A cost-benefit analysis (CBA), or a benefit-cost analysis, compares projected costs to projected benefits (or outcomes) of a significant decision. The purpose of performing a cost-benefit analysis is to evaluate whether or not the project or decision is worth pursuing from a business perspective.
Understanding what a cost-benefit analysis is
Simply put, you can translate costs and benefits into risk versus reward to gain clarity on what’s best for your business.
For example, if the benefits outweigh the costs of a potential project or decision, this will tell business leaders that it’s a good decision to make.
On the other hand, if the costs outweigh the benefits, then business leaders know it may not be the best route to take and they can look for alternatives.
To understand which variable outweighs the other, you must first translate the cost and benefits into the same metric—and we’ll get into how to do that later.
Where cost-benefit analysis comes from
As with other business methods and strategies, the cost-benefit analysis process is a type of business intelligence tool. It is a set of functions that translate data into actionable information so business leaders can better understand their options.
“Business intelligence” is a term that was first coined in 1865 by Richard Miller Devens in his book, Cyclopaedia of Commercial and Business Anecdotes—but it was an approach that French engineer Jules Dupuit pioneered about two decades earlier.
Dupuit was witness to a significant boom in France’s railway infrastructure. He wondered if there was a way to maximize railway operations to generate a larger financial return for the railway producers and railcar owners.
The results of his efforts proved that city leaders could accurately measure the costs and benefits of the railway system project and reach an informed decision—and the rest is history.
Why businesses might conduct a cost-benefit analysis
Considered a data-driven decision-making method, business owners can use the cost-benefit analysis process in virtually any type of company, startup, or organization because it can be used for any decision.
Conducting a cost-benefit analysis is something every business owner, accountant, or stakeholder should become familiar with because its benefits are twofold:
- Firstly, it provides an analysis of the social gains and losses that could arise, allowing you to measure the benefits (or issues) that you, your customers, or stakeholders may experience from your project.
- Secondly, it provides an analysis of the economic gains and losses that could arise, allowing you to measure the upfront costs and long-term costs associated with the project.
With these two essential features, the benefit-cost analysis process translates everything into monetary value (so that benefits and costs are easily comparable) and asks:
Does the good (benefits) outweigh the bad (costs) for this project (business decision)?
After conducting the analysis, you’ll have an answer. You’ll know whether you should take the next step toward accomplishing your goal with this decision or take a step back if the benefits aren’t worth the costs.
Tools used in a cost-benefit analysis
Before you jump into conducting a cost-benefit analysis, you need to have the right tools with the correct information.
There’s a lot of data that goes into pursuing this process, so you’ll want to start with forecasting potential benefits and costs, evaluating those benefits and costs, and then plugging those numbers into the benefit-cost ratio.
Forecasting methods
Forecasting is an essential aspect of business planning that allows leaders to predict and gain valuable insight into their future needs and outcomes.
Forecasting is crucial when evaluating a cost-benefit analysis because you can’t predict the future benefits without some level of forecasting. There are several types of forecasting techniques that leaders can choose from when inputting values into their benefit-cost ratio formula:
- Qualitative technique: Qualitative research focuses on expert opinions because there is not enough historical data to rely on to create an accurate forecast. Within the qualitative approach are the Delphi and market research methods.
- Quantitative technique: Quantitative research is about finding patterns and cause-effect relationships between two variables when there is plenty of data to work with. Within the quantitative approach are the time-series analysis and causal methods.
The market is constantly changing, so using the right forecasting method to learn what is likely on the horizon is critical for CBA decision making.
For example, because the causal method identifies cause-effect relationships, it may help business leaders determine the relationship between the risk (costs) vs. reward (benefits) when conducting a cost-benefit analysis.
Cost-benefit analysis formulas
Net present value formula
Net Present Value is used to find the present value (PV) of the costs and benefits of a project so that it can be easily translated into a readable, understandable equation for the decision-makers.
Net Present Value (NPV) = PV of Future Benefits – PV of Future Costs
As you might guess, “benefits” can’t be measured as actual monetary costs can.
However, you can make approximations of benefits. In most cases, business owners opt for converting these metrics into economic value since that’s typically the easiest way to understand and compare.
Benefit-cost ratio formula
The benefit-cost ratio (BCR) is the formula used to find the ratio of the present value (PV) of risk versus rewards for a given project:
Benefit-Cost Ratio = PV of Expected Benefits / PV of Expected Costs
If the outcome is greater than 1.0, then the project should have a positive PV.
This formula is essential in the cost-benefit analysis process because it shows the relationship between the risk and reward while using the same metric.
