Cost-Benefit Analysis Execution

Introduction 

Cost-benefit analysis has its roots in welfare economics from the 19th century. As differentiated from the economic theory of decision making by individual consumers and enterprise owners, welfare economics emphasizes public decisions that impact the economic interests of more than one perso. "The idea of collating advantages of benefits to whomsoever they may accrue with the expected expenses," states the Flood Control Act of 1936. This makes it clear that the public investment decision is unmistakably social in character.

In the 1950s academic interest in the Cost-Benefit analysis (CBA) was also growing. The simultaneous release of works by Eckstein, Mckean, and Krutilla and Eckstein in 1958, however, marked the true turning point.. These publications attempted “to formalize public investment criteria pertaining to established criterion of welfare economics.

In terms of project analysis, no method other than CBA enjoys widespread application or analytical power. Cost-benefit analysis has long served as an institutionalized component of federal decision making for water projects. In addition, the application of cost-benefit analysis to federal policy has been expanded in recent years to include regulatory rule making of many types, providing additional evidence of CBA's usefulness and power.

What is Cost-Benefit Analysis? 

Cost benefit analysis is a financial analysis tool used to compare the benefits provided by a portfolio component, program, project or solution against its cost. It is frequently used to determine the best viable solution from a set of alternatives. Prior to the execution of a project, cost-benefit analysis is frequently performed as part of project or portfolio managerial activities.
Considering the results of an actual versus expected cost-benefit analysis is one way to assess the business value of the solution.

At its most beneficial usefulness level, cost-benefit analysis is able to expose the entire cost of a project or program and  correlate them to the benefits' monetary worth. The analyst can furthermore quantify the program's or project's net benefits (or costs), examine the benefits to costs ratio, measure the rate of return on the government's commencing investment, and counterbalance the program's benefits and costs against comparable programs or suggested alternatives.

The following costs and benefits are assessed as an effective CBA:

Costs:

✔  Intangible costs: Any other costs that can’t be quantified, such as the brand
damage if the market doesn’t respond positively to the product.
✔  Direct costs: These are all the costs that are directly related to the
manufacturing of the product. Such as materials, equipment, labor, etc.
✔  Indirect costs: Other expenses that are not directly related to the product such
as rent, utilities, or transportation costs.
✔  Opportunity costs: The loss of opportunities that occurs when a decision is 
made instead of another. For instance, manufacturing a product that may have been more
successful than the one you chose to build might have been a viable option.
✔  Cost of potential risks: Any project is susceptible to a variety of risks. The possibility
of experiencing unforeseen costs should constantly be taken into account.

Benefits: 

✔  Direct: The measurable benefits in monetary value that you get from the
project. In this circumstance, the revenue, profit and sale gained from your product.
✔  Indirect: Benefits that you can perceive but not necessarily measure such as
increased brand awareness.
✔  Total benefits
✔  Net benefits
 

It is necessary to quantitatively assess the aggregate benefits and costs to conclude whether the benefits outweigh the costs. If so, moving on with the project would be the sensible choice. If not, the business should reevaluate the project to determine whether it can be modified to raise benefits or lower costs in order to make the project profitable.The business should probably steer clear of the project in any other case.

The Purpose of Cost-Benefit Analysis

Using CBA serves two key objectives:

1. To ascertain the feasibility, justification, and profitability of the project's business case by determining if its benefits surpass its costs.
2. To offer a threshold starting point for project comparisons by identifying the specific project with benefits that outweigh expenses.

The following overview of the various type where a business might undertake a cost-benefit study is provided by the cost-benefit analysis examples that follow: 

- Outcomes from a CBA of an intercession to decrease the amount of trans fats over the food supply industry are provided in the example.

Source: Centers for Disease Control and Prevention

 

- Four additional staff will be required by Sports Global Ltd as it aims at growing its business. The company's management decided to apply a cost-benefit analysis to determine whether or not the expansion is beneficial. Information about expansion's benefits and costs is available in the following states:

 

• If the business expands and recruits four employees within a year timeframe, it is anticipated that this would result in a 50% increase in sales representing approximately $250,000 in revenue benefit.
• Also, as a result of the new hire, the company's worth will rise, generating $ 30,000 in supplemental revenue.
• The additional employees’ salaries are estimated to be in the range of $160,000.
• An additional $15,000 is anticipated to be used on hiring.
• The additional gear and software necessary will cost the amount of $25,000 in total.

