An Introduction to Cost-Benefit Analysis
How much do I earn? Or how much do I save is the question which constantly keeps on alarming in the minds. The success mantra of business and lifecycle is “how much do I have; how much do I need.” And the formula applies to every sphere of life. Whether it’s business or career, your success will be determined by recognizing your requirements. It’s essential to reap the most benefits from your investment, ideas, and options in today’s relentless business environment. To draw out maximum – organizations from MNC’s, start-ups to small enterprises use cost-benefit analysis brace their decision-making process. The cost-Benefit analysis helps the management identify the best return on investments based on cost, resources, etc.
Why do I need to adapt to the cost-benefit analysis system? As an entrepreneur, multiple questions might be brimming your mind, and one such is why I need to incorporate cost-benefit analysis. Whether you are an individual purchasing a house or a business professional scaling a new sales strategy, you use the CBA method. CBA is an integral part of every business, government, and personal decision making.
While developing a project, you need to make lots of decisions. You even need to consider some crucial aspects, and those crucial aspects can be essential for the success of the venture. Due to such criticalities, business managers don’t make decisions on gut instinct or assumptions. Instead, they try hard to minimize the risk and work only they are certain. But in a world of uncertainties and constantly fluctuating economies, how can it be accomplished? The answer is to consult data, reports, charts, etc. Use them to evaluate data, make decisions using a process called cost-benefit analysis. With cost-benefit analysis, you can minimize the risk whereas maximizing the rewards.
What is Cost-Benefit Analysis?
In simpler words, cost-benefit analysis is a process primarily used by business professionals to weigh the sum of the benefits, financial gains against the negatives, and risks against these actions. The technique is often used while opting for a course of approach. Some analysts even use the model to assign value to intangible assets.
Cost-benefit analysis or benefit-cost analysis is a business process through which management analyze decisions, steps, or decisions and even evaluates a value for intangibles. The system is built by determining the profits and associated costs and then subtracting it from the benefits. When done is, it provides concrete insights that can be used to derive conclusions.
History of Cost-Benefit Analysis
The cost-benefit model was originated in water development projects in the US Military Corps of engineers. The model was developed by French engineer and Economist Jules Dupuit in the year in the 1840s 1840s. But later, in the 1950s 1950’s it gained popularity and was used as a tool for weighing benefits and project cost to determine whether the project is worth investing. As the name suggests, the cost-benefit analysis adds up the benefits of the actions then compares it with the cost and risk associated with it.
Cost-Benefit Analysis Steps
Till now, you might have studied the benefit of performing cost-benefit analysis. But might be bewildered about how to do a cost-benefit analysis? But there isn’t any proved and tested method for doing a cost-benefit analysis. But certain core elements need to be present in every analysis. Opt for the method that works best with your industry type. Here we have some of the basic steps which you will go through while performing cost-benefit analysis.
- Step 1 – List All the Costs: The first step is to brainstorm, enlist all the cot associated with the project note it down. Likewise, do with the benefits. Can you think of any other unexpected cost, mention it down?
- Step 2 – Add Monetary Value to the Cost: It includes physical cost and the cost to human efforts involved in each phase of the project. Try To include as many as possible costs. Costs are easy to estimate than revenue. Also, remember all the costs which will be incurred once the project will end.
- Step 3 – Assign Value to Benefits: It’s somewhat similar to step 2. But the quirk is that firstly it’s difficult to estimate the revenue of a product, especially a new one. Secondly, the benefits that you anticipate are often intangible, soft. For example: What’s the impact of a positive work environment? Its employee satisfaction, mental wellness. What value could you assign to such impacts?
- Step 4 – Compare Costs and Benefits: As in step 1, you have listed all costs and benefits. Use them for analysis and decide your course of action. For doing so, add up all the benefits and sum up all the costs; if by chance the costs outweigh the benefits, then it’s time to revamp your strategies.
Elements of Costs Benefit Analysis
Before performing a cost-benefit analysis, analysts or product manager has to assign a monetary value to all items listed in the cost-benefit list. But while applying monetary measurement, analysts need to be cautious and take special care about not underestimating the costs and overestimating the benefits. A balanced, conservative approach must be followed with conscious effort to avoid any subjective tendencies while calculating estimated is best suited while assigning value to cost and benefit for the analysis.
Costs Involved in CBA:
- Direct Costs: It includes labor expenses, production costs, inventory, purchasing of raw materials, etc.
- Indirect Costs: It includes expenses related to overhead costs from management, rent, utilities, electricity bills, etc.
- Intangible Costs: It can be the impact of any decisions over employees, customers.
- Opportunity Costs: it includes all the costs incurred in expanding the business, such as buying a new plant, alternative investments.
- Potential Risks Costs: Such a regulatory risk, environmental impacts, government policies, competitions, etc.
Benefits include in CBA:
- Sales, revenue, and income hiked due to an increase in the production or launch of new products.
- Intangible Benefits: Enhanced employee satisfaction because of salary hike, workplace environment, training, and customer satisfaction because of quality product delivery.
- Competitive Advantage such as gaining market share because of the new product launch.
How Accurate is Cost-Benefit Analysis?
Entrepreneurs, product managers often inquire for the most accurate business methodologies or models to boost their business and productivity. But out of several business models for upgrading business and investment appraisal introduced last decades, none of the models has gained such popularity and attracted more attention than cost-benefit analysis did. But still, the question is, how accurate is the CBA model. The accuracy of benefit-cost analysis relies on the data you put into the process.
Here are some of the reasons due to which inaccuracies occur:
- Relying too much on previous data, especially those old projects that are entirely different in function, size, etc.
- Using subjective impressions while making assumptions.
- Using improper use heuristic approach for evaluating values for intangibles.
- Underestimating the costs, whereas overestimating the benefits.
Being an entrepreneur, you would have noticed some businesses start with a bang but eventually winds up in a year. This is because they over finance some projects and then struggle to make returns on investment. The reason behind failing the idea is they sound tremendous in the meeting hall but didn’t generate returns. A Cost-benefit system determines whether your project is worth investing in or not. If any business idea strikes your mind, so initially get done with cost-benefit model.