Successful business managers make rational and informed decisions. They don’t just make decisions based on their gut or instinct. Instead, they take their time to weigh all the possible options. This helps them minimize any risk that would otherwise affect their business in one way or the other. But one may ask, “How do you arrive at one decision in such a world with myriad variables and ever-changing economic spheres? Well, the one tool that stands effective when it comes to decision evaluation is the cost-benefit analysis.
What is a cost benefit analysis?
Cost Benefit Analysis (CBA) refers to a mathematical approach that helps in the comparison of the cost and expected benefits of two or more options or projects. Therefore, it helps an individual or an organization to determine which potential decision can make the most financial sense when it comes to investment. Also, it identifies the benefits associated with a particular investment and the involved costs and deducting the costs from the benefits. It is applied in various institutions such as software development, construction, education, healthcare, among other businesses.
The Relationship Between Cost Benefit Analysis and Net Present Value
Well, before you engage in any kind of project, or buying a property, it is always recommended that you weight the expected costs against the benefits. This will help you reach an informed and rational decision. In most cases, CBA is often done for long-term goals. However, because of the fluctuations, inflations, and other changing factors in the market, it’s always good to know the net present value. Net present value in economic terms refers to a method whereby future benefits or costs are calculated based on the present values. Therefore, if the net present is positive, then that is an indication that the decision is good for investment since benefits overshadow costs. Nonetheless, if the result is negative, then the investment decision shouldn’t be recommended.
How to Calculate Cost Benefit Analysis
Most companies do look for ways to make their investment returns positive. For this reason, they do try as much as they can to minimize their risks by conducting an exhaustive CBA. However, while some find it a long and tedious process, other individuals/companies simply don’t know where to start. Therefore, if you are such an individual/organization, know that you are in the right place. The following is a step-by-step guide on how you can calculate CBA for your business entity.
Step 1: Identify costs
First and foremost, you should compile a comprehensive list of all the expenses that are associated with your planned investment or action. Remember, costs are categorized into different varieties i.e., direct costs, indirect costs, tangible costs, intangible costs, and real costs.
Direct costs– these are costs that are directly associated with the production of the project or investment.
Indirect costs– are costs that are not directly accounted for the investment. They are either fixed or variable.
Tangible costs– are costs associated with an identifiable source or asset. They include rents, payrolls, among others.
Intangible costs– these costs are difficult to identify and fluctuates with consumer demands.
Real cost– these are costs that are involved in the actual production process, such as labor costs and raw materials.
Step 2: Identify Benefits
Once you’ve compiled a comprehensive list of all the costs incurred in the project/investment, you need to embark on identifying and quantifying all benefits anticipated should the investment/project be implemented. First, identify the monetary benefits such as profits from products and services, the contribution from investors, reduction in production, among others.
Also, you need to identify some of the nonmonetary benefits that are likely to arise. These include reliability, increased durability, improved customer satisfaction, etc.
Step 3: Evaluate costs and Benefits
This is the final step of cost-benefit analysis. Here, you can take all the benefits as well as the sum of the costs and put them in a b/c equation. If the sum of costs is greater than the total benefits, this is n indication that the project/investment is not worth undertaking. However, if the total costs and benefits are more or less equal, then it’s recommended that you re-evaluate the CBA. In many a time, such cases do arise due to errors or incorrect calculations. If the sum of the benefits is higher than the sum of the cost incurred, then that’s an indication that the project/investment is potentially worthwhile.
Sample of Cost-Benefit Analysis
‘Good Health’ is a startup hospital that has been in operation for close to two years now. The manager, however, plans to expand its operations in the third working year. The hospital management decides to run a cost-benefit analysis to determine whether or not the decision is beneficial or feasible.
The management analyzes a time horizon of one year and estimates that the total revenue collected will amount to $200,000. However, this will be possible if 2 more physicians are hired and more hospital equipment worth $100,000 bought. The salary of the physicians will be $ 70,000, and the cost of hiring and training will be $5,000.
Therefore, when calculating the CBA, we first get the total costs by adding all the costs.
In this case, it will be salaries + equipment+ cost of hiring and training
= 100,000+ 70,000+ 5,000
= $ 175,000
Additionally, there is the cost of expanding consultation rooms which stand at $10,000.
On the other hand, the benefits that will come after the implementation of the plan will be $200,000. Therefore, using the benefit-cost ration, we get 175,000/200,000= 0.875. Given that the value is positive and that the total benefits are greater than the costs, the CBA indicates that the decision to expand the hospital’s operation is feasible and beneficial to the company.
Cost-Benefit Analysis Templates
Cost-Benefit Analysis Worksheet
Cost-Benefit Analysis Example for PPT
Cost-Benefit Analysis in Project Management
Cost-Benefit Analysis Template (Xls)
Generally, Cost Benefit Analysis is a simple yet essential financial technique that helps investors to decide whether or not to pursue their dream project. To calculate the CBA, you only need to compare the cost and the benefits associated with the project. If the cost outdoes the total benefits projected, then the entire investment/project isn’t worthwhile. However, if the benefit accrued is higher than the total costs, then the project is feasible.