One of the main ways people make decisions is by using a cost benefit analysis (or CBA).
Whether you're a renter considering purchasing a new home or a business weighing a new sales strategy, you're probably using a CBA. It's an integral part of corporate, individual and even government decision making.
Even when big companies like Macy's (M - Get Report) move to repurchase hundreds of millions of dollars of their own debt, executives are using CBA. In fact, most actions undertaken by companies involve CBA in some form or other.
But, what actually is cost benefit analysis, and how is it used? What are some examples of cost benefit analysis?
What is Cost Benefit Analysis?
Cost benefit analysis is a process used primarily by businesses that weighs the sum of the benefits, such as financial gain, of an action against the negatives, or costs, of that action. The technique is often used when trying to decide a course of action, and often incorporates dollar amounts for intangible benefits as well as opportunity cost into its calculations.
Although CBA can be used for short-term decisions, it is most often used when a company or individual has a long-term decision.
CBA is an easy tool to determine which potential decision would make the most financial sense for the business or individual. The process also takes indirect benefits or costs into consideration, like customer satisfaction or even employee morale. And opportunity cost often plays a big role when deciding between several options. When listing potential costs and benefits, companies or analysts will often factor in things like labor costs, social benefits and other factors that may not be immediately obvious.
Still, CBA is similar to net present value (or NPV), which is often used by investors.
So, what's the difference between CBA and NPV?
Cost Benefit Analysis vs. Net Present Value
When performing a cost benefit analysis, or CBA, it is generally helpful to weigh the total benefits and total costs of a future project at their present value - which is where net present value comes in. Given that CBAs are often done with a long-term view in mind, the value of money often changes due to inflation and other factors, making it helpful to factor in the net present value of the figures you are analyzing when conducting a CBA.
Net present value, as the name suggests, is a method used to determine the benefits of undertaking an investment by calculating the future benefits or costs in terms of their present value. If the net present value is positive for the calculation (meaning the benefits outweigh the costs), the action or decision will generally be a good investment. If negative, the opposite is likely true.
In CBA, net present value is used to calculate net present costs and net present benefits.
How to Calculate Cost Benefit Analysis
For standard CBA, the formula, the benefit/cost ratio, is fairly simple:
Benefit/cost, simplified as b/c.
While there are slightly more complex formulas, the benefit-cost ratio is essentially just taking into account all of the direct or indirect costs and benefits and seeing if one outweighs the other. Additionally, running a CBA often takes into account opportunity cost and is frequently used to compare different options by calculating their benefit-cost ratios.
The formula reflects the sum of all the benefits divided by the sum of all the costs, with consideration for the duration of the decision or action (or, analysis horizon).
Cost Benefit Analysis Steps
Cost benefit analysis is fairly simple to execute, and can be helpful when considering a new course of action or strategy.
Step 1: Compile lists
The first thing to do when running a cost benefit analysis is to compile a comprehensive list of all the costs and benefits associated with the potential action or decision.
Consider not only the obvious costs (like the cost of installation for new software, or for the software itself) but also possible intangible costs like the opportunity cost of picking one software over another, or over another option like hiring a new employee.
Additionally, consider all the possible benefits of the course of action or decision - how much might it add to your revenue? What other benefits may be inherent in the action that would make it outweigh the costs? For example, would a new software improve efficiency or capabilities that could promote new business or make current operations run smoother? Be sure to also consider intangible benefits as well as obvious, fiscal ones.
Step 2: Give the costs and benefits a monetary value
Once you have two comprehensive lists of costs and benefits for the action, assign monetary values to each individual cost or benefit.
For some, the values will be obvious - like the cost of installing the software might be $500. However, it is also important to try to assign monetary values to direct or indirect and tangible and intangible costs or benefits if possible. For example, installing a new software may render an employee's computer inaccessible for a couple hours, costing that employee working time or productivity and therefore money generated for the company.
Once you assign monetary values for each cost and benefit, add all the costs and benefits respectively and set up the equation.
Step 3: Set up the equation and compare
Take the sum of the benefits (the sum of all the monetary values assigned to the benefits of the action) and the sum of the costs (all the monetary values of the costs of the action) and plug them into the b/c equation.
The equation should be a numerical equation, and if the numerical benefits (the sum of the fiscal values for the benefits of the action) outweigh the costs, it is advisable to proceed with the decision. If not, the company or individual should re-examine the potential action and make adjustments accordingly.
