Every day, business managers must make dozens of decisions. Managers who are good at making decisions don’t just make them based on their instincts. You must weigh each option when making a business decision. The simplest method to determine which option is best is cost-benefit analysis. It is crucial to perform a cost-benefit assessment on any project. You can reduce risks and maximize your return on investment by using cost-benefit smartly.

You might be wondering what a cost-benefit analysis is? What is a cost-benefit analysis and how can you do it? What are its limitations? Continue reading to find out all the answers.

What is a Cost-Benefit Analysis (CBA)?

Cost-benefit analysis, as its name implies, is a process that compares estimated costs with expected benefits to decide whether or not to proceed with a project. The manager performs a cost-benefit assessment to determine the company’s potential profit and costs before embarking on a new project. The company’s profit and cost will decide if the project can be made profitable or not.

Once you fall in love with your business idea, you will be able to let your imagination run wild. Companies have suffered badly because they invested money in projects that sound good but don’t generate any returns. You can save money and achieve your goals by using cost-benefit analysis.

The basis of decision-making is cost-benefit analysis. This analysis provides valuable and unique insight that will help you:

Analyzing the benefits and costs of a project will help you determine if it is feasible financially. You can use this benchmark to compare projects by determining which projects have more benefits than their costs.

How do you perform a cost-benefit assessment? 

Step 1: Define the goals of your project

The most important step in cost-benefit analysis, and the most important, is to identify the problem. You must have a clear understanding of the goals and objectives before you can make a decision about whether to pursue the project. The most direct terms are best for a cost-benefit analysis. It is better to ask the question “Should I hire a customer service executive?” then “How should we resolve our customer expectations?”

Step 2: Brainstorm benefits and costs

What is the cost?

Once you have a clear goal, it’s time to start brainstorming all costs related to the project and compiling a complete list.

These are some of the costs that might be involved in a cost-benefit analysis.

• Direct costs: Direct labor cost, inventory, manufacturing expenses, etc.

• Indirect Costs: Electricity and overhead costs from management, rent and utilities, etc.

These tangible costs must be considered, but also the intangible ones. These intangibles include the impact on customers, delays in product delivery, and employee impacts.

Business managers should also consider potential costs associated with the project or action, such as alternative investments, buying a factory or building one. You should also consider the potential costs of risks like regulatory risk, environmental impact, and so on.

What are the benefits?

Next, take the time to write down all the benefits the company could receive from this project. These benefits could include increased revenue or sales due to the new product or production. Project managers must also consider other benefits when performing a cost-benefit assessment. Improvements in working conditions and faster delivery can increase employees’ safety and morale as well as customer satisfaction. Additionally, businesses can gain market share or competitive advantages by making a cost-benefit analysis. It is important to take into account both the short-term and long-term benefits that the project might bring.

Step 3: Add monetary values to the benefits and costs

After you have created two complete lists of benefits and costs for the course, you can apply the monetary measures to each benefit or cost. It is difficult to predict the future costs and revenue of a project, especially if it is your first time.

In some cases, such as the cost of installing software to your computer, the monetary value can be clearly seen. It is however more difficult to calculate indirect costs or intangible benefits. Installing new software, for example, may render an employee’s computer unusable for a period of one hour. This can result in decreased productivity and working time for that employee, as well as a decrease in the amount of money the company makes. The new software will allow your employees to work more efficiently and increase their satisfaction. These indirect costs and intangible rewards can be difficult to quantify in monetary terms.

Managers should be conservative and avoid subjective tendencies or misestimates when valuing the benefits and costs. Be mindful of all expenses that could arise during and after the project is launched. You should also consider how costs and benefits may change over time. Stakeholders should be consulted to assess the benefits and costs of the project.

Step 4: Compare the benefits and costs

The final step is to compare costs and benefits, then make your decision. The rational decision is to approve the project if the benefits are greater than the costs. The company should examine the plan and make any necessary adjustments to increase or decrease costs in order to make the project possible. The business should avoid the project if it is not possible.

This is just the beginning of cost-benefit analysis. Most companies will take the payback time into account at this stage. The following formula can be used to calculate your payback period:

Payback period = Total cost/total revenue

Payback periods are the time required for the company’s investment to pay off the debt or reach breakeven. The benefit of the investment is sufficient to cover the cost. The payback period for your projects is shorter, which means you can expect to make money sooner.

What are the limitations to cost-benefit analyses?

Although cost-benefit analysis can be done quickly and easily, the following two factors will limit its accuracy:

• You can see how far in the future you will find benefits.

• Your analysis should be based on these assumptions

It is impossible to accurately estimate the future value.

The biggest disadvantage to cost-benefit analysis is not taking into account the value of time . This means that today’s money is more valuable than future money, as it could be invested to generate income. Therefore, it is important to convert your future cost-benefit analysis into today dollars.

The truth is that the further you look, the more accurate your estimate will be. Cost-benefit analysis is sufficient to make a rational, reasonable decision for small- to medium-sized projects that take less than a year. Cost-benefit analyses may not be able to take into account inflation and interest rates for large projects that last a long time. These financial issues could be significant but not immediate, but they will have a long-term impact on the project.

Don’t make assumptions that aren’t true

Unless you’re very lucky, you won’t get all the information that you need for a cost-benefit analysis. Making assumptions is one way to fill in all the gaps. Making assumptions can be a frightening aspect of cost-benefit analysis for inexperienced business managers.

The cost-benefit analysis process involves many human factors. The analysis may be influenced by a project manager. The business may base too much on data from past projects, without making the necessary adjustments. There are also intangible benefits such as better brand recognition, employee morale, customer loyalty, and so forth. Money may not accurately measure value. It is possible for people to place subjective value on intangible items. Intangible items can be difficult to value and assign a monetary value due to the uncertainty and ambiguity involved. This leads to poor analysis and inefficient decision-making.

Last words

It is important to conduct a cost-benefit analysis before deciding whether a project is worthwhile. For making straightforward financial decisions,cost-benefit analysis may be a useful tool. For complex, costly and expensive decisions, however, it is a good idea to use more robust methods like Net Present Value (NPV) or the Internal Rate of Return.