Cost-Benefit Analysis Definition
Cost benefits analysis refers to a technique used to measure the return against cost in both financial and environmental aspect. The technique provides a better analysis of the data under evaluation. The current economy is based on analytics, and people make many decisions based on the daily activities. These decisions are made for the purpose of marketing studies, business plans. The analysis of the data helps the organization to achieve an effective evaluation of the economic and social outcomes of the activities. In this regard, the cost-benefit analysis plays an important role in helping the organizations, companies, and institutions to make an informed economic and social decision. Besides, it helps the organizations to determine the feasibility of the projects the investor intend to invest. During the analysis, both the direct and indirect cost from a project is evaluated to determine its feasibility. After conducting the cost benefits analysis, the planner or managers should make decisions based on the following question; it is worth to invest in the project? Should the project continue? Since cost-benefits analysis is carried throughout the project`s life, these questions are therefore asked in every stage of project life.
A Little More on What is Cost-Benefit Analysis
The cost-benefit analysis technique is used to measure the costs per unit of a product produced against profits generated by that product when it is sold.
When the ratio obtained is high, it means that the investor has generated higher profit at a lower cost. This makes the fundamental analysis for the future investment. When planning to make an investment decision, it is important for the investor to evaluate the ratio between cots and benefits to determine the viability of the project.
Variables that determine cots benefit ratio.
The cost and benefit ratio are influenced by various variables. Some of the variables that affect cost and benefits include:
- The cost of investment leasing, financial margin, employees, taxes repelling of sales, discount for prompt payments, liabilities such as insurance claims and contribution to the security of the employees.
- The final prices of produced products and profit margin per unit.
- The level of optional production
- Turnover rate
- Depreciation expenses and their provisions for services or goods.
- The cost for financing loans or credits and the interest charged on loans.
These variables play an important role in determining the cost-benefit ratio and help the investor to make a decision whether a project is worth investing or not based on its profitability and cost. Usually, the investor seeks at least a ratio of 3 monetary units of profit for every monetary unit of cost. In this regard, have that wider ratio margin covers future contingencies that might arise unexpectedly such as lose of court cases, machinery attrition, decreased in production, diminishing marginal profit and the speculative attacks on the project. It also covers the contingencies that may arise due to change in consumer preferences concerning the products produced by the company, stiff or unfair competition and actions of the untrustworthy employees.
For example, let’s assume that an investor wants to start up mango export business to the US. The sales are projected to be 10, 000 mango fruits per month. The price per unit mango to be 1 Euro. The provision for wear and tears due to distribution to be 10%, tax to be 20% and the distribution cost and other fixed costs to be 30%. The time for mango consumption is projected to be 6 months. Therefore, the cost-benefit analysis is determined as demonstrated below;
Gross profit = units * price per unit
= 10, 000 * 1 = 10,000 Euro
Total cost = product wear + taxes + fixed cost
= 10% + 20% + 30% = 60%
Therefore, the total costs = 60% * 10,000 Euro
Net profit = gross profit – costs
10, 000 Euro – 6000 Euro = 4000 Euro per month
Therefore, the total profit for this project will be;
4000 Euro * 6 months = 24000 Euro
References for Cost Benefit Analysis
Academic Research for Cost Benefit Analysis
- Environmental sustainability and cost–benefit analysis, Barbier, E. B., Markandya, A., & Pearce, D. W. (1990). Environment and Planning A, 22(9), 1259-1266. This paper examines the cost-benefit analysis and the environmental sustainability. The author presents that the incorporation of cost-benefit analysis into environmental sustainability has been given little concerns and this should not be the case. The author argues that the concept of environmental sustainability plays an important role in carrying out cost-benefit analysis especially in the shadow projects.