 

=>  Analyze the expansion using Cost-benefit analysis.

 

Solution

• The project's total benefit = Revenue growth from expansion
• The project's total benefit = $30,000 + $250,000 = $280,000
• Total Expansion Cost = Cost of additional hardware and software + Cost of new employees’ salaries + Hiring cost
• Total Expansion Cost = $25,000 + $160,000 + $15,000 = $200,000

Now, the expansion's benefit-cost ratio will be computed as illustrated below.
 

= $280,000 / $ 200,000

Source: Ashish Kumar Srivastar and Dheeraj Vaidya, CFA, FRM

 

Benefit-Cost Ratio = 1.40

As it is beneficial to the business, the analysis of expansion has a positive benefit-cost ratio (the total benefits related to expansion are higher than the entire cost). the business should move forward with the project's expansion and employ extra employees

- Constru Ltd is a real estate developer. It has found a variety of investment possibilities for the investment it intends to make. The following details are available on the benefits and costs of different investing options:

 

Option 1

Construct 200 flats, of those which 100 will be leased out for $2,000 per year for a period of ten years. The 100 rental flats would be sold off after ten years for $100,000.

Construction would cost $110,000 each flat, and they might be sold around $150,000 apiece, in accordance with the cost side. In addition to the cost of construction, the annual cost of employees and sales would indeed be $ 700,000. The project would take $1,500,000 in investment and would continue for two years.

 

Option 2

Build 100 flats, of which 20 will be leased for $5, 000 per year over a five-year period. The 20 rental flats would be sold for $120,000 after five years.

Construction would cost $150,000 each flat, which may be sold for $200,000 per, according to the cost side. In addition to the cost of construction, the annual cost of employees and sales would indeed be $450,000. The project's finance cost would be $4,000,000, and it would take one year to complete.

Analyze the investment options using Cost-benefit analysis.

 

Solution

Option 1

The benefit-cost ratio can be calculated as,

Source: Ashish Kumar Srivastar and Dheeraj Vaidya, CFA, FRM

= 27000000 / 26400000

 

Benefit-Cost Ratio = 1.02

Option 2

The benefit-cost ratio can be calculated as,

Source: Ashish Kumar Srivastar and Dheeraj Vaidya, CFA, FRM

= 18700000 / 17900000

 

Benefit-Cost Ratio = 1.04

Benefit-cost ratios for options 1 and 2 are 1.02 and 1.04, respectively. Transparently, option 2 offers a better benefit to cost ratio when we link it to option 1, hence the company should select option 2. 

 

Notably: During the stage of determining viable options and providing recommendation, Cost-benefit analysis is one of the key tool techniques applied. If benefit-cost ratio or Net present value (NPP) are higher than 1, the solution options can be considered. On the contrary, when these indices are lower than 1, project sponsors or executives will not make any choice for these proposed options because costs jump the benefits.

 

The major steps in a cost–benefit analysis

Running these types of analysis prior to making significant business choices has substantial financial benefits. Conducting the analysis also means that it allows you to parse out crucial information..

With various methods approaching the guide to do a cost-benefit analysis, analysts may feel overwhelmed in choosing the most appropriate way to adapt their solutions. Therefore, there is not completely a standard process for executing cost-benefit analysis. Each organization will match different types of processes. Here is the recommendation of using a standardized seven-step-model to help analysts to perform a successful cost-based analysis which can be applied to multiple industries.

 

Step 1: Initiating a Framework for Your Analysis

Decide what goals and objectives you desire to accomplish with your proposal. What should we accomplish for the project to be deemed successful? This will be critical in interpreting the analysis's findings and can allow you to identify and comprehend your benefits and costs.

Similarly, decide what metric will be used to measure and compare the benefits and costs. To accurately compare the two, the same "common currency" should be used to measure both benefits and costs.

 

Step 2:  Identify costs

Spend some time considering the project's associated costs. Generating a comprehensive list that covers every cost you can imagine that could have an effect, such as:

• Upfront costs
• Unexpected costs
• Tangible costs
• Intangible costs
• Ongoing or future costs
• Any potential risks could arise and cost money

While brainstorming the probable costs of each project and how they correlate to the potential benefits, creating a mind map should be considered.

