Cost Benefit Analysis

What is Cost Benefit Analysis?

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.[1]

Cost Benefit Analysis

Cost Benefit Analysis Definition and Concept

The concept of CBA dates back to an 1848 article by Jules Dupuit and was formalized in subsequent works by Alfred Marshall. The Corps of Engineers initiated the use of CBA in the US after the Federal Navigation Act of 1936 effectively required cost-benefit analysis for proposed federal waterway infrastructure. The Flood Control Act of 1939 was instrumental in establishing CBA as a federal policy. It demanded that "the benefits to whomever they accrue be in excess of the estimated costs."[2]

Cost Benefit Analysis Template

Using the cost-benefit analysis template in this document will provide cost and benefit information that can be used to analyze and evaluate alternative approaches to projects or decisions. Since this CBA is tailored for IT, it is oriented around projects or decisions relating to new systems or processes (although it can be adapted for other purposes).[3]

Cost Benefit Analysis Template

Cost Benefit Analysis Example[4]

For accurate Cost Benefit Analysis, one has to collect ALL the positive and negative factors and have them quantified. One can total up all the positive factors (benefits), total up all the negative factors (costs), and find the difference between the two. One can also group the factors together. A cost-benefit analysis might look something like this:

Cost Benefit Analysis - Purchase of New Stamping Machine
(Costs shown are per month and amortized over four years)

Purchase of Machine .................... -$20,000 includes interest and taxes
Installation of Machine ..................... -3,125 including screens & removal of existing stampers
Increased Revenue .......................... 27,520 net value of additional 100 units per hour, 1 shift/day, 5 days/week
Quality Increase Revenue ..................... 358 calculated at 75% of the current reject rate

Reduced material costs ...................... 1,128 purchase of bulk supply reduces cost by $0.82 per hundred
Reduced Labor Costs ....................... 18,585 3 operators' salary plus labor o/h
New Operator ................................. -8,321 salary plus overhead. Includes training
Utilities ............................................ -250 power consumption increase for a new machine
Insurance ......................................... -180 premiums increase
Square footage ...................................... 0 no additional floor space is required
Net Savings per Month ........................... $15,715

This cost-benefit analysis clearly shows the purchase of the stamping machine is justified. The machine will save the company over $15,000 per month, almost $190,000 a year.

This is just one example of how one can use cost-benefit analysis, determine the advisability of a course of action, and then support it once the action is proposed.

Cost Benefit Analysis Spreadsheet

This comprehensive Cost Benefit Analysis Spreadsheet is an excellent tool to assist IT managers, in their analysis prior to implementing any IT project. The tool will help demonstrate that the most cost-effective alternatives were chosen based on tangible and intangible, quantitative and qualitative criteria.

Cost Benefit Analysis Spreadsheet

Advantages and Disadvantages of Cost Benefit Analysis[5]

The cost-benefit analysis also referred to as “benefit-cost analysis,” is a method of evaluation that estimates the value of projects to determine whether those projects are worth undertaking or continuing. At its most basic, cost-benefit analysis, CBA, could be a calculation that continuing production of a product or product option is no longer viable. At its most complex, CBA can be used to take into account the benefits the company receives as well as the benefits that accrue to the community at large.

  • Simplicity: The main advantage of cost-benefit analysis is that it is easy to understand. You are simply looking at whether benefits outweigh costs. When you do this quantitatively, measuring the dollar amount of the benefits and the costs involved in a project, the cost-benefit is very easy to see. This clarity means that everyone involved will understand the monetary nature of the project and the question of its continuance. Its simplicity also means that doing a CBA is easily possible for various scenarios, locations, and more.
  • Estimation: The simplicity of cost-benefit analysis can paradoxically lead to complications. For instance, if you are performing a cost-benefit analysis to determine whether or not to take on a project, you have to be able to perform accurate estimations about the benefits you would receive from the project. If your calculations are inaccurate, you could deem a project viable, only to later discover it ended up costing the company money. Likewise, you may decide to halt such a project, only to later find that consumer attitudes have changed and you missed out on being a trailblazer in that product type. The best estimations may not line up with actual consumer behavior.
  • Unit of Measurement: Moreover, to gain this simplicity, you have to use a common measurement — one of the disadvantages of CBA. Determining the quantitative benefits of a project is relatively straightforward; you basically add up the costs and the profits and compare the two. However, when you factor in qualitative benefits, the picture can become more complicated. For example, if you are considering implementing an employee bonus program, you will obviously incur costs. In exchange, you may receive benefits like increased employee satisfaction, decreased turnover, and greater productivity. The benefits are significant but difficult to compare — apples to apples — to the costs involved.
  • Accuracy: Further, accuracy with regard to benefits and costs must be closely monitored because benefits are easy to double-count. For example, if you are using CBA to decide whether to build a highway, you may be tempted to tally the increase in property values along with reduced travel time. However, property values would include, to a large extent, the value of location with regard to travel time; thus, if you count both, you would overestimate the project’s benefits.

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