Cost-benefit analysis example
Bruce’s Bookstore is a small, independently-owned bookstore. The business owner, Bruce, is considering expanding its business to include music, e-readers, and audiobooks.
To decide whether or not this expansion is worth the investment, Bruce needs to perform a cost-benefit analysis. It’s also important to conduct a cost-benefit analysis over a series of years so you can make the best decision. So, after conducting some research and accumulating data from his past financials, Bruce has concluded this essential information for costs:
- New employees: The salaries for the new employees will amount to $120,000.
- Getting the new product: The cost of obtaining the music, e-readers, audiobook equipment, and products will be around $15,000.
- Store expansion: The cost to partially renovate the store is around $5,000.
Bruce is looking at $140,000 in estimated costs for this potential bookstore expansion. So, let’s look at the potential benefits Bruce might foresee:
- More sales: With a wider variety of current trending products, Bruce’s Bookstore is expected to experience a 50% increase in sales ($100,000), which puts Bruce’s Bookstore at an annual revenue benefit of $200,000.
- Store’s value increases: When Bruce is ready to retire and sell the bookstore, he wants to be sure he makes enough money back—with this expansion, he estimates he’ll be able to sell the store for $300,000 instead of its present value of $150,000.
With more sales as the main benefit and employee, product, and expansion expenses as the costs, Bruce now has to conduct a cost-benefit analysis to evaluate whether or not this expansion is an excellent decision.
With this information laid out, Bruce used the benefit-cost ratio formula to determine if the ratio is greater than one:
$250,000 / $140,000 = 1.78
Any ratio over 1.0 is a positive outcome, so this cost-benefit analysis tells Bruce that the expansion would be an excellent business decision.
Pros and cons of a cost-benefit analysis
The cost-benefit analysis process is a great way to evaluate significant projects and their effect on your finances and customers.
But while CBA is an excellent method for many large-scale business decisions, it doesn’t have to be used for everything—in fact, there are a few missing features when it comes to this process.
Here’s what you need to know when it comes to weighing the pros and cons:
Pros
- Provides invaluable insight. The CBA process provides insight and clarity into major decisions and unpredictable situations.
- Helps you make rational decisions. It can be hard to evaluate the weight of a decision, especially if you’re leaning toward one way more than the other. CBAs allow you to think rationally and not emotionally, meaning you can be sure you’re making proper, data-driven decisions.
- Discovers hidden costs. Throughout the process, you might be able to find hidden fees, whether it’s a potential loss in profit or customer satisfaction.
- Have a competitive advantage over others in the industry. This extra work pays off big time: With a fleshed-out CBA, you can quickly adjust to market trends and changes, which might take businesses months to catch up with. This helps you stay relevant, give customers what they want, and avoid any projects that may be problematic instead of beneficial.
Cons
- Misses some critical variables. The fact is that business—like life—is unpredictable, so the odds are good that you’re going to run into some unexpected and unpredicted costs. You can make room in your budget for extra expenses, but there’s almost no way to have an accurate number every time.
- Ineffective for long-term projects. Quite often, large projects that require major decision-making are also long-term projects—but due to the changing market, associated costs, wants, needs, and revenue, CBA isn’t always the right choice for projects that could take years to complete.
- Requires plenty of research and data. A lot of data is necessary for you to complete a comprehensive CBA process. For starters, you need to decide what forecasting methods you want to use to determine the net present value formula, which determines the benefit-cost ratio formula.
How to conduct the cost-benefit analysis process
The easiest way to conduct a cost-benefit analysis is with a CBA template—but before you dive into filling out the blanks of your template, you should know what to expect so you avoid running into any unanswered questions. Follow this simple, five-step process to create your analysis.
Part #1: Establish a framework
Your framework starts with identifying the scope so you can accurately decide:
- What you’re evaluating
- What the problem is
- What question you’re looking to answer
Your scope should include plenty of preparation and research, like forecasting. Forecasting is a great way to measure your history and performance, identify essential statistics from your target demographics, and discover potential problems or opportunities through a mixture of quantitative and qualitative research.
Let’s go back to Bruce at Bruce’s Bookstore for our example.
Bruce did some market research and found that most buyers are interested in modern bookstores that include technology, like e-readers.
So, Bruce’s framework focuses on possibly expanding his bookstore to address popular market trends so that he can stay relevant in the industry within his community—and hopefully, in turn, make more sales and increase overall value.
Part #2: Identify your costs and benefits
Costs and benefits need to be identified and organized into categories so you can assign a dollar value to each of them.
