Cost-Benefit Analysis Definition
A cost-benefit analysis is a model used by businesses in analyzing decisions. Here, the business adds up the benefits or the retreads from taking a particular action, and then subtracts the cost of such actions from the result. Most analysts and valuators tend to put monetary worth on intangible things like the rewards which one derives from living in a city or region. Most importantly, a large number of analysts tend to factor in opportunity cost when making this analysis.
A Little More on What is Cost-Benefit Analysis
Most managers, especially those who are careful and find joy in getting the best result for their companies often conduct a cost-benefit examination before engaging on a new project or erecting new infrastructures. This analysis will cover the potential expenses that will be incurred in starting such a project as well as the revenue the company might generate from such an establishment. In most cases, the results from a cost-benefit analysis will inform a firm whether to continue its proposed project or switch to something that’ll be much more profitable. It is important to note that conducting cost-benefit analysis doesn’t guarantee the success of failure of a project though, it is just a measure of the “potential” success or failure of such a project.
How Cost-benefit Analysis Works
In performing such an analysis, there are different steps which an analyst must take, with the first being the compiling of a list of all the cost or expenses and the potential benefits or rewards associated with any proposed project or decisions. The costs in this case must consist of both direct and indirect time. In other words, you’ll want to analyses both tangible costs, intangible costs, opportunity costs, and costs associated with risk. Cost associated with risks in this case refers to the value of risks which one is willing to take in the project. For manufacturers creating new products, the risk might be low demand or high tax. Putting a cost on such risks is a good way to go. Benefits on the other hand should include all direct and indirect revenues. This includes both tangible benefits, intangible benefits, and other rewards which they might get from the project. Intangible benefits in this case might be the exposure which a business might get for embarking on such a project or the safety and comfortability of employees, which in turn leads to higher productivity. After taking note of these things, the analyst’s second step should be to apply monetary value to each of the items on his list. Trying as much as possible to prevent overestimation or underestimation should be of utmost concern to the analysts. An analysts should be conservative when placing cash values on the items in the list. He should be stringent as much as possible, and avoid emotional errors.
Lastly, the analysts gets to run the cost-benefit measurement using the value he placed on all the items in the list. Here, he compares the value of the benefits to the value of the cost, and determines if the project is a suitable fit or not. If the benefits outdo the cost, the company will be advised to go on with the project as long as it was their original idea. However, if the cost of such a project outperforms the benefits, then moving on might just be a bad idea. The rational advice to the company at this point will be to look for better projects.
Shortcomings of the Cost-Benefit Analysis
Cost-Benefit analysis might just sufficient for decision making on projects that command small to mid-level capital for financing. It is also useful for projects that take a fairly short time to complete. However, for bigger projects, cost-benefit analysis might not be a right fit. This mainly because this examination doesn’t take into account different economic occurrences like inflation and market fluctuation, as well as different factors like interest rates, different cash flows and the current monetary value. In cases like this, cost-benefit analysis can be replaced with other analysis methods such as “net present value” or internal “rate of return.”