Cost-Benefit Analysis

 Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis, is a systematic approach to estimating the strengths and weaknesses of alternatives. It is used to determine options which provide the best approach to achieving benefits while preserving savings in, for example, transactions, activities, and functional business requirements.^[1] A CBA may be used to compare completed or potential courses of action, and to estimate or evaluate the value against the cost of a decision, project, or policy. It is commonly used to evaluate business or policy decisions (particularly public policy), commercial transactions, and project investments. For example, the U.S. Securities and Exchange Commission must conduct cost-benefit analyses before instituting regulations or deregulations.^[2]: 6

CBA has two main applications:^[3]

1. To determine if an investment (or decision) is sound, ascertaining if – and by how much – its benefits outweigh its costs.
2. To provide a basis for comparing investments (or decisions), comparing the total expected cost of each option with its total expected benefits.

CBA is related to cost-effectiveness analysis. Benefits and costs in CBA are expressed in monetary terms and are adjusted for the time value of money; all flows of benefits and costs over time are expressed on a common basis in terms of their net present value, regardless of whether they are incurred at different times. Other related techniques include cost–utility analysis, risk–benefit analysis, economic impact analysis, fiscal impact analysis, and social return on investment (SROI) analysis.

Cost–benefit analysis is often used by organizations to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of any alternatives and the status quo. CBA helps predict whether the benefits of a policy outweigh its costs (and by how much), relative to other alternatives. This allows the ranking of alternative policies in terms of a cost–benefit ratio.^[4] Generally, accurate cost–benefit analysis identifies choices which increase welfare from a utilitarian perspective. Assuming an accurate CBA, changing the status quo by implementing the alternative with the lowest cost–benefit ratio can improve Pareto efficiency.^[5] Although CBA can offer an informed estimate of the best alternative, a perfect appraisal of all present and future costs and benefits is difficult; perfection, in economic efficiency and social welfare, is not guaranteed.^[6]

The value of a cost–benefit analysis depends on the accuracy of the individual cost and benefit estimates. Comparative studies indicate that such estimates are often flawed, preventing improvements in Pareto and Kaldor–Hicks efficiency.^[7] Interest groups may attempt to include (or exclude) significant costs in an analysis to influence its outcome.^[8]

French engineer and economist Jules Dupuit, credited with the creation of cost–benefit analysis

History

The concept of CBA dates back to an 1848 article by Jules Dupuit, and was formalized in subsequent works by Alfred Marshall.^[9] Jules Dupuit pioneered this approach by first calculating "the social profitability of a project like the construction of a road or bridge"^[10] In an attempt to answer this, Dupuit began to look at the utility users would gain from the project. He determined that the best method of measuring utility is by learning one's willingness to pay for something. By taking the sum of each user's willingness to pay, Dupuit illustrated that the social benefit of the thing (bridge or road or canal) could be measured. Some users may be willing to pay nearly nothing, others much more, but the sum of these would shed light on the benefit of it. It should be reiterated that Dupuit was not suggesting that the government perfectly price-discriminate and charge each user exactly what they would pay. Rather, their willingness to pay provided a theoretical foundation on the societal worth or benefit of a project. The cost of the project proved much simpler to calculate. Simply taking the sum of the materials and labor, in addition to the maintenance afterward, would give one the cost. Now, the costs and benefits of the project could be accurately analyzed, and an informed decision could be made.