This equation can also be set up for multiple different options or projects and can help companies compare options side by side.
But, what are some actual examples of CBA?
Cost Benefit Analysis Examples
In our first example, a financial technology startup is expanding and adding two new programmers. The CEO of the company decides to run a cost benefit analysis to determine whether the decision will be beneficial to the company - and to what degree.
The company is analyzing a time horizon of one year, and estimates that revenue would increase some 50% if the two programmers were hired.
On the cost side of the equation, the CEO must examine the cost of the two programmer's salaries - estimated at $75,000. Additionally, there is the cost of recruitment, which might be around $3,000. Training could add an additional $4,000.
Additionally, there is the cost of new work areas and computers, totaling $5,000, and the cost of additional licensing for software and the like, around $2,000.
The total direct and indirect costs would total around $89,000.
When calculating benefits, the CEO would examine the benefit of additional revenue within a 12 month period, estimated around $100,000. Additionally, the increase in product quality resulting from the new programmers (and therefore presumed customer satisfaction) would increase by 10%, adding an estimated $10,000 in value to the company.
In total, the benefits would be $110,000. Using the benefit-cost ratio equation, that would be BCR = $110,000/$89,000, or 1.24. Given that the value is positive (and the total benefits are greater than the total costs), the cost benefit analysis indicates the decision to hire two additional programmers would be a beneficial move for the company.
Still, another example like that of ProjectCubicle is that of a real estate developer considering several different investment options.
The assumptions for the investments are that option 1 would build 300 houses, renting 50 of them for 10 years at $3,000 per year. The 50 rented units would be sold after 10 years for $60,000.
Construction costs for option 1 would be $80,000 per house, which would sell for $100,000 each. The cost of a sales office would be $1,000,000 and the salaries of sales staff would be $200,000 each year. The project would last 2 years, with a financing cost of $2,000,000 per year.
For option 2, the construction company could build 200 houses, renting 25 of them for 5 years at $3,500 per year. The 25 units could be sold after 5 years for $70,000.
Construction costs for option 2 would be $70,000 per house, and the rest of the homes would sell for $110,000 each. The cost of a sales office would be $2,000,000 and sales staff salaries would be $150,000 each year. The project would last 1 year, with a financing cost of $1,500,000 per year.
For option 1, costs would include:
Construction cost = $24,000,000
Sales office cost = $1,000,000
Cost of sales staff = $400,000
Financing cost = $4,000,000
Total costs would therefore be $29,400,000.
For option 1, benefits would include:
Income from rentals = $1,500,000
Income from sales = $25,000,000
Income from sales after rental = $3,000,000
Total benefits would therefore be $29,500,000. Using the cost benefit analysis formula b/c, the ratio would be 29,500,000/29,400,000, or 1.0. Since the equation is possible, the benefits for option 1 outweigh the costs. However, since the developer is trying to decide between two projects, the same analysis needs to be performed for option 2.
For option 2, costs would include:
Construction cost = $14,000,000
Sales office cost = $2,000,000
Cost of sales staff = $150,000
Financing cost = $1,500,000
Total costs would therefore be $17,650,000.
For option 2, benefits would include:
Income from rentals = $437,500
Income from sales = $19,250,000
Income from sales after rental = $1,750,000
So, the total benefits for option 2 would be $21,437,500. The b/c ratio for option 2 would therefore be 21,437,500/17,650,000, or 1.2.
Comparing both options together, it is clear that option 2 has a higher benefit-to-cost ratio (and costs less to execute) and would therefore be the most fiscally resourceful option for the developer to pick.
To help facilitate performing a CBA, there are several templates available online.
Advantages and Disadvantages of Cost Benefit Analysis
Cost benefit analysis can be a helpful tool for businesses or individuals to undertake when considering a new course of action.
Running a CBA for a potential decision can help visualize the implications and impact of that course of action, and is often very helpful for smaller or medium-sized decisions that are more immediate in scope of time.
However, there are some disadvantages to practicing a CBA in certain circumstances. For bigger decisions with a longer time horizon, CBAs can sometimes fail to take into account other factors that might not be significant in the short term but would impact the long term, like inflation, interest rates and other larger, more long-term factors. For these calculations, net present value or internal rate of return are often better methods to use.
Additionally, performing a CBA can often put projects or decisions in a purely numerical point of view, which may fail to take into account unforeseen events or circumstances that might affect the action.