While starting and running a company, you will make thousands of choices. Some decisions are significant, and some are small, but each will affect your business in some way. As time goes on, you may wonder whether there are any strategies you can implement to increase the chances of making the right decision.
Good news: There are. During the decision-making process, taking the time to perform a cost-benefit analysis (CBA) can help you determine the best course of action for a particular situation.
Just what is a cost-benefit analysis? It’s a process that allows you to compare expected potential revenues versus expected potential costs so you can better determine whether an option is right for your company.
In this article, we’ll cover everything you need to know about cost-benefit analyses and how they can help you grow your business.
What is a cost-benefit analysis?
French engineer Jules Dupuit coined the phrase “cost-benefit analysis” in the 1840s. About 100 years later, the phrase became popular with economists.
In a business context, a cost-benefit analysis outlines and analyzes the expected potential revenues against the expected potential costs, helping determine whether an action has an acceptable risk-to-reward ratio. You may also see this referred to as benefit-cost analysis. There is no difference between the two terms — they are synonymous.
Although a cost-benefit analysis can give you a better look at a project, it’s not an end-all-be-all. As we’ll detail below, a cost-benefit analysis is limited in scope, and it’s not a substitute for more sound financial strategies. When making a large-scale decision with vast sums of money, you’re better off using things like Net Present Value (NPV), Internal Rate of Return (IRR) or Return on Investment (ROI).
These equations analyze your cash flows and future interest rates to better determine the opportunity cost of a project. CBA merely looks at primary revenues and expenses, acting as a quick and simple tool that you can use when making a non-financial decision.
When performing a CBA, you broadly add up expected total benefits and compare them to the expected total costs. Your results produce what’s known as the “payback period.” This is an expression of how long it will take for you to repay the costs of the decision.
Although CBAs can be quite beneficial, they’re not something you should rely on all the time. There are only specific scenarios when you should use a CBA.
When should you use a cost-benefit analysis?
Cost-benefit analyses are typically used when comparing projects or making crucial business decisions. These decisions are usually heavily related to finances and spending money, and are used early in the project development phase. Some typical applications include:
- Relocating or opening a new location
- Hiring an employee
- Acquiring more capital
- Entering a new partnership
- Purchasing new equipment
- Selling equity
- Implementing a new computer system
These are all small-scale financial decisions that are straightforward. More in-depth decisions, like acquiring another company or launching a new product, deserve more thorough economic research.
Now that you know when you’ll use cost-benefit analysis, let’s take a closer look at how to calculate a CBA to determine the benefits of the project.
How to calculate a cost-benefit analysis
When running a cost-benefit analysis, you’ll essentially create a pros-and-cons list with numbers attached to each factor. To begin, you need to determine which unit of measurement you’ll use. You’ll probably end up using dollar values if you’re expressing your decision in monetary terms. You should be able to use this unit of measurement for every factor.
After determining your unit of measurement, follow these steps.
1. Figure out future costs and benefits
The first thing you need to do for a CBA calculation is to sit down and determine all of the expected costs and benefits that could take place. You can be liberal in coming up with this information.
This should be your best attempt to forecast the project. Be sure to consider and include all factors, such as labor, raw materials, reallocation of resources, training, drops in sales, etc. Determine whether the costs will be ongoing and for how long.
You’ll want to do the same for benefits as well. Some of the apparent benefits that you can consider include your profit margin, reduced labor costs or quicker turnaround time.
The most efficient way to complete a cost-benefit analysis is to refer to and implement a cost-benefit analysis worksheet, which will ensure that you don’t miss any necessary steps. Be as thorough as possible, and don’t leave anything out. Every little bit counts, even though it may not seem like it when you’re itemizing.
Keep in mind that these numbers must be as accurate as possible. While you may have to estimate some figures, do everything in your power to narrow them down to a precise prediction of your costs and losses. A cost-benefit analysis can be very beneficial, but if the numbers are incorrect, it could be a very costly mistake.