The Corps of Engineers initiated the use of CBA in the US, after the Federal Navigation Act of 1936 mandated cost–benefit analysis for proposed federal-waterway infrastructure.^[11] The Flood Control Act of 1939 was instrumental in establishing CBA as federal policy, requiring that "the benefits to whomever they accrue [be] in excess of the estimated costs."^[12]

More recently, cost-benefit analysis has been applied to decisions regarding investments in cybersecurity-related activities (e.g., see the Gordon–Loeb model for decisions concerning cybersecurity investments).^[13]

Public policy

CBA's application to broader public policy began with the work of Otto Eckstein,^[14] who laid out a welfare economics foundation for CBA and its application to water-resource development in 1958. It was applied in the US to water quality,^[15] recreational travel,^[16] and land conservation during the 1960s,^[17] and the concept of option value was developed to represent the non-tangible value of resources such as national parks.^[18]

CBA was expanded to address the intangible and tangible benefits of public policies relating to mental illness,^[19] substance abuse,^[20] college education,^[21] and chemical waste.^[22] In the US, the National Environmental Policy Act of 1969 required CBA for regulatory programs; since then, other governments have enacted similar rules. Government guidebooks for the application of CBA to public policies include the Canadian guide for regulatory analysis,^[23] the Australian guide for regulation and finance,^[24] and the US guides for health-care^[25] and emergency-management programs.^[26]

Transportation investment

CBA for transport investment began in the UK with the M1 motorway project and was later used for many projects, including the London Underground's Victoria line.^[27] The New Approach to Appraisal (NATA) was later introduced by the Department for Transport, Environment and the Regions. This presented balanced cost–benefit results and detailed environmental impact assessments. NATA was first applied to national road schemes in the 1998 Roads Review, and was subsequently rolled out to all transport modes. Maintained and developed by the Department for Transport, it was a cornerstone of UK transport appraisal in 2011.

The European Union's Developing Harmonised European Approaches for Transport Costing and Project Assessment (HEATCO) project, part of the EU's Sixth Framework Programme, reviewed transport appraisal guidance of EU member states and found significant national differences.^[28] HEATCO aimed to develop guidelines to harmonise transport appraisal practice across the EU.^[29]

Transport Canada promoted CBA for major transport investments with the 1994 publication of its guidebook.^[30] US federal and state transport departments commonly apply CBA with a variety of software tools, including HERS, BCA.Net, StatBenCost, Cal-BC, and TREDIS. Guides are available from the Federal Highway Administration,^[31][32] Federal Aviation Administration,^[33] Minnesota Department of Transportation,^[34] California Department of Transportation (Caltrans),^[35] and the Transportation Research Board's Transportation Economics Committee.^[36]

Accuracy

In health economics, CBA may be an inadequate measure because willingness-to-pay methods of determining the value of human life can be influenced by income level. Variants, such as cost–utility analysis, QALY and DALY to analyze the effects of health policies, may be more suitable.^[37][38]

For some environmental effects, cost–benefit analysis can be replaced by cost-effectiveness analysis. This is especially true when one type of physical outcome is sought, such as a reduction in energy use by an increase in energy efficiency. Using cost-effectiveness analysis is less laborious and time-consuming, since it does not involve the monetization of outcomes (which can be difficult in some cases).^[39]

It has been argued that if modern cost–benefit analyses had been applied to decisions such as whether to mandate the removal of lead from gasoline, block the construction of two proposed dams just above and below the Grand Canyon on the Colorado River, and regulate workers' exposure to vinyl chloride, the measures would not have been implemented (although all are considered highly successful).^[40] The US Clean Air Act has been cited in retrospective studies as a case in which benefits exceeded costs, but knowledge of the benefits (attributable largely to the benefits of reducing particulate pollution) was not available until many years later.^[40]

Process

A generic cost–benefit analysis has the following steps:^[41]

1. Define the goals and objectives of the action.
2. List alternative actions.
3. List stakeholders.^{[dubious – discuss]}
4. Select measurement(s) and measure all cost and benefit elements.
5. Predict outcome of costs and benefits over the relevant time period.
6. Convert all costs and benefits into a common currency.
7. Apply discount rate.
8. Calculate the net present value of actions under consideration.
9. Perform sensitivity analysis.
10. Adopt the recommended course of action.

