This article provides a practical explanation of Cost Benefit Analysis. After reading this, you’ll understand the basics of this powerful financial management and decision making tool.
What is a Cost Benefit Analysis?
A Cost Benefit Analysis (CBA) is a systematic approach that can be used to get an idea of the strengths and weaknesses of, for example transactions, investments, business processes and other activities. This mostly monetary evaluation method is used to identify effective options and make responsible choices, which are both advantageous and save costs. The method also values intangible aspects, such as the advantages that come with working in a certain area, or potential reputation loss after making high-risk strategic choices. The benefits and costs are expressed in monetary terms, and are adjusted for the time value of money, which is important if you want to use the net present value as the common basis.
The Cost Benefit Analysis can be used for buying and construction decisions surrounding property investments for example, but also for decisions that have an impact on society. Social cost-benefit analyses also take into account the external effects of a decision. Take for example the development and construction of a large dam in a part of the river Nile that flows through Ethiopia. The advantage of such a dam would be that Ethiopia could store large amounts of water. On the other hand, the construction would have disastrous consequences for the water supply to Egypt. Such a project would of course result in a lot of tension between the two countries.
The first person known to have used a Cost Benefit Analysis in industry, was Jules Dupuit, a French engineer. The autodidact economist outlined the basic elements of what later became known as the cost-benefit analysis to establish the toll for a bridge that he was working on. The process was later refined and popularised by British economist Alfred Marshall.
Applications of the Cost Benefit Analysis
As mentioned above, the Cost Benefit Analysis (CBA) is used in a wide range of different fields. It’s used in the corporate world, the public sector, by financial institutions and non-profit organisations. The analysis method can offer unique and valuable insights regarding:
The development of benchmark tools when comparing projects
- Feasibility studies of project proposals
- The evaluation of new purchases/ investments
- The measurement of social advantages
- The assessment of the desirability of a proposed policy
- The assessment of proposed change processes
- Establishing the effects of a process or proposal on the stakeholders
Steps of a Cost Benefit Analysis
1. Establishing the expected (intangible) costs and benefits of the project
Take some time to brainstorm about all the costs associated with the project and compile a list of all those costs. Repeat this with all the advantages associated with the project outcome. Some important questions you could include are, for example:
- Are there any unexpected costs that you might actually be able to identify beforehand?
- Are there any additional advantages associated with the project outcome, on top of those initially anticipated?
- Is the time value of the costs and benefits taken into account sufficiently? What’s the lifespan of the project?
- What are the fixed and variable costs of the project?
- What are the expected direct and indirect costs?
- Which physical and intangible benefits are associated with the project?
Types of costs you should think of include: operational costs, human resource costs, insurances, property, facilities, materials and transport costs. But they also include intangible costs such as time, energy or a loss of safety or customer loyalty.
Different types of benefits include: income, savings, higher interest, increased capital or intangible aspects such as customer satisfaction, a safer work environment or happy employees.
2. Expressing the costs and benefits in the same units
Costs are relatively easy to express in monetary terms, but that’s usually not the case for the benefits. It is however necessary to express the costs and benefits in the same units if you want to make a comparison. That’s why it’s important to spend some time thinking about the advantages of the project. How much is a better reputation going to generate? Will you be able to attract more customers? How much extra turnover can you expect? What’s the project’s impact on the environment, employee satisfaction, workers’ health or the feeling of safety they experience? All these advantages or effects need to be valued in monetary terms.
3. Comparing the costs and benefits
The final step consists of comparing the value of the costs to the value of the benefits. Calculate the total costs and the total benefits and compare the two values to see if the benefits outweigh the costs. After this, you can make a decision based on the outcome of your comparison.
Cost Benefit Analysis example
Cafe Inc., a Colombian coffee exporter with an office in Europe, has seen its profits going up for four years in a row, but their capacity is insufficient to meet the increasing demand for coffee abroad.
Cafe Inc. considers tapping into a new market in Western Europe, but this will require additional manpower. They’ll also need to expand their premises and the employees will need to be supplied with new equipment.
Cafe Inc. conducts a cost-benefit analysis to determine whether the new strategy is in fact feasible.
- Cafe Inc. expects their turnover to increase by 40% after expanding their capacity.
- Cafe Inc. expects that with a larger number and more skilled employees, their productivity will increase by 8% on average.
- Considering the current shortage, Cafe Inc. already needs to hire extra, temporary staff. The extra staff are hired for 150 hours per month at 40 euros per hour.
- Cafe Inc. expects to be able to recoup their investment in one year.
The assumptions that were made regarding the costs, as well as the benefits, are subjective and fairly uncertain. Especially the turnover increase can’t be predicted with much certainty, but the owner of Cafe Inc. decides nonetheless to go ahead with the new strategy and expansion plans. After the first year, he expects the additional benefits to exceed €150,000.
Cost Benefit Analysis – shortcomings and additions
The Cost Benefit Analysis method might be sufficient for projects involving small to medium-sized investments and a short to average lead time. However, when it comes to long-term projects, a Cost Benefit Analysis doesn’t sufficiently take into account important financial aspects such as inflation, interest rates, cash flow fluctuations and present value. In these instances, other predictive indicators are more suitable, like the Net Present Value (NPV) or the Internal Rate of Return (IRR).
It’s possible to increase the reliability of the assumptions in a cost-benefit analysis, by using a sensitivity analysis and adding the discount rate.
Robert Kaplan recommends the use of a sensitivity analysis in order to check the accuracy in light of a set of variables. The sensitivity analysis is used to test how robust the outcome of a cost-benefit analysis is when certain situations or some of the numbers in the analysis change.
The discount rate is used to express the time value of money. It’s based on the interest rate, the anticipated inflation and a compensation for the risk associated with the investment. The discount rate is also a fixed component of the Discounted Cash Flow Analysis (DCF).
It’s Your Turn
What do you think? Do you recognise the explanation about the DuPont Analysis? Could the DuPont identity help you get an understanding of the financial effectiveness of your organisation? Which factors do you think are needed for a realistic prognosis of a company’s profitability?
Share your experience and knowledge in the comments box below.
- Quah, E., & Haldane, J. B. S. (2007). Cost-benefit analysis. Routledge.
- Robinson, R. (1993). Cost-benefit analysis. BMJ, 307(6909), 924-926.
- Sugden, R., & Williams, A. (1978). The principles of practical cost-benefit analysis. OUP Catalogue.
- Zhuang, J., Liang, Z., Lin, T., & De Guzman, F. (2007). Theory and practice in the choice of social discount rate for cost-benefit analysis: a survey (No. 94). ERD working paper series.
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