Before investing in a project, it is crucial to determine whether or not it is viable. Making timely determination helps save companies and businesses valuable time and money. Next, a careful analysis should be conducted using certain tools to provide the organization with a clear picture of the effort, time, and money required to implement the project. The cost-benefit analysis is one such tool.
What is a Cost Analysis?
A cost analysis focuses on the cost of any given decision, project, or action without considering what the total outcome will be. This type of analysis is the first step you would take before doing the other 3 economic evaluations to see if it is feasible or suitable for the company. It’s a process that many businesses utilize faced with a decision.
Organizations use cost-benefit analysis to examine and compare projects, decisions, or systems against the profit, benefits, or opportunities they offer. It, therefore, adds up the benefits of the course of action involved and compares them with the cost associated with it. To conduct calculations, a dollar amount must be assigned to every cost and benefit. The benefits are then subtracted from costs to help form a picture of the financial profits the organization aims to gain and determine if business objectives and goals will be met. A cost-benefit analysis also enables organizations to determine if a project or decision is worth pursuing.
Historical Aspect of it
The cost-benefit analysis was created in the 1840s by Jules Dupuit, a French economist and engineer. Though it was used for government projects and infrastructure, any business can use it today. To attain an accurate analysis, a tangible cost and benefit factors should be used. Assigning a monetary value to benefits is difficult as revenue is unpredictable and, at times, intangible. Other factors like project supporters that need the data to back up the project may also influence the outcome. Hence, monetary value is often assigned to cost rather than a benefit.
Why Do you Need it?
There are a few clear reasons why a cost-benefit analysis template should be created. Understanding why it is needed will help ensure that businesses use it effectively. Other than helping a business decision as to whether or not to invest in a project, a cost-benefit analysis template also does the following:
- It helps businesses explore several paths to implement a project
- It helps the business run several cost-benefit analyses at the same time.
- The business can obtain more data to help in the decision-making process.
- It supplies significant decision-makers in the company with information that helps them come to well-measured choices.
- It helps businesses mitigate the risks associated with implementing expensive projects.
How Does CBA Work?
A cost-benefit analysis examines the potential cost and revenue that a business may generate from a project. Using this data, the business can determine whether or not the project is financially feasible. If not, the business may then consider pursuing another project. This decision can be made based on the opportunity cost factored into the cost-benefit analysis. Opportunity costs are the benefits that can be realized as a result of choosing one course of action over another. It ensures that the cost-benefit analysis is thorough by considering all options and potential opportunities missed. Therefore, cost-benefit analysis facilitates a better decision-making process within the business.
When and Who Should Use it?
A cost-benefit analysis is conducted before a project begins to help gauge factors such as the scope, success criteria, risk, among others associated with the project. It can also be used after the implementation of the project to analyze the impact of the course of action taken within the project. Finally, a cost-benefit analysis template can be used whenever a business is unsure if the path chosen to implement the project is in its best interest.
How to Conduct?
Conducting a proper cost-benefit analysis is key to attaining precise, accurate results. A well-outlined process can help ensure that an effective process is followed.
The following steps should be used when conducting a cost analysis:
Establish a framework for analysis
First, establish a framework by identifying the goals and objectives that need to be accomplished for project success. Next, identify the cost and the benefits and choose a metric to be used for the comparison. These details should be included in the cost-benefit analysis template that will help in the interpretation of the analysis.
Identify your costs and benefits
Next, identify two lists of the cost and benefits. Brainstorming helps identify the costs associated with the project, such as payrolls, equipment, travel costs, and other possible monetary expenses. Creating separate categories will ease referring to the details outlined in the cost analysis.
The following categories should be used:
There are five types of costs that should be highlighted in the cost category in the cost-benefit analysis template. Understanding each type will help ensure that adequate details are outlined when indicating these costs. They also ensure that the business takes all aspects of the cost of the project into consideration.
The following types of costs should be highlighted:
Direct costs are incurred due to their association with the project or activity. They may include labor, material, manufacturing or production, and inventory. Usually, these costs are the easiest to identify in the cost-benefit analysis.
Indirect costs are fixed expenses. It means that these types of costs are incurred throughout the project or the running of the business. For example, they may include rent, utilities, and overhead costs associated with the management of the business.
Intangible costs are any costs that are difficult to identify or measure. They are more qualitative than quantitative. For instance, a shift in customer satisfaction due to changes in customer service delivery or a shift in productivity levels.
Opportunity costs are costs incurred when a business loses benefits or opportunities due to pursuing one course of action over another, such as choosing to build something over buying it or making alternative investments.
Cost of potential risks
Cost of potential risks are costs that arise due to possible issues that may arise during the project. These costs may include any issue caused by environmental factors etc.
The list should also contain a separate category outlining the project’s benefits. The benefits can be divided into four groups in the analysis template. The groups help ensure that the business understands what it aims to gain.
The following groups should be highlighted:
Direct benefits are gains made directly resulting from the implementation of the project, such as increased sales or revenue resulting from a new service or product.
Indirect benefits are gains or returns measured by customer interest in the brand product or service. Just like indirect costs, these gains are qualitative.
Intangible benefits are not explicitly measurable. They cannot be directly or solely identified through the project’s results or process. For example, improved team morale.
Competitive benefits are gains that give the business an advantage over its competitors. For instance, when a business is the first to progress to the top in the industry.
Assign a value to each cost and benefit
A value should then be assigned to each of the costs and benefit. Use the same ‘common currency’ during this process. Often a dollar amount or value is assigned to each cost and benefit. Though direct costs and benefits can easily be assigned this value, indirect and intangible costs and benefits may be difficult to quantify. Several software options and methodologies are available to help assign less than evident values to these types of costs and benefits.
