last step of your analysis is to compare the value of your costs to your benefits. Use this analysis to decide your steps forward.

   To do this, you should calculate your total costs and total benefits, then compare the two to determine if the benefits adequately outweigh your costs. You’ll also want to consider the payback time and how long it might take to break even.

   Your equation might look something like this:

   Total cost / Total Revenue (or benefits) = Length of time (Payback Period)

Benefits of Cost-Benefit Analysis

The cost-benefit analysis process may sound tedious, but it’s vital to helping you make good decisions.

• It helps you make wise decisions. Before you start the process of making a big decision, many managers will want to be sure their decisions are right and that their ROI expectations are accurate.

  To determine this important information, many managers will conduct a cost-benefit analysis to evaluate all potential costs and revenues from the project. This is important when pitching the project to leadership teams or even their teams.

  The outcome of the analysis should determine the next steps for the project. Sometimes it will be moving ahead with the initial ideas, sometimes it will be moving forward with some changes, and sometimes it might mean that the project isn’t financially feasible, leading to the decision to pursue a different project.

• It helps you compare options. Many cost-benefit analyses will also factor an opportunity cost into the process. The opportunity cost is an alternative benefit that the company may gain when choosing one alternative over another. An opportunity cost would be foregone or missed as a result of a certain choice or decision. When you factor in these costs, you can weigh the costs and benefits from a different perspective.

Cost-benefit analysis is a great process to take yourself or your team through to consider all options and any missed opportunities. Ensuring you collect all of this information and data before making a final decision is important and allows you to be much more thorough and, ultimately, make better decisions.

Limitations of Cost-Benefit Analysis

Despite its clear strengths, the cost-benefit analysis process does have some limitations you should be aware of.

• It isn’t as in-depth as net present value (NPV). For smaller cost projects or projects that might have a short or intermediate time to completion, an in-depth cost-benefit analysis might be enough to help make an educated, well-thought-out decision.

  However, if you’re working on a long-term project that has a major company-wide impact, a cost-benefit analysis might not be the solution you’re looking for. The cost-benefit analysis might overlook important financial concerns that could include things like inflation, interest rates, and the present value of the currency where you reside.

  You might have better success with a method like alternative capital budgeting analysis methods, like net present value (NPV).

  Net present value states that the amount of money or cash in the present day is worth more than receiving the amount at a later date because the money received today could be invested in something to turn income around.

  Using net present value also uses an alternative rate of return that might have been earned had the project never been implemented or completed.

• It relies on correct forecasts. Cost-benefit analysis can be a little tricky, as it includes forecasts of things such as future revenue or sales. If one or two of these forecasts are off, the results of your analysis can be skewed and questioned by those working on the projects or those responsible for financial decisions. This is one of the major limitations of the cost-benefit analysis.

• It can create a false confidence. Cost-benefit analysis might give you only the illusion that you’ve covered all of your bases when there is much more to know.

  You might be led to believe that you know exactly what to expect and have made a very informed decision when the actual outcome will always depend on how the project unfolds over time.<

• It can remove gut instinct. If you feel strongly that your venture is the right one for your business, even though your cost-benefit analysis shows it might not be worth the expense, you might be wary to move forward.

  However, at the end of the day, you are the only one who can decide if a certain decision is right for you and your business.

Using Cost-Benefit Analysis Within Its Limitations

If you are accurate and feel that you have identified the individual cost and benefit estimates to the best of your ability, the cost-benefit analysis could be the method for you. Performing this kind of analysis can benefit you even if it’s impossible to fully predict every single expense.

Unpredictable situations of expenditures are inevitable in every single venture, but being able to predict them to the best of your ability will help you anticipate curve balls you may not have otherwise planned for.

It can also help you make a more rational decision, forcing you to take your time and plan out the costs you plan to incur. This will help eliminate any emotional decision you may be fearful of making and requires you to look at all of your variables as objectively as possible.

Cost-Benefit Analysis FAQ

1. What is the formula for cost-benefit analysis?

   The formula for cost-benefit analysis is:

   Present value of future benefits / Present value of future costs = Benefit-cost ratio

   To determine how long it will be until your benefits outweight your costs, use this formula:

   Total cost / Total revenue (or benefits) = Length of time (Payback period)

2. What are the five steps of cost-benefit analyisis?

   The five steps of cost-benefit analysis are:

   1. Set your analysis plan.

   2. Identify your costs.

   3. Identify your benefits.

   4. Analyze both costs and benefits.

   5. Make a final recommendation based on your findings.

3. What is a cost-benefits analysis example?

   An example of cost-benefits analysis is a project that is estimated to cost $500,000 and estimated to produce a $550,000 profit. In this example, the manager has added up all of the costs of the equipment, materials, and work hours of the project, which resulted in $500,000.

   Then, he estimated that the project would earn $550,000 in profit based on the number of sales it would create. Finally, he divided $550,000 in benefits by $500,000 in cost, getting a cost-benefit ratio of 1:1.1.

4. What is the purpose of cost-benefit analysis?

   The purpose of cost-benefit analysis is to determine whether or not the benefits of a project will outweigh its costs. This is useful for a variety of business decisions.

   Although this process has its limitations, it can help companies minimize the risk of taking on projects that will cost more than they’ll return.

Final Thoughts

If you’re running or working for a business today, it’s important to make sure you get the most out of every decision you make, whether it be an idea, an option, or an investment.

Depending on your circumstances, this may be a difficult task. However, using a cost-benefit analysis can help individuals within a business make practical yet important decisions.

Using cost-benefit analysis can help you and your teams identify the highest and best return on investment (ROI) you receive, depending on the cost, resources, and risk involved in the decision you’re making.

For example, let’s say you’ve recently taken on a big project at work. However, it’s more complicated than you initially projected and you’re considering a new hire to help keep up with the workload.

To determine the practicality and benefit of bringing a new person to the team, you can use cost-benefit analysis. The benefits of hiring this new employee must outweigh the associated cost.

Author

Caitlin Mazur

Caitlin Mazur is a freelance writer at Zippia. Caitlin is passionate about helping Zippia’s readers land the jobs of their dreams by offering content that discusses job-seeking advice based on experience and extensive research. Caitlin holds a degree in English from Saint Joseph’s University in Philadelphia, PA.