Life is a series of decisions that require weighing the costs and benefits. Whether you’re contemplating taking on a new project at work, starting a new business, or determining whether an initiative is worth continuing, it’s essential to take a setback and evaluate the pros and cons of the different scenarios. Not only does this help you navigate difficult circumstances, but it also helps protect your interests –whether in your personal or professional life. However, without the right tools and guidance of a cost benefit analysis, you run the risk of making choices that may not work out in your favor. Thus, costing you time and money. Therefore, if you want to learn the ins and outs of conducting a detailed cost benefit analysis, keep on reading.
- A cost benefit analysis compares costs and benefits to decide if it is favorable for a business.
- The equation of this analysis is the sum of the expected benefits – the sum of the associated costs = cost benefit.
- Cost benefit analyses are better for short and mid-term projects than long-term ones.
- These analyses can help simplify decision-making processes in your business.
What is a cost benefit analysis?
A cost benefit analysis is a systematic process used by businesses to determine the benefits of a specific decision or action, minus the total costs associated with that decision. In other words, it is the process of comparing projecting costs and benefits to determine if a decision is favorable for a business and whether it makes sense for the direction the company wants to head in the future.
Costs will include:
- Direct costs
- Indirect costs
- Intangible costs, also known as costs that are not easily quantifiable or estimated
- Opportunity costs
- Costs of potential risks
Benefits will include:
- Direct benefits
- Indirect benefits
- Total benefits
- Net benefits
Moreover, once you have determined all the costs and benefits associated with your business project, you want to use the following formula to calculate your cost benefit.
Sum of the expected benefits – the sum of the associated costs = cost benefit
The Pros and Cons of a Cost Benefit Analysis
Furthermore, by conducting a cost benefit analysis for your business, you can experience several advantages, including:
- Discovering any hidden costs that would otherwise be undetectable at first glance
- Making sound choices based on observable data to get favorable results
- Gaining a competitive market advantage against other businesses in your sector
- Simplifies your business decision-making process from start to finish
Moreover, while these benefits can be highly advantageous for your business, there are some limitations to conducting a cost benefit analysis. Let’s take a close look at some of these down below.
- It can be challenging to determine long-term results. Therefore, this process should only be used for short and mid-term projects and decisions.
- It is difficult to predict all variables that can impact the final outcome.
- Your analysis is only as effective and complex as the data you choose to use to conduct your costs and benefits in the first place. As a result, if you do not have significant data collection protocols in place, your cost benefit analysis will not be helpful.
What are the 4 steps of cost-benefit analysis?
Now, let’s take a look at the four steps associated with conducting your own cost benefit analysis for your business.
Step 1: Establish Your Analysis Framework
Before beginning your cost benefit analysis, it’s essential to establish a framework for your analysis. Therefore, write down and identify what you are trying to accomplish and the goals and objectives. Additionally, you should also determine what metric system you will use to compare your costs and benefits.
Step 2: Identify Your Costs and Benefits
Next, you want to identify all your costs and benefits associated with this proposed project or decision using the various costs and benefit factors listed above.
Step 3: Assign a Monetary Amount to Each Cost and Benefit
Furthermore, the next step in your cost benefit analysis is to assign a monetary amount to each cost and benefit. While your direct costs and benefits will be more straightforward in giving a monetary amount, you may need to use a software program or approximate indirect costs and benefits to achieve an accurate final result.
Step 4: Calculate Your Net Benefits
In the last step in your analysis, you will use the total sum of the expected benefits minus the total sum of the associated costs to determine your net benefits. Once this is complete, you will need to compare the net benefits with the related expenses. If the net benefits are larger than the associated costs, then this decision or project can be deemed favorable for your business. In contrast, if the costs are more than the net benefits following your calculation, you may wish to reconsider this decision and search for other proposals before moving forward.
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An Example of a Cost Benefit Analysis
Moreover, now that we understand what a cost benefit analysis is and the steps required to conduct this business decision-making process, let’s look at a simple example for reference below.
Project 1: Your company wants to manufacture a new product that is expected to cost $150,000. This product is predicted to generate $200,000 in sales. Therefore, our calculation for this project is:
$200,000 – $150,000 = $50,000 (net benefit)
Project 2: Your business wants to enhance a current product, with the enhancements estimated to cost $20,000. With the new enhancements, your products are expected to generate $250,000. As a result, your calculation for this project is:
$250,000 – $20,000 = $230,000 (net benefit)
Based on these two calculations, a company executive or stakeholder is more likely to lean towards project two. This is because the costs compared to net benefit are more favorable than in project one. However, keep in mind, when determining your own cost benefit analysis for your business, the calculations will be more in-depth and complex depending on the factors you choose to weigh.