What Is Cost-Benefit Analysis?

If the benefits greatly outweigh the costs, the decision should go ahead; otherwise, it should probably not. Cost-benefit analysis will also include the opportunity costs of missed or skipped projects. A CBA is the process of comparing the costs of a project to the benefits generated from it and determining if a business should invest in the project. While a CBA is usually expressed in monetary terms, intangible costs like time and health risks are sometimes also taken into consideration along with the impact on business income. CBAs are useful anytime there are priorities competing for limited resources.

The first example was a simple analysis that did not consider the time value of money. For a CBA to be as accurate as possible, a discounted cash-flow analysis should be used to reflect the figures in today’s dollars. You have to take current interest rates and the time period of the project into account. In a larger company, for example, before a financial manager performs a discounted cash-flow analysis, they often calculate their company’s payback period so they can see how quickly they will make back their investment. Because a safety investment project involves costs in the present and both costs and benefits in the future, at the beginning the net benefit stream will be negative; it will become positive at a certain point in time. Cost-benefit analysis is more controversial if non-economic values are also relevant.

The claim, made above, that cost-benefit analysis presupposes value monism might thus be misconceived. Firstly, even if cost-benefit analysis were merely a technical approach, interpretations of what this approach amounts to — even by most proponents of the approach — would often suppose a kind of value monism. Secondly, as a merely technical approach cost-benefit analysis might not indeed suppose value monism, but it does suppose value commensurability because it presumes that all values can be measured on a common scale. This may be a problematic assumption (see Section 2.4 and Hansson’s chapter in this Volume, Part V, especially Section 4.5).

What Are the Project Costs and Benefits?

CBA attempts to measure the positive or negative consequences of a project. A similar approach is used in the environmental analysis of total economic value. Costs tend to be most thoroughly represented in cost–benefit analyses due to relatively-abundant market data. The guiding principle of evaluating benefits is to list all parties affected by an intervention and add the positive or negative value (usually monetary) that they ascribe to its effect on their welfare. A benefit-cost ratio is determined by dividing the projected benefits of a program by the projected costs. In general, a program having a high benefit-cost ratio will take priority over others with lower ratios.

However, with any type of model used in performing a cost-benefit analysis, there are a significant amount of forecasts built into the models. The forecasts used in any cost-benefit analysis might include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If one or two of the forecasts are off, the cost-benefit analysis results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis. For very large projects with a long-term time horizon, a cost-benefit analysis might fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money. Finally, the results of the aggregate costs and benefits should be compared quantitatively to determine if the benefits outweigh the costs. If not, the business should review the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable.

Sensitivity Analysis Table for Product Purchase

So when comparing a cost (today’s value) with a benefit (some time in the future’s value) you run the risk that your outputs could be incorrect and therefore misinform decisions. This is where Net Present Value comes in where you convert all values in the calculation to today’s (present) value. The most important Cost benefit analysis contributor to an accurate, insightful cost-benefit analysis is accurate data. This makes it easier for authorized stakeholders to pull accurate, up-to-date information to inform their analyses. Numbers can be automatically exported to Excel or provided in the form of a report to key decision-makers.

• To keep things simple, you can just calculate your net cost-benefit and leave it at that.
• Also sometimes called a benefit-cost analysis, this is a well-established process for guiding leaders to make decisions that are rooted in and informed by data on company goals and priorities and budget realities.
• The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.
• As explained above, the rate of return is used to calculate the present values of your project’s costs and benefits, which are needed to find the cost-benefit ratio.
• To compensate for this difference in valuation, it is possible to use different methods.

As such, it takes account of all economically relevant impacts, whether valued by the market or not. By contrast, investment appraisal considers only the impacts on shareholder wealth of a project or policy, by taking into account effects on a firm’s revenues and costs. Now it’s time to estimate the value of each cost and benefit you’ve listed. This is most straightforward for tangible categories you can assign a specific dollar amount to—like direct costs, indirect costs, and direct benefits. For intangible categories like intangible costs and indirect benefits, assign KPIs in lieu of dollar amounts.

It determines whether the benefits outweigh the costs and whether they are financially sound and supportive. Cost-benefit analysis (CBA) is a process or tool to support decision making in projects. CBA in whatever form is a necessary process all organisations should consider in order to assist decision making and ensure investment funds are spent on projects which promise the greatest return. It will also assist with better ownership and governance over benefits realisation once the project starts which is critical. Below is a sample sensitivity analysis worksheet a CIO might use to evaluate a product purchase alongside a CBA — it’s overly simplified for the sake of space. It combines product attributes, like suitability for the task, with business considerations.

Now, the costs and benefits of the project could be accurately analyzed, and an informed decision could be made. Also make sure to factor in an objective look at any risks involved in maintaining the status quo moving forward. Include the basics, but also do a bit of thinking outside the box to come up with any unforeseen costs that could impact the initiative in both the short and long term. In some cases geography could play a role in determining feasibility of a project or initiative.