Tally the total value
Tally the total costs of each of the costs and benefits from the analysis. If the business benefits outnumber the cost, then the project or decision is worth pursuing; however, if the results show that the cost outweighs the benefits, consider an alternative decision or project. Revisit the framework to help find cost reductions that can be made for the project to be more affordable and practical.
Compare costs and benefits
Finally, make careful comparison of the total of costs and benefits outcome. Review the analysis to ensure all costs and benefits have been included in it. Consider a clear timeline for how long it may take the benefits to repay the costs. Careful consideration should also be placed on whether the project is a sound investment and whether the business is willing to set aside the time and resources required to execute it.
Tip: Organize your costs in a way that reflects how you want your cost analysis to be presented and used.
Cost-Benefit Analysis Templates
We provide free downloadable cost-benefit analysis templates, which are easy to use. They will help ensure that you remain focused on the task at hand, which in this case is conducting a cost-benefit analysis. They also help speed up the process of filing your analysis details.
Advantages and Disadvantages
A cost-benefit analysis is relatively easy and straightforward to conduct. However, there are advantages and disadvantages associated with conducting it. Businesses must evaluate and decide whether conducting the analysis is worthwhile.
The advantages and disadvantages of preparing a cost-benefit analysis include the following:
Small to mid-level capital expenditure projects and short to mid-level completion time projects require the cost-benefit analysis for sensible and well-informed decisions to be made. However, large projects require capital budget analysis methods such as net present value (NPV). NPV states that present-day cash flow is more valuable than future cash because present money can be considered invested and earned income. It uses an alternative return rate that could be earned if the project is not executed. NPV is calculated by estimating future cash flow and determining the correct return rate.
The following are pros associated with using cost-benefit analysis:
It is data-driven
The cost-benefit analysis is data-driven, facilitating an evaluation that is non-biased and opinion-free in terms of evaluation. It helps enable the business to evaluate and compare based on facts and evidence. The data-driven nature of the cost analysis also ensures that actions are carried out based on logic.
It makes decisions simpler
Cost-benefit analysis simplifies the project by breaking down costs and benefits, making it easy to make vital business decisions. Through the simplicity of the cost-benefit analysis, information is broken down into fathomable chunks enabling decision-makers to arrive at an informed decision.
It can uncover hidden costs and benefits
Cost and benefits can also be uncovered due to the extensive evaluation and identification process. Businesses should ensure that the process of identifying the costs and benefits is carried out thoughtfully by brainstorming within the organization. Indirect and intangible costs and benefits tend to be the most difficult to uncover in the analysis.
The cost-benefit analysis does not factor in financial concerns like inflation, interest rate, varying cash flow and the present value of money. This makes it unsuitable for large projects that have a long-term time horizon. However, any type of model used in carrying out CBA can forecast future revenue or sales, alternative return rates and expected future cash flow. These forecasts are often factored into the models used in conducting CBA. A major limitation is that if one or two forecasts are incorrect, then the results of the CBA may be be inaccurate.
The following are the limitations of the cost-benefit analysis:
It’s difficult to predict all variables
Using a cost benefit analysis can make it difficult to predict all variables associated with the project regardless of whether the costs and benefits are identified. Factors such as a change in market demand, material costs, and the global business environment can all significantly impact the outcome of the project. Using the analysis for long-term evaluation without considering such factors can lead to an inaccurate conclusion.
It’s only as good as the data used to complete it
Data is at the center of the cost-benefit analysis. If incomplete and inaccurate data is used, then the results reflect it. Preparing a comprehensive cost-benefit analysis will ensure that accurate information is provided.
It’s better to use it for short and mid-length projects
Short and mid-length projects utilize the cost-benefit analysis more suitably. When used with long-term projects, the business faces difficulty making accurate predictions due to the extended project timeline. Long-term forecasts may also fail to consider emerging factors that may impact the analysis, such as inflation.
It removes the human element
The human element of the analysis is removed, which can prove to make it difficult for businesses to analyze the project or decision for non-monetary reasons. The cost-benefit analysis does not consider the moral or human perspective but rather the technical aspects of the project.
Key takeaways of preparing a cost-benefit analysis include following:
- A cost-benefit analysis is conducted to measure and compare the benefits associated with taking a particular course of action against the cost of doing the same.
- Measurable financial metrics like revenue earned or costs saved resulting from the pursuit of the project are involved in the analysis.
- Intangible benefits and costs and the effects of a decision such as a customer satisfaction or employee morale are all included in the cost-benefit analysis template.
- It can be written before a business embarks on executing a project or decision after the project is being implemented to help establish the impact of the action within the project or when a business is unsure as to whether it is in its best interest to continue with the course of action as planned.
Frequently Asked Questions
First, the costs and benefits must be identified and quantified. Both, the total costs and benefits must then be compared. An observation should finally be made about whether the benefits outweigh the costs or whether the costs outnumber the benefits. Opportunity costs of other alternative projects should also be factored in to decide whether the project or decision is worth pursuing.
The method or tool used depends on the specific project or investment. The standard methods used include net present value (NPV), which determines the cash flow value based on whether it is in the present or expected future or benefit-cost ratio (BCR), which can help sum up the overall relationship of the costs and benefits. Regression modeling, valuation, and forecasting techniques are other tools that businesses can utilize.
The cost of conducting the cost-benefit analysis is the time taken to evaluate the estimated potential cost and reward carefully. It may also include the money paid to an analyst or consultant to carry out the work on behalf of the business. Another cost may include the various estimates and forecasts required to create the cost-benefit analysis, which may be based on wrong or biased assumptions. A benefit is that when objectively and accurately done, the cost-benefit analysis aids good and well-informed decision making.
Yes, a cost analysis can be helpful for both large organizations and small businesses. It’s a tool designed to help you make better decisions for your company.