Tina has a bag company. She is considering buying new equipment for her factory. How shall she decide on the best options? She needs to determine if benefits outweigh costs over the period of time. She can do this by using the Cost-Benefit Analysis. It is a useful decision-making tool.
In this lesson, we will introduce the concept of Cost-Benefit Analysis and learn about its advantages and disadvantages. We will also look at steps to perform Cost-Benefit Analysis (CBA). By the end of this lesson, you will know:
In 1840s, Jules Dupuit, a French engineer and economist introduced the concepts that led to the formation of the Cost Benefit Analysis. As its name suggests, it involves adding up the benefits of a course of action and then comparing these with the costs associated with it. It became a popular concept in the 1950s. Businesses consider it as a simple way of weighing up project costs and benefits, to determine whether to go ahead with a project. Before taking on a new project, it is sensible to conduct a cost-benefit analysis to evaluate all the potential costs and incomes that a business might generate from the project. If the benefits generated be more than the associated, it shows the project is financially feasible; if not, it is wise to pursue an alternate project.
Taking into account the opportunity cost. Most models of cost-benefit analysis 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 foregone or missed opportunity as a result of a choice or decision. When we factor in opportunity costs, it allows us to weigh the benefits from alternative courses of action and not merely the current 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.
Apart from opportunity costs, some other costs are also to be considered.
Benefits to be considered might include the following
Step One: Brainstorm Costs and Benefits
First, take time to brainstorm all of the costs associated with the project, and make a list of these. Then, do the same for all of the benefits of the project. Can you think of any unexpected costs? And are there benefits that you may not initially have anticipated?
Step Two: Assign a Monetary Value to the Costs
Costs include the costs of physical resources needed, as well as the cost of the human effort involved in all phases of a project. Costs are often relatively easy to estimate (compared with revenues).
It's important that you think about as many related costs as you can. For example, what will any training cost? Will there be a decrease in productivity while people are learning a new system or technology, and how much will this cost?
Step Three: Assign a Monetary Value to the Benefits
This step is less straightforward. Firstly, it's often very difficult to predict revenues accurately, especially for new products. Secondly, along with the financial benefits that you anticipate, there are often intangible, or soft, benefits that are important outcomes of the project.
For instance, what is the impact on the environment, employee satisfaction, or health and safety? What is the monetary value of that impact?
As an example, is preserving an ancient monument worth $500,000, or is it worth $5,000,000 because of its historical importance? Or, what is the value of stress-free travel to work in the morning? Here, it's important to consult with other stakeholders and decide how you'll value these intangible items.
Step Four: Compare Costs and Benefits
Finally, compare the value of your costs to the value of your benefits, and use this analysis to decide your course of action.
To do this, calculate your total costs and your total benefits, and compare the two values to determine whether your benefits outweigh your costs. At this stage it's important to consider the payback time, to find out how long it will take for you to reach the break-even point – the point in time at which the benefits have just repaid the costs.
For simple examples, where the same benefits are received each period, you can calculate the payback period by dividing the projected total cost of the project by the projected total revenues:
Total cost / Total revenue (or benefits) = Length of time (payback period)
Example of Cost-Benefit Analysis
Suppose there are two projects where project one is incurring a total cost of $8,000 and earning total benefits of $ 12,000 whereas on the other hand project two is incurring costs of Rs. $11,000 and earning benefits of $ 20,000, therefore, by applying cost-benefit analysis the Cost-Benefit ratio of the first project is 1.5 ($8,000/ $12,000) and the ratio of the second project is 1.81 ($11,000/$20,000) which means project two is feasible being having high cost-benefit ratio.
The time value of money is a central concept in doing a cost-benefit analysis. The reason is that the amount of money received today has greater value than getting the same amount of money in the future. Compensating for this difference between the present value and the future value of money is essential if a cost-benefit analysis is to accurately quantify the costs and benefits of the action being studied.