Evaluation

CBA attempts to measure the positive or negative consequences of a project. A similar approach is used in the environmental analysis of total economic value. Both costs and benefits can be diverse. Costs tend to be most thoroughly represented in cost–benefit analyses due to relatively-abundant market data. The net benefits of a project may incorporate cost savings, public willingness to pay (implying that the public has no legal right to the benefits of the policy), or willingness to accept compensation (implying that the public has a right to the benefits of the policy) for the policy's welfare change. The guiding principle of evaluating benefits is to list all parties affected by an intervention and add the positive or negative value (usually monetary) that they ascribe to its effect on their welfare.

The actual compensation an individual would require to have their welfare unchanged by a policy is inexact at best. Surveys (stated preferences) or market behavior (revealed preferences) are often used to estimate compensation associated with a policy. Stated preferences are a direct way of assessing willingness to pay for an environmental feature, for example.^[42] Survey respondents often misreport their true preferences, however, and market behavior does not provide information about important non-market welfare impacts. Revealed preference is an indirect approach to individual willingness to pay. People make market choices of items with different environmental characteristics, for example, revealing the value placed on environmental factors.^[43]

The value of human life is controversial when assessing road-safety measures or life-saving medicines. Controversy can sometimes be avoided by using the related technique of cost–utility analysis, in which benefits are expressed in non-monetary units such as quality-adjusted life years. Road safety can be measured in cost per life saved, without assigning a financial value to the life. However, non-monetary metrics have limited usefulness for evaluating policies with substantially different outcomes. Other benefits may also accrue from a policy, and metrics such as cost per life saved may lead to a substantially different ranking of alternatives than CBA.In some cases, in addition to changing the benefit indicator, the cost-benefit analysis strategy is directly abandoned as a measure. In the 1980s, to ensure workers' safety, the US Supreme Court made an important decision to abandon the consideration of return on investment and instead seek the lowest cost-benefit to meet specific standards. ^[44]

Another metric is valuing the environment, which in the 21st century is typically assessed by valuing ecosystem services to humans (such as air and water quality and pollution).^[45] Monetary values may also be assigned to other intangible effects such as business reputation, market penetration, or long-term enterprise strategy alignment.

Time and discounting

CBA generally attempts to put all relevant costs and benefits on a common temporal footing, using time value of money calculations. This is often done by converting the future expected streams of costs (${\displaystyle �}$) and benefits (${\displaystyle �}$) into a present value amount with a discount rate (${\displaystyle �}$) and the net present value defined as:

he selection of a discount rate for this calculation is subjective. A smaller rate values the current generation and future generations equally. Larger rates (a market rate of return, for example) reflects human present bias or hyperbolic discounting: valuing money which they will receive in the near future more than money they will receive in the distant future. Empirical studies suggest that people discount future benefits in a way similar to these calculations.^[46] The choice makes a large difference in assessing interventions with long-term effects. An example is the equity premium puzzle, which suggests that long-term returns on equities may be higher than they should be after controlling for risk and uncertainty. If so, market rates of return should not be used to determine the discount rate because they would undervalue the distant future.^[47]

Methods for choosing a discount rate[edit]

For publicly traded companies, it is possible to find a project's discount rate by using an equilibrium asset pricing model to find the required return on equity for the company and then assuming that the risk profile of a given project is similar to that the company faces. Commonly used models include the capital asset pricing model (CAPM):

and the Fama-French model:

where the  terms correspond to the factor loadings. A generalization of these methods can be found in arbitrage pricing theory, which allows for an arbitrary number of risk premiums in the calculation of the required return.

Risk and uncertainty

Risk associated with project outcomes is usually handled with probability theory. Although it can be factored into the discount rate (to have uncertainty increasing over time), it is usually considered separately. Particular consideration is often given to agent risk aversion: preferring a situation with less uncertainty to one with greater uncertainty, even if the latter has a higher expected return.

Uncertainty in CBA parameters can be evaluated with a sensitivity analysis, which indicates how results respond to parameter changes. A more formal risk analysis may also be undertaken with the Monte Carlo method.^[48] However, even a low parameter of uncertainty does not guarantee the success of a project.

