It’s essential to analyze how it will impact the company’s bottom line when a company is making a new hire, starting a new project, adopting a new software system, or pivoting to a new market.
How do you know whether a project is worth the money and effort? How do you persuade others that your plan has a business case? Performing a cost-benefit analysis is the way entrepreneurs and businesses determine whether a new project is worth the investment.
What is a cost-benefit analysis?
A cost-benefit analysis is a method of balancing the predicted costs and benefits connected with a project. The cost-benefit analysis includes calculating all costs of a decision and subtracting that amount from the total projected benefits of the plan. This data-driven decision-making is used in startups and established companies.
How do you conduct a cost-benefit analysis?
1. Establish a Structure for Your Analysis
You must establish a structure for your analysis. Identify the purpose you’re addressing with the program. What does success look like? That is essential for you to understand the results of your study. Decide what metrics you will use to compare the costs and benefits. This usually includes assigning a dollar amount to each possible benefit and cost. Use your company’s organizational chart to help remind you how this plan may impact other parts of your business.
2. What is the cost of the status quo?
Sometimes doing nothing is the right thing to do. But it could also lead to disaster. Use this analysis to determine whether doing nothing could end up costing more than investing in this new project.
3. Identify Your Benefits and Costs
Make two separate tables. One of all of the calculated benefits, and the other of the expected costs. The most obvious costs to identify are the direct costs. Those include expenses directly linked to the creation of the project. For example, costs including manufacturing, labor, inventory, materials, and inventory are direct costs. But it’s vital to go beyond the obvious. How many people will be needed to complete the project?
Will you need to hire new people? How much new equipment will you need? Do you need to replace existing equipment? All of the answers to these questions are costs to identify when you’re performing this analysis.
Other categories of costs include:
- Intangible Costs. These are all costs that are complicated to quantify and measure. When employees learn that new software instead of doing their usual work, the company incurs an intangible cost. These intangible costs also include your employees’ health and safety or strengthening your position with distributors.
- Unexpected costs. Costs from a potential risk that may have a price. There may be legal, regulatory, or environmental risks.
- Opportunity Costs. This refers to lost benefits that occur when a business pursues one product or strategy over another.
- Indirect Costs. These are shared costs that can’t be traced to a single activity. Typically, these are fixed overhead expenses, such as rent and utilities that add to the burden of conducting business. These can also include all supporting activities, including general administration, payroll processing, legal, and accounting costs. Indirect costs may produce what researchers call “lumpy costs.” These are costs that behave like steps. Initially, they show an economy of scale, but then the costs increase when they meet capacity. For example, when a capacity limit of staffing, facilities, or equipment is reached. At that point, the organization has to make a notable increase to its “fixed” capacity, and average unit costs are large once again. If the volume of service grows, unit costs will tend to decline over time. So the cost to the business of even a small increase may vary wildly depending on how close the company is to exhausting its capacity for indirect costs.
Since some of these costs are certain, while others are not, it’s appropriate to run several possible scenarios with each uncertain factor. Incorporate those uncertainties into contingency plans that you will design before executing the project. And when you are analyzing costs, make sure you are properly accounting for any sunk cost.
Likewise, benefits can be:
- Direct: For example, increased revenue and sales generated from a new product. What additional revenue will come in from the investment? Describe what the return on investment means to your organization—you could measure it by revenue, efficiency, or market share.
- Competitive: For example, a competitive advantage to being a first-mover within an industry.
- Intangible: For example, improved staff morale.
- Indirect: Such as improved customer satisfaction from your business.
4. Describe a dollar amount for each benefit and cost
You must assign a dollar amount to each cost and benefit that you’ve identified. This should be an exhaustive list of all benefits and costs.
Direct benefits and costs are the most obvious. But intangible and indirect benefits and costs are challenging to quantify. Those are essential for you to understand the unintended consequences of your project.
5. Tally the Total Value of Benefits and Costs and Compare
Once every benefit and cost has a dollar amount, sum up each table. When benefits exceed the costs, you’ve got a business case for the decision. It’s clear that when your costs outnumber total benefits, you should reconsider the project.
Use the cost-benefit ratio equation to conduct this analysis: sum of benefit value ÷ sum of cost value = cost-benefit ratio. If your answer is one greater than or equal to one, it is a financially viable idea. But there are still several other aspects to consider in your cost-benefit analysis.
6. Continue to test your cost-benefit analysis with additional calculations
If the project has a positive ratio, you should also analyze your payback period. Your payback period shows when you will make your return on investment. You can calculate your payback period by taking your investment cost divided by the net cash flow from the project. For example, if a new machine will produce an additional $15,000 in annual cash flow, and the new machine will cost $35,000 to purchase, it will take 2.3 years for the company to recoup its investment.
The purchasing power of a dollar will be less in one year than it is today. For example, if the rate of inflation is three percent, in one year, one dollar will only be worth 97 cents. In 12 months, you’ll pay one dollar to buy an item that costs 97 cents today.
Lost return on investment
When spending money to fund your project today, you will lose potential income from interest if you were to invest the money instead.
Discount Rate, Net Present Value, and Sensitivity Analysis.
The discount rate represents the future value of today’s currency weighing the effects of inflation and the lost return on investment. You should also factor Net Present Value to determine the immediate costs and revenue. It is also vital to run a sensitivity analysis to consider the risks and uncertainties in your projections.
Question your framework
Continue to question your structure as outlined in step one. What did you miss when creating the initial framework? When the costs exceed the benefits, consider what alternatives you haven’t examined. Also, you may be able to classify price reductions that will empower you to reach your goals more affordably while remaining effective. Show your plan to a colleague and invite them to point out flaws in your original structure.
Present your idea to stakeholders
You can create a decision tree to determine your scenarios, weigh the projected outcomes, and present your findings to decision-makers in a way that’s simple to understand.
Pros and cons of cost-benefit analysis
Like the cost-benefit analysis itself, there are advantages and disadvantages to this approach.
Advantages of Cost-Benefit Analysis
- It makes decisions simpler: Decisions in business are often complicated. By interpreting a choice of benefits versus costs, the analysis is not complex.
- It is data-driven: This method removes opinions and personal bias. It is an evidence-based evaluation of your choices. So it encourages your organization to make logical decisions.
- It can uncover hidden benefits and costs: This method requires you to outline all possible benefits and costs connected to the project. This should help you reveal less-than-obvious portions, like intangible and indirect costs.
Limitations of Cost-Benefit Analysis
- It’s only as good as the data used to complete it: If you have incomplete data, the results of the study will also be inaccurate.
- It’s difficult to predict all variables: It is difficult to anticipate every circumstance that may impact your project. There may be long-term changes in material costs and market demand, for example.
- It removes the human element: Some things are more important than money. While a business must make revenue, this analysis does not account for the human perspective of the business decision. The greatest monetary benefit is not always an indication that the option is the best choice.
- It’s best for short-term and mid-length plans: If the goal is for the long term, it is difficult to make accurate predictions. Over time, costs and benefits may vary based on the market and changes to consumer preferences. So for projects that include longer timeframes, a cost-benefit analysis can miss the mark. Use this method for projects that will take months instead of years. For longer-term decisions, use a method like the internal rate of return.
Cost-benefit analysis is a systematic approach that we can use to analyze the risks and rewards of a project so we can choose the best solution. In the end, this analysis isn’t the only strategy that you should use to determine whether to select a course of action in your business. But it is a simple way to make a decision based on logic.