Cost Benefit Analysis: An Easy Guide in 4 Points

Introduction

Cost benefit analysis refers to an approach done systematically in order to estimate all the weaknesses and strengths of various alternatives in order for one to get the most profitable benefits while also ensuring savings are a maximum. A CBA can help one decide on a particular course of action or even decide against one in case it turns out to be too expensive. 

1. What is the cost-benefit analysis?
2. Understanding cost-benefit analysis.
3. The CBA Process
4. Limitations of Cost-Benefit Analysis.

1) What is the cost-benefit analysis?

As mentioned above, Cost benefit analysis is a tool that allows its users to make cost-effective decisions that can help reduce unnecessary expenditure and ensure more money is saved. It can be used for decisions of all kinds, ranging from those that are strictly commercial all the way to ones that may be related to policymaking.

It can be employed for helping two main  purposes:

• To figure out whether a decision taken financially is sound or not
• To help compare ideas and places of investment with costs and benefits sorted.

The cost-benefit analysis definition also includes the fact that it is always expressed in terms of money. The results are also adjusted for the catering of various factors such as the time value of money, the present value of factors included, and the flow of various costs and benefits as and when they happen. The overall value of a result often depends on a variety of factors such as individual costs and actual cost benefits. 

2) Understanding cost-benefit analysis.

In order to better understand the concept, let’s look at when a CBA is done. Managers of companies and organizations usually carry out a CBA before they are to begin on a new project. This analysis again takes into cognizance a variety of factors such as the potential costs they may incur and what kind of revenue the overall project may generate once done. The result of the analysis and the outcome that comes from this dictates whether or not the project will be pursued. This explains the importance of cost-benefit analysis.

When CBA is at work, It takes something called an “opportunity cost” into consideration. OC refers to the benefits one may have received from a particular option had that been chosen from among the various alternatives. It can also be called a missed opportunity that’s been lost due to choosing some other alternative. Taking this into consideration can help those carrying out a CBA make better and more well-informed decisions. 

3) The CBA Process

Having understood all that a cost-benefit analysis is about, it now time to understand how its performed. The first step is to compile a that includes all the expenses and benefits that are expected to be associated with the project.

Some examples of costs that can be included are:

• Costs that can be directly incurred, such as labour costs, manufacturing costs, procurement of raw materials, etc.
• Costs that are hidden or maybe indirectly incurred such as management, paying of rent, etc.
• Costs that are intangible (ones that can’t be seen, only felt) incurred due to customer relations, employee relations etc.
• Various kinds of OC, such as renting a plant instead of buying one
• A list of potential risks that may occur during the course of the project.

cost-benefit analysis techniques also include considering a variety of benefits, such as:

• Increase of revenue or earnings due to an increase in overall sales due to production f a new product
• Intangible benefits that can range from employee satisfaction and a boost of morale to customers being satisfied and becoming permanent ones.
• Gaining a share in the market or even have an advantage due to various decisions.

It is the duty of the manager to apply proper money management and measurement techniques while conducting a CBA to ensure the best results are achieved. No cost should be over or underestimated as this may lead to faulty decision making. A careful, conservative and well thought out approach can better help in ensuring that the estimates made in the various cost-benefit analysis steps are accurate. Avoiding any kind of tendencies that can be subjective in nature will only help to ensure that the best calculations are made.

A quantitative approach to determine whether benefits outweigh costs or otherwise should be adopted. In case the analysis proves to be in favour of the expectations from the project, then it should definitely be taken. However, if for some reason, it fails to deliver, then the business needs to review the project and take a call on deciding whether to proceed with the project or seek some other alternatives. Various factors should be considered and steps to influence them should be taken to make the outcome more profitable.

4) Limitations of Cost-Benefit Analysis.

As is the case with any technique or method chosen to get a job done, CBA also has its limitations that may affect the overall outcome to be achieved. When the projects are small and the size isn’t too big, the in-depth analysis can still be done without any unnecessary issues. However, when the expense in consideration is relatively large and the size of the project to be conducted stands out as well, the figures may be difficult to work with and the overall analysis may be incorrect as it can tend to ignore and overlook attributes that may affect the daily functioning of the business. 

In such cases when the projects are massive and a variety of factors may play a role in influencing the overall budget, then alternatives to CBA can be opted for. Net present value is often a better way to analyze budgets for such situations. The concept here states that the amount of money today is always of a higher value as today’s money can still be invested and be used to earn an income.

This is all that there is to know about what is cost-benefit analysis, the advantages of cost-benefit analysis, and some limitations that one may run into.

Conclusion

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