Cost-Benefit Analysis
Companies must carefully consider many factors when it comes to making decisions about a new project or plan. It is important to avoid wishful thinking or over-reliance on intuition. The most prudent project managers rely on objective analysis when deciding which path to take to maximize overall benefit while minimizing risk.
Often, this assessment comes in the form of a cost-benefit analysis (CBA). The following article serves as a guide to CBAs and how to conduct one properly.
What is a Cost Benefit Analysis?
A cost-benefit analysis (CBA) is a systematic method for weighing the potential costs against the prospective benefits of a decision. Cost and benefit are typically measured in dollars, especially when they involve metrics like materials or sales profits. However, some costs and benefits are less tangible. Organizations may assign items such as company image or environmental impact as a dollar amount in the calculation or consider them separately in the analysis.
Companies often incorporate an opportunity cost—a benefit associated with an alternative opportunity they would forgo if making a particular decision—into a CBA as well. For example, if choosing to begin manufacturing product A means you cannot manufacture product B, the gains from product B are considered an opportunity cost and count against the benefits in the CBA of product A.
Once an organization carefully identifies and assigns values to all costs and benefits, they subtract the total costs from the total benefits. If the net is positive, this indicates a net benefit for the decision. A net negative suggests that the company reconsider the decision or make a different choice.
How a CBA can inform intelligent decisions.
Because big decisions can significantly affect an organization’s overall health, a cost-benefit analysis is one of the most important tools that project managers have in their cost management toolboxes. They might conduct a CBA before implementing a new project or making a decision and at any number of junctures within a project.
Managers should take care not to underestimate costs or overestimate benefits. Being as conservative as possible is preferable since some unforeseen costs never make it into the initial calculation. They should also make every effort to remain as objective as possible when determining values and not to let optimism or pessimism color the assigned values.
For example, suppose a manager considers hiring additional team members to distribute the workload of current employees better and have room to grow their business. The costs associated with this decision might include the following:
- The salary and benefits costs for new employees
- Onboarding/training costs for new employees
- Costs associated with advertising open positions and conducting interviews
- The cost of work offloaded onto the new employees that current employees can handle (For example, if you have a salaried employee who consistently works 50 hours per week, and their workload will be reduced to 40 hours per week when a new hire arrives to take up some of the excess, the ten extra hours of work you get from the salaried employee is the cost associated with this decision.)
- The cost of workspaces, computers, or other equipment that new employees need
The benefits associated with this decision might include the following:
- Improved employee morale resulting from smaller workloads and less required overtime
- Increased work product generated by the new employees
- Expansion of employee skill set by introducing workers with new and different skills
- The future ability to take on more work and/or larger and more involved projects
Again, you should assign a dollar amount to each cost and benefit. A net positive in the difference indicates that hiring new employees is a sound investment.
How to conduct a cost-benefit analysis in five steps:
The CBA process begins with the careful surveying of all possible costs and benefits associated with a decision and ends with using the results to make an informed choice. The basic steps are as follows.
1. Generate a list of all associated costs and benefits.
While many of the costs and benefits are immediately obvious, such as the price of labor or the expected income from a service, others are less clear. Be sure to include intangible items that are of importance as well, such as customer satisfaction or changes to your brand image.
The list should be as comprehensive as possible and include opportunity costs and secondary costs, such as electricity or overhead, and the benefits associated with future outcomes.
2. Assign monetary values to all tangible costs and benefits.
Things like wages, the sale price of items, the cost of advertising, and so on constitute tangible costs and benefits. These are relatively easy to assign a monetary value to. However, this does not mean those values will be entirely straightforward. You may need to carefully consider interactions, such as the financial impact of likely responses by competitors, to any changes you make.
As best you can, apply conservative estimates, and seek to err on the side of underestimating benefits while overestimating costs. This puts you in the best position to safeguard against unexpected financial fallout.
3. Give consideration to intangible costs and benefits.
How you handle the associated costs and benefits of intangible items may vary. Often, analysts determine a method to assign a monetary value to intangible items, although this can be subjective. Instead, you may wish to categorize these items separately so that you can consider their effects in parallel when making a final decision.
4. Translate the costs and benefits into a concrete metric.
Add the total dollar amount for costs and the total dollar amount for benefits. Then, take the difference, subtracting the cost from the benefits. The result will be a positive or negative dollar amount indicating the predicted outcome of the decision.
Suppose you chose to consider intangible benefits, such as morale or environmental impact. In that case, you might have two such numbers to consider separately, or you may have a number for your tangible cost benefit difference alongside a bulleted list of intangible pros and cons.
5. Make an informed decision.
Once you complete the analysis, you can use the results to make an informed decision. Often, if the net result is a sufficiently large positive number, it is worth going ahead. A negative value indicates financial loss by making the decision.
It is not always as cut and dry as looking at the numbers, however. Sometimes, a decision might make sense if the monetary impact is only slightly negative, but the effect on your company image is likely to be significantly positive. This complex determination is why many choose to place a monetary value on intangible benefits, allowing for a more straightforward calculation and final decision-making process.
Calculating your team’s costs and benefits.
Anytime you make critical business decisions, you should consider all the tools at your disposal. As outlined in this article, a cost-benefit analysis is an effective and valuable way to compare prospective costs. The results of a CBA should allow you to make a decision from a much more informed position than before the analysis.