Principle of maximum entropy

Suppose that we have sources of uncertainty in a CBA that are best treated with the Monte Carlo method, and the distributions describing uncertainty are all continuous. How do we go about choosing the appropriate distribution to represent the sources of uncertainty? One popular method is to make use of the principle of maximum entropy, which states that the distribution with the best representation of current knowledge is the one with the largest entropy - defined for continuous distributions as:

where ${\displaystyle \mathcal{�}}$ is the support set of a probability density function ${\displaystyle �(�)}$. Suppose that we impose a series of constraints that must be satisfied:

where the last equality is a series of moment conditions. Maximizing the entropy with these constraints leads to the functional:^[49]

where the ${\displaystyle {�}_{�}}$ are Lagrange multipliers. Maximizing this functional leads to the form of a maximum entropy distribution:

There is a direct correspondence between the form of a maximum entropy distribution and the exponential family. Examples of commonly used continuous maximum entropy distributions in simulations include:

• Uniform distribution
  • No constraints are imposed over the support set ${\displaystyle \mathcal{�}\in [�,�]}$
  • It is assumed that we have maximum ignorance about the uncertainty
• Exponential distribution
  • Specified mean ${\displaystyle \mathbb{�}(�)}$ over the support set ${\displaystyle \mathcal{�}\in [0,\mathrm{\infty })}$
• Gamma distribution
  • Specified mean ${\displaystyle \mathbb{�}(�)}$ and log mean ${\displaystyle \mathbb{�}(\log �)}$ over the support set ${\displaystyle \mathcal{�}\in [0,\mathrm{\infty })}$
  • The exponential distribution is a special case
• Normal distribution
  • Specified mean ${\displaystyle \mathbb{�}(�)}$ and variance ${\displaystyle \text{Var}(�)}$ over the support set ${\displaystyle \mathcal{�}\in (-\mathrm{\infty },\mathrm{\infty })}$
  • If we have a specified mean and variance on the log scale, then the lognormal distribution is the maximum entropy distribution

CBA under US administrations

The increased use of CBA in the US regulatory process is often associated with President Ronald Reagan's administration. Although CBA in US policy-making dates back several decades, Reagan's Executive Order 12291 mandated its use in the regulatory process. After campaigning on a deregulation platform, he issued the 1981 EO authorizing the Office of Information and Regulatory Affairs (OIRA) to review agency regulations and requiring federal agencies to produce regulatory impact analyses when the estimated annual impact exceeded $100 million. During the 1980s, academic and institutional critiques of CBA emerged. The three main criticisms were:^[50]

1. That CBA could be used for political goals. Debates on the merits of cost and benefit comparisons can be used to sidestep political or philosophical goals, rules and regulations.
2. That CBA is inherently anti-regulatory, and therefore a biased tool. The monetization of policy impacts is an inappropriate tool for assessing mortality risks and distributional impacts.
3. That the length of time necessary to complete CBA can create significant delays, which can impede policy regulation.

These criticisms continued under the Clinton administration during the 1990s. Clinton furthered the anti-regulatory environment with his Executive Order 12866.^[51] The order changed some of Reagan's language, requiring benefits to justify (rather than exceeding) costs and adding "reduction of discrimination or bias" as a benefit to be analyzed. Criticisms of CBA (including uncertainty valuations, discounting future values, and the calculation of risk) were used to argue that it should play no part in the regulatory process.^[52] The use of CBA in the regulatory process continued under the Obama administration, along with the debate about its practical and objective value. Some analysts oppose the use of CBA in policy-making, and those in favor of it support improvements in analysis and calculations.