To estimate hypotheticals, you may want to look at your past financial statements and history. You could also consider things like an industry analysis and market research, which may give you some insight into the types of moves you’re trying to make. Also, consider speaking with experts who could more accurately put a monetary value to a specific event or occurrence.
Also, think about any indirect costs and benefits. For instance, perhaps there are social benefits like improved office morale that could occur. Maybe your decision has a significant impact on your community or your environment. Quantifying these figures and assigning a monetary value could be challenging, but estimate to the best of your ability. You’ll do this during the next step.
2. Translate the costs and benefits into monetary values
Now that you have your list of expected benefits and costs, you’ll need to assign a monetary value to them. You’ll likely find that it’s easier to measure expenses than it is benefits.
For instance, it’s much easier to say an employee working at a pop-up holiday shop for 10 hours per week, making $20 an hour, will cost you $200 per week. It’s much more challenging to predict how much revenue this person will be responsible for bringing in.
You’ll also want to think about costs from the perspective of the lifespan of the project. For example, let’s say you need to train employees on how to use new equipment. Not only will this training cost money, you’ll also lose out on potential revenue because your employees are training instead of working.
Lastly, note that you may want to consult with other decision-makers on your team during this step, especially when trying to place a value on subjective, intangible benefits and costs. Consider asking for guidance from fellow owners, stakeholders and employees. You can also perform market research to help you predict figures more accurately.
3. Determine the value of the project
Now that you know the expected costs and benefits of the project, you can compare the two. The easiest way to do so is by subtracting the costs of the project from the benefits. If your net benefits figure is positive, the project may be worth completing. If this figure is negative, the project will cost you more than you’ll earn.
A more in-depth way to look at this is the benefit-cost ratio, which measures cost-effectiveness. When you use this ratio, you’ll divide your benefits by your costs. The equation looks like this:
Benefit-cost ratio = benefits ÷ costs
The higher this number is, the more likely the project is to be successful. A ratio of “1” means that you break even. Anything less than one means that you’re taking a loss.
For example, let’s say you have expected future benefits of $50,000 and expected future costs of $25,000. $50,000 ÷ $25,000 = 2. This means that you’ll earn twice your investment.
On the other hand, let’s say that your expected benefits are $25,000 and costs are $50,000. $25,000 ÷ $50,000 is 0.5. Your investments will lose money.
4. Compile your findings and plan your action
Now that you’ve completed your CBA, it’s time to determine the best course of action. Perhaps you realize that you need to go back to the drawing board and figure out ways to make the project more beneficial.
Maybe you realize that a project is worth it because it benefits outweigh costs, but you don’t have the capital to invest in project costs at this point. Whatever the case may be, now will be the time when you figure out if it’s best to execute your plan at this point in time.
The downsides of a cost-benefit analysis
A CBA is an excellent tool for providing a straightforward look at a project. But, if that project isn’t so straightforward, a CBA has severe limitations.
One of the most significant flaws of cost-benefit analyses is that they struggle to predict benefits and costs from period-to-period. You may be able to look at the benefits and value of a project as a whole, but it’s much more challenging to do so when returns vary from period to period.
These are instances when other financial calculations that we mentioned earlier, like NPV, IRR, and ROI, come into play. These equations also allow you to measure the time value of money, which acknowledges the present value of funds now is more valuable than the same amount in the future. You can’t adjust your CBA for this.
Furthermore, there is a lot of subjectivity when it comes to CBAs, especially when measuring revenues. You may find it hard to quantify and predict expected future returns. Underestimating benefits may not be the end of the world, but overestimating them can cut into your profits and have a long-lasting impact on your company.
Is a cost-benefit analysis right for your business?
Despite its shortcomings, as a small business owner, the cost-benefit analysis should be a no-brainer. It should be a staple of your decision-making. No matter how insignificant a decision may seem, it will have a ripple or butterfly effect that can have long-lasting implications for your company.
A cost-benefit analysis allows you to take your best shot at estimating these expected future costs and benefits. However, you should be aware of the limitations that CBAs can have. So long as you remember to look at your books and financial statements for more complex decisions, you’ll put your business in a much better position for success.