It is rare for an organization to have unlimited resources; they must choose the best of all the opportunities available to them. One of the ways organizations make decisions is by using cost-benefit analysis.
This technique is also applicable to deciding on a new action.
Cost-benefit analysis is the most popular project selection technique; it’s also known as a “Benefit-Cost Analysis.” This topic has a vast scope. I will be giving a basic understanding of this method; covering it all in one blog post would be very difficult.
What is Cost-Benefit Analysis (CBA)?
Cost-benefit analysis is a benefit measurement method that is usually performed by top management. They gather data and analyze all projects. Then they try to find which project is more profitable.
Once this process completes, they develop the project charter.
Cost-benefit analysis provides valuable information, such as:
- Expected Profit
- Time value of the profit
- The basis to compare the projects
In the cost-benefit analysis, you find and convert the benefits into monetary values. Afterward, you subtract the investment costs from the benefits to get the result.
You can proceed if the result is positive, but if it is not, you should abandon the idea.
For instance, assume your company is involved with manual bookbinding, and you propose that management buy equipment to improve the efficiency.
Before submitting the proposal, you will perform the cost-benefit analysis. You will list the cost of the investment. For example:
- Machine cost
- Maintenance cost
- Cost of electricity used by these machines
Then you will identify the benefits, such as
- Profit from improved production
- Cost of reduced workforce
- Cost of the better quality product
You will figure out the cost investment and the monetary value of benefits.
You will then perform the cost-benefit analysis by subtracting the cost of investment from the benefits. Show this figure to management and justify your proposal.
Time Value of the Profit
In cost-benefit analysis, you calculate the expenditure and the expected profit. Understand that profit earned after several years will not have the same value as today, consider inflation while analyzing the cost. Inflation erodes the value of money.
For example, assume a 5% inflation yearly. What you can buy for 100 USD today will cost 105 USD after one year.
Calculating the Current Worth
Assume that you invest 100,000 USD in a project. You expect to earn a 10,000 USD profit after one year.
Considering a yearly inflation of 5%, what will the current value be?
The formula to find the Current Value is
FV = CV(1+r/100)^n
FV = Future Value
CV = Current Value
r = Inflation
n = time
FV = 10,000 USD
r = 5
Putting these values in the formula,
10,000 = CV(1+0.05)^1
CV = 10,000/1.05
CV = 9,523.80
Therefore, the current value of your profit is 9,523.80 USD.
The Basis to Compare the Projects
Cost-benefit analysis helps you select the best project when there are many many. Here you compare the profit earned from each project in current value and you will choose the one with the highest profit.
If it is a multiyear project, you cannot see the profit in today’s value. You may think you will get a profit from it; however, a Net Present Value (NPV) analysis could be eye-opening.
The Advantages of Cost-Benefit Analysis
Cost-benefit analysis has many advantages. It helps organizations select from many choices. It is also useful when an organization takes a new course of action. This analysis has several basic advantages:
- It justifies selecting a project.
- It helps to compare the cost invested and benefits.
- It provides a baseline for comparing available options.
- It compares the future earnings with today’s dollar value.
- It helps select the most profitable project.
Limitations of Cost-Benefit Analysis
This technique has a few limitations.
It is useful for small projects with shorter durations. As the duration increases, this technique becomes more complex. Bigger projects are more difficult; converting intangible costs are not easy and this technique is not useful.
As the project becomes bigger and more complex, intangible costs and benefits rise. Converting these costs and benefits into monetary form is not an easy task. Inflation plays an important role in longer projects. Also, the greater the duration, the greater the risks.
The cost-benefit technique is a systematic approach to calculating the investment cost and received benefits. You can use this when you have to select a project among many options. This technique also helps you when taking new action, but becomes more difficult as the duration of the project or cost increases, this technique becomes more difficult.
How do you use cost-benefit analysis in your organization? Please share your thoughts in the comments section.