- Cost–benefit analysis for transport networks: theory and application, Kidokoro, Y. (2004). Journal of Transport Economics and Policy (JTEP), 38(2), 275-307. This paper evaluates cost-benefit analysis for transport networks. The paper presents both the practical and theoretical models for estimating benefits against cost in the transport industry. The author provides three ways through which the benefits of an investment in the transport infrastructure can be determined. These include; summing up the changes in excess in all consumers’ and producers’ routes. Secondly, it can be determined by summing up the changes more than invested consumers’ and producers’ routes. Lastly, it is determined by evaluating the total benefits in the prioritized case and changes in the deadweight loss in all the routes
- Cost–benefit analysis and the theory of public finance, Musgrave, R. A. (1969). Journal of Economic Literature, 7(3), 797-806. This paper examines the application of cost benefits analysis and the theory of public investment. The author presents that the technique of cost-benefit analysis can be used to evaluate the feasibility of the public projects before the public funds are spent on them. The cost-benefit analysis helps the decision makers in the public finance to determine the benefits that are expected from a project and the expenses that are likely to be incurred in investing in the projects
- The theory of cost–benefit analysis, Drèze, J., & Stern, N. (1987). In Handbook of public economics (Vol. 2, pp. 909-989). Elsevier. This paper discusses the theory of cost-benefit analysis. It provides an in-depth understanding of the method of cost-benefit analysis by providing a formal description of the of the subject. It also examines the theoretical basis for other models that are used for decision making. The author presents that the main object of cost-benefit analysis is to provide effective and consistent procedures used to evaluate the decision.
- Corporate social responsibility: A theory of the firm perspective, McWilliams, A., & Siegel, D. (2001). Academy of management review, 26(1), 117-127. This paper examines the use of cost-benefit analysis to make decisions regarding participation in corporate social responsibility. The concept of cost-benefit analysis helps the company to evaluate the cost they would incur in providing social services to the community and the benefits that will be generated from such activities. When the evaluation of benefits is found to be more than the cost, then the company will participate in the CSR and when the cost is more than the benefits the company will not participate in the activity. In general, the paper examines the relationship between financial performance and CSR.
- Cost–benefit analysis: a survey, Prest, A. R., & Turvey, R. (1965). The Economic Journal, 75(300), 683-735. This paper surveys the use of cost benefit analysis in making financial and social decisions. The author seeks to outline the development that have occurred with the concept of cost benefit analysis and the use of the concept in various fields. More specifically the paper examines the use of cost benefit analysis in the areas such as land usage, transport, education, research and health.
- Risk analysis in investment appraisal, Savvides, S. (1994). Project Appraisal, 9(1), 3-18. This paper explores the risk analysis technique in making investment appraisal decision. The paper examines the importance of risk analysis in the investment appraisal in the making in making an investment decision and appraising the existing project. The author outlines the application of the Monte-Carlo technique in risk assessment and analysis in assessing the investment project.
- The cost of price incentives: An empirical analysis of motivation crowding-out, Frey, B. S., & Oberholzer-Gee, F. (1997). The American economic review, 87(4), 746-755. This paper examines the cost of price incentive model in investment decision making. This method is considered to be an empirical evaluation of motivation crowding-out. The author presents that this technique also provides a critical assessment that creates an informed decision regarding the feasibility of a project.
- Cost–benefit analysis., Robinson, R. (1993). BMJ, 307(6909), 924-926. Cost benefits analysis is the most used technique in assessing and evaluation of the feasibility of a project. This paper explores ways through which cost-benefit analysis can be used to evaluate the economic feasibility of a project. The author presents that there are two ways through which cost-benefit analysis be sued to assess the viability of a project. First, it can be used through the human capital approach. This means that compares the contribution of people to the production and the wages paid to human resources. Secondly, it is used through a stated preference approach. This based on personal evaluation by assessing the wages they are willing to accept risks or pay for a given specific service.
- Transaction cost analysis of strategy‐structure choice, Jones, G. R., & Hill, C. W. (1988). Strategic management journal, 9(2), 159-172. This paper analyses the links between structure, organization performance and structure using transaction cost analysis. It determines the growth limit for a company seeking to invest in the international business. Secondly, it explores the strategies to achieve growth. Lastly, it determines changes in the structure and strategy used by the organization in a particular period.
- Cost effectiveness/utility analyses: Do current decision rules lead us to where we want to be?, Birch, S., & Gafni, A. (1992). Journal of health economics, 11(3), 279-296. This paper examines the utility analysis or cost-effectiveness in the current economy. The author presents that despite the increased studies on evaluation of health care programs, little or no attention is focused on the theoretical foundation of the utility analysis and cost-effectiveness. The paper also discusses the validity of the rules used in the decision used to achieve the intended objectives. The study revealed that the use of cost-effective techniques and utility analyses could be used by the organization to pursue the stated goals of the organization.