Are you looking to propose a new project in your company? Or revise existing strategies that might affect the business? While there are several aspects you must consider before making any significant moves, there’s one burning question that you must answer- is it worth the money and resources?
The best way to find out is by running a cost-benefit analysis. Read on to find out what it means and how you can use it.
What is a Cost Benefit Analysis?
A cost-benefit analysis (CBA) systematically evaluates the costs and benefits of a decision, project, or investment. The goal is to make decisions that maximize benefits and minimize costs.
Simply put, it helps you decide whether or not to move ahead with a business decision. How? By comparing the estimated cost to the benefits associated with the decision. If the benefit is greater than the cost, the decision is good to make. But if it’s the other way around, you might want to rethink the plan.
This is an excellent way to parse out important information, uncover hidden expenses and benefits, and simplify decision-making.
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Cost-benefit Analysis Importance
Businesses need to constantly stay on top of the latest market trends and adopt new technology to stay relevant. For this, they often have to make huge investments. Running a CB Analysis before making a decision will help you determine if the opportunity is worth the cost and whether you’ll be able to make a profit.
Moreover, there might be situations where you have multiple options to choose from. CBA helps you rank these options based on ROI and select the most viable one. At the same time, it also helps you evaluate the opportunity costs of the other options.
Cost-benefit Analysis Steps
When it comes to cost-benefit analysis, there’s not a one-size-fits-all technique. But each technique often includes five common steps-
1. Create a Strategy
Start by specifying the goals you want to accomplish with the proposal. Then, list down the tasks you need to achieve to complete the project. This will help you identify areas for resource allocation and the estimated costs and benefits.
Similarly, determine the metric you’ll use to measure the cost and benefits. For accurate results, make sure you use the same currency for both.
2. Estimate the costs
The next step is to calculate the cost you’ll incur. For this, you can collaborate with other departments. For example, if you want to implement new software, your IT team can give you a better estimate of the cost.
You must also consider other resources like a cybersecurity solution, employee training, etc. Once done, segment these costs into different categories like fixed, variable, direct, indirect, etc. Here are a few examples-
Direct costs– Manufacturing overhead, inventory, production, raw material costs, etc.
Indirect costs– Rent, utility prices, overhead administrative expenditures, electricity bills, etc.
Intangible costs– Impact on customers, employees, training, turnaround times, etc.
Opportunity costs– Alternative investments, the gap between buying and establishing a plant, etc.
Cost of possible risks– Changes in Government regulations, new competition, and other environmental factors.
3. Estimate the Benefits
After outlining the estimated cost, you must estimate the benefits you can reap from the project/decision. This can broadly be classified into two-
Direct Benefits: The project’s real financial benefits that you will gain. For example, if you’re planning to launch a new product or service, the direct benefit will be the money you make from the sales. Similarly, if you’re implementing a parking management software, you can save the cost of employing a dedicated team to manage office parking.
Indirect Benefits: These are benefits that are possible to appreciate but may not be quantifiable, like improved brand recognition, increased productivity, employee satisfaction and retention, etc.
4. Complete Analysis Calculations
With both cost and benefit clearly laid out, you can now proceed with the analysis. A simple way to do this is by subtracting the costs from the benefits. If the benefits outweigh the costs, the project has a net value to the organization. For more accurate results, you can also use other methods like the Benefit-Cost Ratio (BCR) or the Net Present Value (NPV) model.
5. Offer Suggestions
As a CBA expert, you must carefully verify the results before reporting them to executives. Make sure it details the expenses, rewards, total impact, and how the results support the analysis’s original goal.
Before making a recommendation, you must also consider the resource availability of the company. For example, your company might not have the budget or resources to accommodate your recommendation. So, even though investing in a software or upgrading a piece of equipment might be profitable from a cost-benefit perspective, it might not be wise to proceed with it.
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Limitations of Cost-Benefit Analysis
While a cost-benefit analysis is an excellent way to determine the worth of a business decision, it also has its limitations. These include-
1. It does not consider important financial factors like inflation, interest rates, variable working capital, and the current value of money for massive projects with a long time horizon.
2. The analysis required all elements of costs and benefits to be accurately quantified. However, certain errors like the inability to forecast future values can lead to inaccurate results, further causing inefficient decision-making.
3. It does not include benefits whose monetary values are difficult to ascertain. For example, employee or client satisfaction.
Whether you’re planning to implement a big or small project, a cost-benefit analysis is an excellent way to make important decisions backed by data. It helps you verify the expected benefits of an investment and select the right option. But remember, benefits are not 100% monetary. Therefore, you must also consider other intangible benefits to make an informed decision.