Criticisms

As a concept in economics, cost-benefit analysis has provided a valuable reference for many public construction and governmental decisions, but its application has gradually revealed a number of drawbacks and limitations. A number of critical arguments have been put forward in response. That include concerns about measuring the distribution of costs and benefits, discounting the costs and benefits to future generations, and accounting for the diminishing marginal utility of income.^[53][54][55]in addition,relying solely on cost-benefit analysis may lead to neglecting the multifaceted value factors of a project.

Distribution

CBA has been criticized in some disciplines as it relies on the Kaldor-Hicks criterion which does not take into account distributional issues. This means, that positive net-benefits are decisive, independent of who benefits and who loses when a certain policy or project is put into place. Phaneuf and Requate phrased it as follows "CBA today relies on the Kaldor-Hicks criteria to make statements about efficiency without addressing issues of income distribution. This has allowed economists to stay silent on issues of equity, while focusing on the more familiar task of measuring costs and benefits".^[56] The challenge raised is that it is possible for the benefits of successive policies to consistently accrue to the same group of individuals, and CBA is ambivalent between providing benefits to those that have received them in the past and those that have been consistently excluded.^[57][53][58] Policy solutions, such as progressive taxation can address some of these concerns.

Discounting and Future Generations

Others have critiqued the practice of discounting future costs and benefits for a variety of reasons, including the potential undervaluing of the temporally distant cost of climate change and other environmental damage, and the concern that such a practice effectively ignores the preferences of future generations.^[55][59][60] Some scholars argue that the use of discounting makes CBA biased against future generations, and understates the potential harmful impacts of climate change.^[61] The growing relevance of climate change has led to a re-examination of the practice of discounting in CBA.^[62][63]

Marginal Utility

The main criticism stems from the diminishing marginal utility of income.^[64][65] According to this critique, without using weights in the CBA, it is not the case that everyone “matters” the same but rather that people with greater ability to pay receive a higher weight.^[66][67] One reason for this is that for high income people, one monetary unit is worth less relative to low income people, so they are more willing to give up one unit in order to make a change that is favourable for them.^[68] This means that there is no symmetry in agents, i.e. some people benefit more from the same absolute monetary benefit. Any welfare change, no matter positive or negative, affects people with a lower income stronger than people with a higher income, even if the exact monetary impacts are identical.^[67] This is more than just a challenge to the distribution of benefits in CBA, it is a critique of the ability of CBA to accurately measure benefits as, according to this critique, using unweighted absolute willingness to pay overstates the costs and benefits to the wealthy, and understates those costs and benefits to the poor. Sometimes this is framed in terms of an argument about democracy, that each person's preferences should be given the same weight in an analysis (one person one vote), while under a standard CBA model the preferences of the wealthy are given greater weight.^[54]

Taken together, according to this objection, not using weights is a decision in itself – richer people receive de facto a bigger weight. To compensate for this difference in valuation, it is possible to use different methods. One is to use weights, and there are a number of different approaches for calculating these weights.^[66] Often, a Bergson-Samuelson social welfare function is used and weights are calculated according to the willingness-to-pay of people.^[69][70] Another method is to use percentage willingness to pay, where willingness to pay is measured as a percentage of total income or wealth to control for income.^[67] These methods would also help to address distributional concerns raised by the Kaldor-Hick criterion.

Limitations in the scope of assessment

Economic cost-benefit analysis tends to limit the assessment of benefits to economic values, ignoring the importance of other value factors such as the wishes of minority groups, inclusiveness and respect for the rights of others.^[71] These value factors are difficult to rank and measure in terms of weighting, yet cost-benefit analysis suffers from the inability to consider these factors comprehensively, thus lacking the integrity and comprehensiveness of social welfare judgements. Therefore, for projects with a higher standard of evaluation, other evaluation methods need to be used and referred to in order to compensate for these shortcomings and to assess the impact of the project on society in a more comprehensive and integrated manner.^[72]

References - see https://en.wikipedia.org/wiki/Cost%E2%80%93benefit_analysis

What Is Cost-Benefit Analysis, How Is it Used, What Are its Pros and Cons?

