Cost-Benefit Analysis

A cost-benefit analysis is a process businesses use 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 the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town, and most analysts will also factor opportunity cost into such equations.

Before erecting a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs and revenues a company may be generate if upon completing the project. The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.

The first step in the process is to compile a comprehensive list of all the costs and benefits associated with the project or decision. Costs should include direct and indirect costs, intangible costs, opportunity costs, and the cost of potential risks. Benefits should include all direct and indirect revenues and intangible benefits, such as increased production from improved employee safety and morale, or increased sales from customer goodwill. The analyst should then apply a common unit of monetary measurement to all items on the 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.

The final step is to compare the results of the aggregate costs and benefits quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review of the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company may abandon the project.

For projects that involve small- to mid-level capital expenditures and are short to intermediate in terms of time to completion, an in-depth cost-benefit analysis may be sufficient enough to make a well-informed, rational decision. For very large projects with a long-term time horizon, cost-benefit analysis typically fails to account for important financial concerns such as inflation, interest rates, varying cash flows and the present value of money. Alternative capital budgeting analysis methods including net present value or internal rate of return are more appropriate for these situations.