The decision or alternative might be a project, investment, organizational change and any business initiative. In addition the same approach can be used for evaluating cost and benefits for stakeholders such as customers.
What is involved in the analysis?
1. Evaluation of the change in total cost with or without a certain alternative including all the direct and indirect costs as well as all the soft costs and opportunity costs of a decision.
2. Evaluation of the change in benefits with or without the particular decision or alternative. The benefits should include all the changes not only the financial benefit but also any other benefit such as social benefit, safety benefit, competitive benefit, long-term development benefit, third-party benefits, etc.
By focusing only on the financial perspective of the cost-benefit analysis organizations can make mistakes when comparing multiple alternatives. For example, project A might financially look slightly more attractive than project B, however project B might bring additional non-financial benefits to the company such as potential growth in market share or technology advantage which cannot be quantified at the point of making the decision.
In addition to evaluating short-term benefits and costs you should be able to evaluate the long-term impact. For example, cutting operational costs in short term can result in increased profitability, but in long term it can result in lost customers and lost revenue and reputation for the business.
The effective analysis requires experience because in addition to the numerical side it involves and requires understanding of the business in order to be able to come up with all relevant costs as well as benefits for the company.
Cost benefit analysis can be used not only for the company analysis but also for the business stakeholders and it is a powerful business tool. For example, by using the same analysis for the customers, companies can make the case of showing the way how customer save or get additional benefits by using their products and services (for more examples on this read the article TCO – Selling with the Total Cost of Ownership).
Another important and effective tool in evaluating and comparing total costs is ABC (read the article and examples on Activity Based Costing) for evaluating both direct and indirect or overhead costs in your business.
For the financial part of the analysis which is originally how the analysis has been developed, you need to pay attention to the timing of the decision for the analysis. Long-term decisions should use the concept of time value of money to adjust for inflation, interest, opportunity costs, etc. over the years.
Large organizations such as corporations and government agencies use a predefined and specific approach for performing cost benefit analysis which allows them to standardize the process in order to be able to evaluate many alternatives across the board.
Smaller organizations generally do not have a standardized approach but still use the cost benefit analysis on a daily basis either by using some formal process or on a case by case basis. Even individuals use the same approach when they evaluate decisions and alternatives on a daily basis.
Regardless of the process, the organization, the purpose of the analysis, etc. typically the cost-benefit analysis approach needs to include the following steps:
- Potential alternatives which need to be evaluated by the decision makers
- Brainstorming all the costs involved in the decisions (direct, indirect, soft, opportunity costs…)
- Categorizing and listing all the costs for the alternatives for easy comparison
- Brainstorming all the benefits and change in benefits by selecting one decision over another including non-financial benefits such as reputation, branding, customer satisfaction, product advantage, core capacity, differentiators, safety issues, legal issues, etc.
- For long-term projects adjust financial data by using time value of money
- At this point you should be able to build a spreadsheet table where you have all the costs and benefits in column A and various alternatives in row 1. This allows you to populate and compare everything in one place.
- Evaluate and compare the financial and nonfinancial costs and benefits and make a decision based on the top priorities for your business.
What is cost-benefit analysis?
CBA is a business approach to quantifying and comparing the costs and the benefits of a particular business project, initiative, program, improvement and any type of potential change in the organization. Eventually, any change in the way we do business like restructuring, reorganizing, process improvement, investment, etc. requires certain level of investment and risk while offering change in the existing cost structure and certain benefits.
When analyzing a single project or initiative the cost-benefit analysis is focused primarily on comparing the cost on one side and benefits in the other and estimating which side has a higher value. On the other hand, when evaluating multiple projects organizations rank and compare the potential CBA outcomes.
Is CBA just a number game?
While theoretically this approach should be number-based and fact-based in reality various perspectives must be considered to make the right decisions including many which are hard to quantity.
Types of cost which should be considered in cost / benefit evaluation:
- Fixed cost – does this initiative impacts the current fixed cost?
- Variable cost – will this project change the existing variable costs in our business?
- Step cost – Do we expect shift in out step cost?
- ABC – Will this change impact the existing activities in our business and influence the existing ABC structure?
- Opportunity cost – What do we sacrifice / lose / risk by implementing this change?
Types of benefits
– Financial benefit – Financial gains are quantified and compared directly to the costs.
– Strategic benefit – Would this project create additional strategic benefit for the company?
– Branding / Marketing Benefit – Will this change improve the current positioning of the business in the marketplace?
– Productivity / efficiency / time saving benefit – Would this change improve our productivity?
– Other benefits to be considered – legal, intellectual, environmental, competitiveness, competence, expertise, etc.
Calculating the relevant costs
By considering the comments and the categories listed above you are aware that what sounds theoretically simple in reality is not straightforward and easy to do. However many business people add additional complexity to this approach by overanalyzing and including many variables which are not relevant (factors which don’t really change regardless of the decision made).
Try to keep the analysis as simple as possible by listing only the major variables which have a significant impact on your business because those variables need to influence your decision.
How relevant is the outcome of your analysis?
Depending on the type of the initiative or project under evaluation the results of your analysis will have different impact on the final decision. The higher in your organization the final decision is being made more intangible factors will have the impact on the final decision. For example, the CEO of your company may be more interested in factors other than tangible numbers.