Michela Buttignol / Investopedia

What Is a Cost-Benefit Analysis?

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.

KEY TAKEAWAYS

• A cost-benefit analysis is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action.
• A cost-benefit analysis involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
• A cost-benefit analysis can also include intangible benefits and costs or effects from a decision such as employees morale and customer satisfaction.
• More complex cost-benefit analysis may incorporate sensitivity analysis, discounting of cashflows, and what-if scenario analysis for multiple options.
• All else being equal, an analysis that results in more benefits than costs will generally be a favorable project for the company to undertake.

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.

 

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.

The 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.

Identify Project Scope

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. It is at this point that a company should assess whether it is equipped to perform the analysis. For example, a company may realize it does not have the technical staff required to perform an adequate analysis.

During the project scope development phase, key stakeholders should be identified, notified, and given a chance to provide their input along the process. It may be wise to include those most impacted by the outcome of the analysis depending on the findings (i.e. if the outcome is to renovate a company's website, IT may be required to hire multiple additional staff and should be consulted).

Determine the Costs

With the framework behind us, it's time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs. Costs may 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.

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.

"Costs" can be financial (i.e. expenses recorded on an income statement) or non-financial (i.e. negative repercussions on the community).

Determine the Benefits

Every project will have different underlying principles; benefits might include the following:

• Higher revenue and sales 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.

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 require more in-depth critiquing. This may include:

• Applying discount rates to determine the net present value of cashflows.
• Utilizing various discount rates depending on various situations.
• Calculating cost-benefit analysis for multiple options. Each option may have a different cost and different benefit.
• Level-setting different options by calculating the cost-benefit ratio.
• Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes.

Make Recommendation and Implement

The analyst that performs the cost-benefit analysis must often then synthesize findings to present to management. This includes concisely summarizes the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis.

Broadly speaking, if a cost-benefit analysis is positive, the project has more benefits than costs. A company must be mindful of limited resources that might result in mutually-exclusive decisions. For example, a company may have a limited amount of capital to invest; although a cost-benefit analysis of an upgrade to its warehouse, website, and equipment are all positive, the company may not have enough money for all three.

 

Not all cost-benefit analysis that result in net benefit should be accepted. For example, a company must consider the project's risk, coherence to its company imagine, or capital limitations,

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 the 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.

One of the benefits of using the 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 cost-benefit analysis 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 cost-benefit analysis results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis.

Cost-Benefit Analysis

Pros

• Requires data-driven analysis

• Limits analysis to only the purpose determined in the initial step of the process

• Results in deeper, potentially more reliable findings

• Delivers insights to financial and non-financial outcomes
  

Cons

• May be unnecessary for smaller projects

• Requires capital and resources to gather data and make analysis

• Relies heavily on forecasted figures; if any single critical forecast is off, estimated findings will likely be wrong.

What Are the 5 Steps of Cost-Benefit Analysis?

The broad process for a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform analysis of both costs and benefits, and to make a final recommendation. These steps may vary from one process to another.

What Is the Main Goal of Using a Cost-Benefit Analysis?

The main goal of cost-benefit analysis is to determine whether it is worth undertaking a project or task. This decision is made by gathering information on the costs and benefits of that project. Management leverages the findings of a cost-benefit analysis to support whether there are more benefits to a project or if it is more detrimental to a company.

How Do You Weigh Costs vs. Benefits?

Cost-benefit analysis is a systematic method for quantifying and then comparing the total costs to the total expected rewards of undertaking a project or making an investment. If the benefits greatly outweigh the costs, the decision should go ahead; otherwise, it should probably not. Cost-benefit analysis will also include the opportunity costs of missed or skipped projects.

What Are Some Tools or Methods Used in Cost-Benefit Analysis?