First, make a list and consider all of your direct, indirect, intangible, and opportunity costs:
- Direct costs: Direct labor, maintenance, inventory, manufacturing, renovating
- Indirect costs: Electricity, rent, overhead, utilities
- Intangible costs: Delivery times, customer happiness, employee satisfaction, potential risks like environmental or competitive costs
- Opportunity costs: Comparing one project to another and deciding which one is a better choice—for example, Bruce Bookstore’s expansion vs. not expanding at all
Then, make a list and consider your potential benefits from this project or decision. Bruce at Bruce’s Bookstore might consider these as part of his benefits:
- Intangible benefits: Higher employee morale and better customer satisfaction due to a wider variety of products and services
- Competitive advantage: Gains invaluable insight into the market trends that others in the industry might not have
- Higher value: If Bruce wanted to sell his business, he might be able to market it at a higher value with the expansion
Remember that you can find your benefits through careful quantitative and qualitative research. Although this sounds intimidating, forecasting can be easy and effective if you know where to start. For example, market research can begin with simply checking industry outlooks.
Part #3: Estimate costs and benefits in dollar value
It’s smart to assign a dollar value as your metric of choice when measuring your costs vs. benefits. There are a few reasons why:
- Monetary value is easy to understand
- Tangible (costs) and intangible (benefits) factors are easily compared
- You are measuring the cost of the benefit, so it makes sense to use the dollar value
But how do you evaluate the value of your benefits against your costs?
If your perceived benefit is a more positive reaction from your customers, you need to accurately translate those benefits into monetary value to perform a cost-benefit analysis.
In this case, business owners can translate positive responses from customers into a dollar value by measuring the potential increase in sales based on research and data that would suggest repeated purchases from a happier customer.
Part #4: Draw a timeline for expected costs and revenue
Mapping out a timeline for your project allows you to understand two crucial things:
- How to gather and address the expectations of all relevant parties, like customers, investors, employees, and other stakeholders
- How to plan your next steps properly according to these expectations—as well as the costs and benefits
Bruce’s Bookstore has decided to go ahead and expand. He estimates that the entire project will take about four months to complete. But to stay on track, Bruce has created a timeline that covers the costs and revenue:
We can see that Bruce incurs $49,000 in expenses (cost) throughout the four-month project and is projected to gain approximately $42,500 (benefits).
If you remember, this looks a little different from Bruce’s first sample of a CBA—and you’ll see just how vital mapping out your timeline is in the next step.
Part #5: Analyze the results
We finally arrive at the fun part: analyzing the results and determining whether or not this business venture is worthy.
Using all the information you’ve gathered thus far and inputting that information into a benefit-cost ratio formula, the result will present you with a final number called the ratio.
Let’s plug Bruce’s Bookstore’s numbers into the benefit-cost ratio based on the timeline of costs and revenue table above:
$42,500 (Benefits) / $49,000 (Costs) = 0.86
Remember earlier when we looked at Bruce’s first example, which had a ratio of 1.78?
It turns out that after mapping out his timeline, the project’s actual costs were much more than he expected—thus leaving him with a ratio of 0.86.
Anything below 1.0 is considered a negative return, so it turns out that the expansion of Bruce’s Bookstore may not be a good investment after all.
Using cost-benefit analyses for your business
You know that a cost-benefit analysis benefits any business looking to make a major decision. Still, the CBA process should not be used as a blanket solution for every decision because of the effort required to generate a clear outcome.
So while you don’t want to waste your resources on the CBA process for every decision that you have to make, you should use it when you’re looking for a specific answer or solution, such as:
- Whether or not you should make an investment
- If you can hire more employees
- How to prioritize investments so you can make the highest ROI possible
- Quantifying the effects that a decision, change, or project may have on stakeholders
- Develop a benchmark, goal, or time frame for a project—especially if other projects are being considered
- Gain insight into the market, so you have a leg-up against other businesses in the industry
Ultimately, the cost-benefit analysis process should be used when complex decisions need to be made that may affect the business, the clientele, or stakeholders.
You want to be sure that you’ve done your proper research and considered all parties involved—and CBA allows you to do just that.
Keep track of your CBA results with BILL Spend and Expense
When making big decisions that could significantly impact your business and clients, using the cost-benefit analysis process is almost always a great path.
The good news is that BILL Spend and Expense can help you keep track and document past, present, and future data for accurate forecasting results that will directly affect your cost-benefit analysis formula. That way, you can focus on what matters most: making informed decisions that benefit everyone involved.
Learn more today.
