Used to determine if an investment or decision is wise, verifying whether its benefits outweigh the costs and by how much. It can also provide a basis for comparing projects, which involves comparing the total expected cost of each option against its total expected benefits.
Why use cost—benefit analysis?
Cost—benefit analysis is best for making quick and simple financial decisions. More robust approaches are commonly used for more complex, business-critical or high-cost decisions. It can also be used in a wide variety of situations such as deciding whether to hire new team members, evaluating a new project or change initiative or determining the feasibility of a capital purchase.
What is cost—benefit analysis?
Cost—benefit analysis is a tool for deciding whether to pursue a project. It involves adding up the benefits of a course of action and comparing these with the costs associated with it.
The results of the analysis are often expressed as a payback period. This is the time it takes for benefits to repay costs. Many people who use it look for payback in less than a specific period, such as three years.
How do we do it?
To use the tool, list all the anticipated costs associated with the project and estimate the benefits you'll receive from it.
Where benefits are received over time, work out the time it will take for the benefits to repay the costs.
You can carry out an analysis using only financial costs and benefits. However, you may decide to include intangible items within the analysis. As you must estimate a value for these items, this inevitably brings more subjectivity into the process.
Follow these steps to do a cost-benefit analysis:
Step 1. Brainstorm costs and benefits
First, take time to brainstorm all the costs associated with the project and make a list of these. Then do the same for the benefits of the project. Can you think of any unexpected costs? Are there benefits you may not initially have anticipated?
When you come up with the costs and benefits, think about the lifetime of the project. What are the costs and benefits likely to be over time?
Step 2. Assign a monetary value to the costs
These include the costs of physical resources needed, as well as the cost of the human effort involved in all phases of a project. Costs are often relatively easy to estimate (compared with revenues).
It's important to think about as many related costs as you can. For example, what will any training cost? Will there be a decrease in productivity while people are learning a new system or technology and how much will this cost?
Remember to think about costs that will continue to be incurred once the project is finished. For example, consider whether you will need additional staff, if your team will need ongoing training or if you'll have increased overheads.
Step 3. Assign a monetary value to the benefits
This step is less straightforward than step 2. Firstly, it's often very difficult to predict revenues accurately, especially for new products. Secondly, along with the financial benefits that you anticipate, there are often intangible, or soft, benefits that are important outcomes of the project.
For instance, what is the impact on the environment, employee satisfaction or health and safety? What is the monetary value of that impact?
As an example, is preserving an ancient monument worth $500,000 or is it worth $5,000,000 because of its historical importance? Or what is the value of stress-free travel to work in the morning? Here, it's important to consult with other stakeholders and decide how you'll value these intangible items.
Step 4. Compare costs and benefits
Finally, compare the value of your costs to the value of your benefits and use this analysis to decide your course of action.
To do this, calculate your total costs and your total benefits and compare the two values to determine whether your benefits outweigh your costs. At this stage it's important to consider the payback time, to find out how long it will take for you to reach the breakeven point – the point at which the benefits have just repaid the costs.