Depending on the specific investment or project being evaluated, one may need to discount the time value of cash flows using net present value calculations. A benefit-cost ratio (BCR) may also be computed to summarize the overall relationship between the relative costs and benefits of a proposed project. Other tools may include regression modeling, valuation, and forecasting techniques.

What Are the Costs and Benefits of Doing a Cost-Benefit Analysis?

The process of doing a cost-benefit analysis itself has its own inherent costs and benefits. The costs involve the time needed to carefully understand and estimate all of the potential rewards and costs. This may also involve money paid to an analyst or consultant to carry out the work. One other potential downside is that various estimates and forecasts are required to build the cost-benefit analysis, and these assumptions may prove to be wrong or even biased.

The benefits of a cost-benefit analysis, if done correctly and with accurate assumptions, are to provide a good guide for decision-making that can be standardized and quantified. If the cost-benefit analysis of doing a cost-benefit analysis is positive, you should do it!

The Bottom Line

Some complex problems require deeper analysis, and a company can use cost-benefit analysis when it isn't abundantly clear whether or not to pursue an undertaking. By determining the expenses and identifying what will be favorable, a company can simplify the decision-making process by synthesizing a cost-benefit analysis.

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HOW TO DO A COST-BENEFIT ANALYSIS & WHY IT’S IMPORTANT

Tim Stobierski

Are you unsure whether a particular decision is the best one for your business? Are you questioning whether a proposed project will be worth the effort and resources that will go into making it a success? Are you considering making a change to your business, marketing, or sales strategy, knowing that it might have repercussions throughout your organization?

The way that many businesses, organizations, and entrepreneurs answer these, and other, questions is through business analytics—specifically, by conducting a cost-benefit analysis.

WHAT IS A COST-BENEFIT ANALYSIS?

A cost-benefit analysis is the process of comparing the projected or estimated costs and benefits (or opportunities) associated with a project decision to determine whether it makes sense from a business perspective.

Generally speaking, cost-benefit analysis involves tallying up all costs of a project or decision and subtracting that amount from the total projected benefits of the project or decision. (Sometimes, this value is represented as a ratio.)

If the projected benefits outweigh the costs, you could argue that the decision is a good one to make. If, on the other hand, the costs outweigh the benefits, then a company may want to rethink the decision or project.

There are enormous economic benefits to running these kinds of analyses before making significant organizational decisions. By doing analyses, you can parse out critical information, such as your organization’s value chain or a project’s ROI.

Cost-benefit analysis is a form of data-driven decision-making most often utilized in business, both at established companies and startups. The basic principles and framework can be applied to virtually any decision-making process, whether business-related or otherwise.

STEPS OF A COST-BENEFIT ANALYSIS

1. Establish a Framework for Your Analysis

For your analysis to be as accurate as possible, you must first establish the framework within which you’re conducting it. What, exactly, this framework looks like will depend on the specifics of your organization.

Identify the goals and objectives you’re trying to address with the proposal. What do you need to accomplish to consider the endeavor a success? This can help you identify and understand your costs and benefits, and will be critical in interpreting the results of your analysis.

Similarly, decide what metric you’ll be using to measure and compare the benefits and costs. To accurately compare the two, both your costs and benefits should be measured in the same “common currency.” This doesn’t need to be an actual currency, but it does frequently involve assigning a dollar amount to each potential cost and benefit.

2. Identify Your Costs and Benefits

Your next step is to sit down and compile two separate lists: One of all of the projected costs, and the other of the expected benefits of the proposed project or action.

When tallying costs, you’ll likely begin with direct costs, which include expenses directly related to the production or development of a product or service (or the implementation of a project or business decision). Labor costs, manufacturing costs, materials costs, and inventory costs are all examples of direct costs.

But it’s also important to go beyond the obvious. There are a few additional costs you must account for:

• Indirect costs: These are typically fixed expenses, such as utilities and rent, that contribute to the overhead of conducting business.
• Intangible costs: These are any current and future costs that are difficult to measure and quantify. Examples may include decreases in productivity levels while a new business process is rolled out, or reduced customer satisfaction after a change in customer service processes that leads to fewer repeat buys.
• Opportunity costs: This refers to lost benefits, or opportunities, that arise when a business pursues one product or strategy over another.