Templates to Help With Your Cost-Benefit Analysis

With the framework and categories in place, you can start outlining overall costs and benefits. There is a danger in assuming that the inputs to a cost-benefit analysis are entirely quantitative, which can lead to an excessive degree of certainty regarding the outcome of the analysis. A key issue is that the benefit gained from a decision may depend on the values of the person conducting the analysis – and values vary by person. For example, in a case where an investment decision will lead to improved air quality, it is questionable whether those paying for the project all believe that improved air quality provides the same value; they may not. Another issue is that not all benefits can be converted into a monetary value. For example, paying for a project in order to save an endangered species might be morally correct, but cannot be converted into a specific monetary value.

The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project. The analysis is the cost of the new staff, versus the cash flows to be derived from sale of the new product. A variation on the concept is to replace the cost of new staff with the fees charged by an outside design company that takes on the work. Net present value (NPV) is a calculation that takes the time value of money into account. You discount cash flow back to the present based on the following formulas, which account for each year of cash flows.

What Is Cost-Benefit Analysis (CBA)?

If the measured cost of a project is inaccurately assessed to be slightly low, this could yield a positive value for the project, so that an investment is initiated. Conversely, if the measured cost is inaccurately assessed to be slightly high, this could yield a negative value for the project, thereby cancelling a project that should have proceeded. Consequently, it makes sense to spend extra time verifying the accuracy of the data inputs to a cost-benefit analysis, especially when the outcome is in doubt. The CBA provides as main indicator the NPV, that is, in the case of CBA, compared to the financial analysis, the net of discounted values of social costs and benefits to society (Wijayasundara et al., 2017). In terms of values, cost-benefit analysis might be understood to be the maximization of one overarching or super value. Such a value could be an economic value like company profits, or the value of the product to users but it could also be a moral value like human happiness.

• If the measured cost of a project is inaccurately assessed to be slightly low, this could yield a positive value for the project, so that an investment is initiated.
• This can help you identify and understand your costs and benefits, and will be critical in interpreting the results of your analysis.
• Identify the goals and objectives you’re trying to address with the proposal.

You should also consider cost of intangibles as well as opportunity costs that may be overlooked. In addition to its purchase price and any taxes you will have to pay on it, you must add the cost of interest on the purchase. Even if the company buys the machine outright, you will have to include a sum in the lost interest it would have earned if the money had not been spent. Finally, when calculating the value of replacing three employees, be sure to add overhead costs and benefits costs in addition to their salaries. Accounting is your source for the exact number of the company’s “fully burdened” labor rates. You calculate the selling price of the 100 additional units per hour multiplied by the number of production hours per month.

Using a project management tool can make this step easy—since all of your project information and communications are housed in one place, you can easily look back at past initiatives. But unlike many apps with inferior to-do lists, ProjectManager has a list view that is dynamic. It adds priority and customized tags you can assign team members to own each item. Our online tool automatically tracks the percentage complete for each item in real time. Regardless of the view, they all update live and they’re ready for you to utilize. Cost-benefit analysis is a systematic method for quantifying and then comparing the total costs to the total expected rewards of undertaking a project or making an investment.

The technique relies on data-driven decision-making; any outcome that is recommended relies on quantifiable information that has been gathered specific to a single problem. This initial stage is where the project planning takes place, including the timeline, resources needed, constraints, personnel required, or evaluation techniques. It is at this point that a company should assess whether it is equipped to perform the analysis. For example, a company may realize it does not have the technical staff required to perform an adequate analysis.

The broad process for a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform analysis of both costs and benefits, and to make a final recommendation. A cost-benefit analysis requires substantial research across all types of costs. This means considering unpredictable costs and understanding expense types and characteristics. This level of analysis only strengthens the findings as more research is performed on the state of outcome for the project that provides better support for strategic planning endeavors. The analyst that performs the cost-benefit analysis must often then synthesize findings to present to management. This includes concisely summarizes the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis.

There’s even space to capture other line items, such as telephone charges, rental space, office equipment, admin and insurance. Since we obtained a positive benefit-cost ratio, we can conclude that the project will be profitable for this company. This result implies that the project will generate about $4,43 dollars per each $1 spent to cover expenses. Taken together, according to this objection, not using weights is a decision in itself – richer people receive de facto a bigger weight. To compensate for this difference in valuation, it is possible to use different methods.

Our easy online application is free, and no special documentation is required. All applicants must be at least 18 years of age, proficient in English, and committed to learning and engaging with fellow participants throughout the program. For your analysis to be as accurate as possible, you must first establish the framework within which you’re conducting it. What, exactly, this framework looks like will depend on the specifics of your organization. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.

The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. Nicholas Morpus is the product management software expert for The Ascent, with experience working in the B2B space. This is the most difficult part of the process and it will require some digging to get to the bottom of these values.