Cost-benefit analysis definition
/What is a Cost-Benefit Analysis?
Cost-benefit analysis involves weighing the costs associated with a decision against the benefits arising from that decision. The analysis is used to decide whether to proceed with a course of action or not. Cost-benefit analysis can include both quantitative factors and qualitative factors. For example, the analysis of a decision to construct a facility in a particular city could include quantitative factors, such as the amount of tax breaks that can be obtained, as well as qualitative factors, such as the rating of the schools in that city to which workers would send their children. This approach is quite useful for clarifying the issues associated with a decision.
For decisions involving large amounts of invested funds, the emphasis of a cost-benefit analysis tends to be on the cash flows associated with the investment. This may include the initial and subsequent investment of funds, as well as the tax effects of depreciation, maintenance costs, and projected price points. In this situation, qualitative factors tend to be addressed after a "hard" quantitative analysis has already been completed.
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When to Use Cost-Benefit Analysis
Cost-benefit analysis works best when most of the costs and benefits associated with a decision can be reduced to financial terms, so that they can be more easily compared. In addition, the analysis is most effective when there are few qualitative issues impacting the decision. When there are significant qualitative components associated with a decision, it is nearly impossible to reduce the decision down to a quantitative outcome.
How to Do a Cost-Benefit Analysis
There is no standardized format used for constructing a cost-benefit analysis, but the following steps would be of use in most situations:
Determine what is and is not included in the decision. It is important to put boundaries around the decision model, to keep any excess items from being included. This involves creating a tightly-defined definition of the decision. Thus, the definition of a decision to construct a building is too poorly-defined if it is “whether to construct a new corporate headquarters building,” and could be better defined as “whether to construct a 70,000 square foot headquarters building on the corner of 8th and Main Street.”
Classify all costs and benefits associated with the decision by type, and create a formal listing of them. This should at least include all direct costs, which are those costs that will be incurred or not incurred as a result of the decision. If there are uncertainties about certain costs, then obtain a range of values, including the highest, lowest, and most likely costs for each cost item. All three options may need to be considered in later steps, especially when they impact the overall cost-benefit of a decision.
Work through the list, verifying when each one will be incurred, and develop a present value for each one. A present value requires the use of a discount rate, which may be either the current market rate or a firm’s weighted average cost of capital. If there is a range of possible discount rates, consider calculating present values for the highest, lowest, and most likely discount rates, to see how these variations impact the outcome of the analysis.
Compare the resulting present values of the costs and benefits.
Evaluate the results and consider any intangible cost and benefits not quantified in the analysis. These items may be significant, especially if they materially impact the reputation of the business.
Consider the impact of the decision on all stakeholders who may be impacted by it.
It can be useful to formally identify each cost and benefit, and how it was developed. A second person can then review this documentation and question any items for which the supporting information appears to be suspect. Also, consider conducting a post mortem investigation to see if the assumptions used in the original analysis were valid. If not, integrate the findings of this investigation into future cost-benefit analyses.
Examples of Cost-Benefit Analysis
Examples of decisions to which cost-benefit analysis can be applied are noted below. We address whether to acquire a fixed asset, whether to hire staff to design a new product, whether to hire staff to reduce product failures, and whether to remediate groundwater pollution.
Whether to Buy a Fixed Asset
The analysis is the cost to buy the fixed asset, versus the benefit of any cash flows to be derived by using it. The cost to maintain and upgrade the asset over its useful life should also be included in the analysis, as well as the cost to operate it. You should also consider the working capital investment associated with the purchase, such as the funding required for inventory and receivables when a production line is being considered for the launch of a new product.
Whether to Hire Staff to Design a Product
The analysis is the cost of the new staff, versus the cash flows to be derived from sale of the new product. This analysis should include all benefits also paid to the new staff. A variation on the concept is to replace the cost of new staff with the fees charged by an outside design company that takes on the work.
Whether to Hire Staff to Reduce Product Failures
The analysis is the cost of the new employees, versus the costs to be avoided by maintaining higher product quality levels. This might also include the cost to destroying a small number of units as part of the ongoing testing process.
Whether to Remediate Groundwater Pollution
The analysis is the cost to contain fluids leaking into the soil beneath and adjacent to a production facility, versus the legal fees to be avoided when local residents do not file lawsuits against the company. This analysis may also include the avoidance of a variety of costs that might be associated with such a lawsuit, such as consultant testing to determine pollution levels, as well as pollution mitigation efforts further away from the facility, if the issue is not dealt with promptly.
Uncertainties of Cost-Benefit Analysis
There is a danger in assuming that the inputs to a cost-benefit analysis are entirely quantitative, which can lead to an excessive degree of certainty regarding the outcome of the analysis. A key issue is that the benefit gained from a decision may depend on the values of the person conducting the analysis - and values vary by person. For example, in a case where an investment decision will lead to improved air quality, it is questionable whether those paying for the project all believe that improved air quality provides the same value; they may not. Another issue is that not all benefits can be converted into a monetary value. For example, paying for a project in order to save an endangered species might be morally correct, but cannot be converted into a specific monetary value. It is very difficult to apply a cost-benefit analysis in these situations.
Another concern is that small changes in the accuracy of the data used might have a substantial effect on the decision outcome. This is especially the case when the measured cost and benefit net to a value close to zero. If the measured cost of a project is inaccurately assessed to be slightly low, this could yield a positive value for the project, so that an investment is initiated. Conversely, if the measured cost is inaccurately assessed to be slightly high, this could yield a negative value for the project, thereby cancelling a project that should have proceeded. Consequently, it makes sense to spend extra time verifying the accuracy of the data inputs to a cost-benefit analysis, especially when the outcome is in doubt.
Disadvantages of Cost-Benefit Analysis
There are a few problems with cost-benefit analysis. First, it does not provide consistent results when the decision maker must compare qualitative concepts, without being able to convert them to financial outcomes. The concept can also yield inconsistent results when cash inflows and outflows are expected to occur over long periods of time, since it can be quite difficult to accurately predict the amount and/or timing of the more distant cash flows. For longer-term analyses, it can make more sense to employ a net present value analysis, which is structured to deal with distant cash flows in more detail, as well as to incorporate the time value of money.
Another concern with cost-benefit analysis is the time required to conduct it. Because of the relatively high cost, it rarely makes sense to employ a cost-benefit analysis when reviewing the options related to relatively small expenditures. In these cases, managers typically rely on their experience to make a decision, rather than a hard quantitative analysis.
Alternatives to Cost-Benefit Analysis
There are several alternatives to cost-benefit analysis that might be employed. One is net present value analysis, where the cash flows associated with a decision are compiled and then discounted to their present value. If the present value is positive, then the investment should be made. Net present value analysis is highly dependent on the discount rate used, which may be increased if a project is considered to be quite risky. A higher discount rate reduces the present value of a decision.
Another alternative to cost-benefit analysis is constraint analysis. Under this approach, the focus is on how a decision impacts the bottleneck operation of a business. If the decision increases the throughput of the business, then it will increase profits, and so should probably be accepted. If not, then an expenditure is essentially wasted money, and so should be avoided. For example, the decision to increase the staffing at a bottleneck work center is probably a good idea, as long as it allows the work center to maintain a higher level of output.