Once those individual costs are identified, it’s equally important to understand the possible benefits of the proposed decision or project. Some of those benefits include:

• Direct: Increased revenue and sales generated from a new product
• Indirect: Increased customer interest in your business or brand
• Intangible: Improved employee morale
• Competitive: Being a first-mover within an industry or vertical

3. Assign a Dollar Amount or Value to Each Cost and Benefit

Once you’ve compiled exhaustive lists of all costs and benefits, you must establish the appropriate monetary units by assigning a dollar amount to each one. If you don’t give all the costs and benefits a value, then it will be difficult to compare them accurately.

Direct costs and benefits will be the easiest to assign a dollar amount to. Indirect and intangible costs and benefits, on the other hand, can be challenging to quantify. That does not mean you shouldn’t try, though; there are many software options and methodologies available for assigning these less-than-obvious values.

4. Tally the Total Value of Benefits and Costs and Compare

Once every cost and benefit has a dollar amount next to it, you can tally up each list and compare the two.

If total benefits outnumber total costs, then there is a business case for you to proceed with the project or decision. If total costs outnumber total benefits, then you may want to reconsider the proposal.

Beyond simply looking at how the total costs and benefits compare, you should also return to the framework established in step one. Does the analysis show you reaching the goals you’ve identified as markers for success, or does it show you falling short?

If the costs outweigh the benefits, ask yourself if there are alternatives to the proposal you haven’t considered. Additionally, you may be able to identify cost reductions that will allow you to reach your goals more affordably while still being effective.

PROS AND CONS OF COST-BENEFIT ANALYSIS

There are many positive reasons a business or organization might choose to leverage cost-benefit analysis as a part of their decision-making process. There are also several potential disadvantages and limitations that should be considered before relying entirely on a cost-benefit analysis.

Advantages of Cost-Benefit Analysis

A Data-Driven Approach

Cost-benefit analysis allows an individual or organization to evaluate a decision or potential project free of biases. As such, it offers an agnostic and evidence-based evaluation of your options, which can help your business become more data-driven and logical.

Makes Decisions Simpler

Business decisions are often complex by nature. By reducing a decision to costs versus benefits, the cost-benefit analysis can make this dilemma less complex.

Uncovers Hidden Costs and Benefits

Cost-benefit analysis forces you to outline every potential cost and benefit associated with a project, which can uncover less-than-obvious factors like indirect or intangible costs.

Limitations of Cost-Benefit Analysis

Difficult to Predict All Variables

While cost-benefit analysis can help you outline the projected costs and benefits associated with a business decision, it’s challenging to predict all the factors that may impact the outcome. Changes in market demand, material costs, and the global business environment are unpredictable—especially in the long term.

Incorrect Data Can Skew Results

If you’re relying on incomplete or inaccurate data to finish your cost-benefit analysis, the results of the analysis will follow suit.

Better Suited to Short- and Mid-Length Projects

For projects or business decisions that involve longer timeframes, cost-benefit analysis has a greater potential of missing the mark for several reasons. For one, it’s typically more difficult to make accurate predictions the further into the future you go. It’s also possible that long-term forecasts won’t accurately account for variables such as inflation, which can impact the overall accuracy of the analysis.

Removes the Human Element

While a desire to make a profit drives most companies, there are other, non-monetary reasons an organization might decide to pursue a project or decision. In these cases, it can be difficult to reconcile moral or “human” perspectives with the business case.

In the end, cost-benefit analysis shouldn't be the only business analytics tool or strategy you use in determining how to move your organization into the future. Cost-benefit analysis isn’t the only type of economic analysis you can do to assess your business’s economic state, but a single option at your disposal.

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