 

Simple Mind Map Template
 

Step 3: Identify benefits

Define the potential benefits will be brought when deciding whether to move on with the project.

 

Step 4: Assign the benefits and costs a monetary value

Don't attempt to divide project costs into multiple denominations based on a region or nation if you are performing a cost-benefit analysis for a worldwide firm. If you assign everything the same currency, tracking the factual costs and benefits will be a lot simpler.

It is required to include in the human costs while monetizing costs:

• What number of personnel are required to finish the project?
• Will you need to hire new people?
• How much new equipment will be needed?
• Does existing equipment need to be replaced?
• Will training be involved? How much time will training take up?

 

Step 5: Establish a schedule for expected revenue and costs

Outline out the costs and benefits, including their amount and timetable. The timetable facilitates you to align, identify, and analyze the expectations of all parties involved.

 

Step 6: Compare costs and benefits

By comparing two values, you may assess whether the benefits preponderate costs..
Considering the following when comparing costs and benefits:

➝ Inflation
➝ Lost return on investment
➝ Discount rate
➝ Payback period (PBP)

 

Step 7: Perform sensitivity analysis and recommendation

It enables you to verify the accuracy factors in your estimations and assumptions.

In case of the positive result, it is seen to be worthwhile to continue; if the result is negative, you can figure out the exact data when the balance point is 0.
Once all the comparison has been conducted, it becomes more transparent to decide and adopt the recommended course of action.

Wrap it up, cost-benefit analysis is, broadly speaking, the type of data-driven decision-making that businesses, including established businesses and startups, use the most frequently. Almost every decision-making process, whether it is business-related or not, may be improved upon by adhering to the fundamental principles and structure.

Any findings within the period of conducting cost-benefit analysis must be frequently synthesized by the analyst prior to present to management. This concisely summarizes the costs, benefits, net impact, and how the finding ultimately supports the original purpose of the analysis.

 

Pros and cons of cost-benefit analysis
 

The leverage of cost-benefit analysis as a tool in decision-making by a business or other entity is positive for a wide range of reasons. When depending only on a cost-benefit analysis, there are potentially a variety of several other possible drawbacks and restrictions that should be taken into account.

 

Advantages of Cost-Benefit Analysis

- Data-driven strategy: Using cost-benefit analysis, an individual or entity can evaluate a decision or prospective project without being free of biases. So, it gives an unbiased and fact-based review of your alternatives, which may assist in making your company more data-driven and rational.

- The analysis gives clarity to unpredictable situations. The analyst may more clearly identify and later examine each benefit and cost with the aid of the costs and benefits list.

- It aids in determining whether the benefits outweigh the costs and whether pursuing it would be financially sound and steady.

- Referring to the data presented in the same units can assist analysts come to a rational decision..

- Notwithstanding their differences, it is simple to compare projects of all types.

 

Limitations of Cost-Benefit Analysis

- Difficult to Predict All Variables:
→ Unpredictable changes can occur in market demand, cost of materials, and the general economy, particularly over an extended period of time. Predicting all the variables that might have an influence on the result becomes challenging.

- Incorrect Data Can Skew Results:
→  Your cost-benefit analysis' findings will reflect this if you're relying on erroneous or partial data to complete it.

- Better Suited to Short- and Mid-Length Projects:
→  Cost-benefit analysis has a larger chance of falling short for projects or business choices with longer durations for a variety of causes. Also, it's conceivable that factors like inflation won't be properly taken into account in long-term estimates, which might affect the analysis's overall accuracy.

Conclusion

In a nutshell,  when carrying out a CBA, it is critical to begin with an exhaustive list of all the different costs and benefits that could arise - even if some are later excluded. Otherwise, crucial elements and aspects of the analysis can be disregarded.

In this blog, we have gone through the overview knowledge which includes introduction of Cost-benefit analysis, its referenced definition, the purpose of analyzing CBA with some illustrated examples, and ultimately, the major step of executing a standard cost-based CBA.

Thank you for reading. Despite there is remaining knowledge treasure that needs to be dug deep to get an overall view of cost-benefit analysis, Hopefully, this insight provided would be a helpful reference for you to understand of the importance of cost-benefit analysis for the financial balance and efficient cash flow allocation plan for the project money of a business. Any recommendation or suggested discussion if needed, feel free to contact me: [email protected]. We can have a meaningful discussion.