A cost-benefit analysis is a tool used by Management of businesses, to analyze decisions. The business or analyst sums the benefits of a situation or action and then subtracts the costs associated with taking that action. Some Consultants or Analysts also build models to assign a Naira value on intangible items, such as the benefits and costs associated with living in a certain town.
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.
Benefits and Usefulness of Cost Benefits Analysis to Business
- Revenue and sales increases 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.
Cost-benefit analyses are advantageous because they simplify complex business decisions. Different business projects might entail vastly different types of expenses and details at a low level, but a cost-benefit analysis frames all projects in the same simple terms: total benefits, minus total costs, equals net benefit. The simplicity of the cost-benefit analysis lets businesses compare projects of all types no matter how dissimilar they are.
Another benefit of a cost-benefit analysis is that it provides an objective way to compare projects. Business owners who are emotionally attached to or have time invested in certain projects may be predisposed to pursue those projects, even if there are better options available. Comparing projects based on the actual financial costs and benefits eliminates the emotional element and may help business managers overcome biases for the good of the business.
While a cost-benefit analysis can help a company estimate the net benefit of a project, benefits are typically more difficult to predict than costs. For example, a company might know the exact cost of the materials needed to produce a new product, but it is impossible to know exactly how many units a new product will sell when it goes on the market. Estimating costs and benefits can, however, give a business an idea of the lowest amount of revenue a new project needs to produce to break even and help set revenue goals to make projects profitable.
A cost-benefit analysis can be a useful tool for decision-making, but the accuracy of a cost-benefit analysis is limited by the thoroughness of recognizing likely costs and benefits. If a business fails to recognize potential costs and benefits, it can cause poor results that lead to sub-optimal decisions. For example, if a factory fails to account for the environmental impact of its operations as a cost, it could lead it toward projects that create more pollution, which might be bad for society and hurt the company’s reputation.
In using Cost Benefit Analysis, analysts or project managers 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.
Conclusively, 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 proceed 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.