Cost-benefit analysis is the exercise of evaluating a planned action by determining what net value it will have for the company. Basically, a cost-benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real key to doing a successful cost-benefit analysis is making sure to include all the costs and all the benefits and properly quantify them. It is the fundamental assessment behind virtually every business decision, due to the simple fact that business managers do not want to spend money unless the benefits that derive from the expenditure are expected to exceed the costs. As companies increasingly seek to cut costs and improve productivity, cost-benefit analysis has become a valuable tool for evaluating a wide range of business opportunities, such as major purchases, organizational changes, and expansions.
Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (from such things as management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.
Although its name seems simple, there is often a degree of complexity, and subjectivity, to the actual implementation of cost-benefit analysis. This is because not all costs or benefits are obvious upon initial assessment. Take, for example, a situation in which a company is trying to decide if it should make or buy a certain subcomponent of a larger assembly it manufactures. A quick review of the accounting numbers may suggest that the cost to manufacture the component, at $5 per piece, can easily be beaten by an outside vendor who will sell it to the company for only $4. But there are several other factors that need to be considered and quantified (if possible):
- When production of a subcomponent is contracted to an outside vendor, the company's own factory will become less utilized, and therefore its fixed overhead costs have less components over which to be spread. As a result, other parts it continues to manufacture may show an increase in costs, consuming some or possibly all of the apparent gain.
- The labor force may be concerned about outsourcing of work to which they feel an entitlement. Resulting morale problems and labor unrest could quickly cost the company far more than it expected to save.
- The consequences of a loss of control over the subcomponent must be weighed. Once the part is outsourced, the company no longer has direct control over the quality, timeliness, or reliability of the product delivered.
- Unforeseen benefits may be attained. For example, the newly freed factory space may be deployed in a more productive manner, enabling the company to make more of the main assembly or even another product altogether.
This list is not meant to be comprehensive, but rather illustrative of the ripple effect that occurs in response to changes made in a real business setting. The cost-benefit analyst needs to be cognizant of the subtle interactions of other events with the action under consideration in order to fully evaluate its impact. In fact, accuracy in quantifying the costs and benefits in this sort of analysis is essential in producing information useful for the decision-making process.
The time value of money is a central concept in doing a cost-benefit analysis. The reason is that an amount of money received today has greater value than getting that 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.
Capital budgeting is essentially a cost-benefit analysis that extends the evaluation of costs and benefits into a longer timeframe and therefore greater emphasis is placed on considerations of the time value of money. When the inputs and outputs related to a capital expenditure are quantified by year, they can then be discounted to present value to determine the net present value of the opportunity at the time of the decision.
A formal cost-benefit analysis is a multi-step process which includes a preliminary survey, a feasibility study, and a final report. At the conclusion of each step, the party responsible for performing the analysis can decide whether continuing on to the next step is warranted. The preliminary survey is an initial evaluation that involves gathering information on both the opportunity and the existing situation. The feasibility study involves completing the information gathering as needed and evaluating the data to gauge the short- and long-term impact of the opportunity. Finally, the formal cost-benefit analysis report should provide decision makers with all the pertinent information they need to take appropriate action on the opportunity. It should include an executive summary and introduction; information about the scope, purpose, and methodology of the study; recommendations, along with factual justification; and factors concerning implementation.
Cost-benefit analysis is a decision support method used to help answer questions that often start with "what if" or "should we." It is a mathematical method to measure the benefits of a course of action. It is a powerful tool that can be used to thoroughly analyze the likely net effect to a business of buying new equipment, expanding into a new service area, or outsourcing a task now handled internally. Feeling confident that the benefits derived from an action taken will outweigh the costs of implementing that action makes the decision to proceed much easier.
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