Cost-Benefit Analysis (also known as Benefit-Cost Analysis): It’s an important concept in project management. Simply put, it is performed to identify how well, or how poorly, a project will be concluded. It is done by the experts, project manager, and project teams for board members or high-level management to demonstrate which alternative is better or which project can be selected.
Based on the output provided with the cost-benefit analysis, they recognize which project will bring more profit and which alternative best suits the organization‘s goals.
Why Should We Use Cost Benefit Analysis?
A Cost-Benefit Analysis can be done for every action but commonly used for answering financial questions.
It is a systematic measurement used to calculate the cost to manufacture the product or produce the service & then compare it with the cost of the benefits to be obtained.
CBA method also takes into consideration the current worth of future earnings while making benefit measurements.
What Cost-Benefit Analysis Calculates?
-Profit to be gained from the alternative
-Costs to be spent to build up the alternative
-Time Value of costs, incomes, and profits.
Cost-benefit analysis provides valuable information about:
- Profit to be earned
- Time value of the profit
- The basis to compare the projects.
How to Perform Cost Benefit Analysis
There are four basic steps to be followed to perform Cost-Benefit Analysis:
1. Conducting a Brainstorming
2. Calculating the Costs
3. Calculating the Benefits
4. Comparing Costs and Benefits
1-Conducting a Brainstorming
In this step, brainstorming can be conducted by team/group members based on the inputs and prior experiences. The brainstorming session helps to determine and list all direct & indirect costs.
During the brainstorming, all tangible and intangible costs and benefits should be converted into a monetary value. It is very important to specify the current worth of future costs and earnings at this step
2-Calculating the Costs
CBA determines all costs, expenses related to the project or product and all benefits to be gained in terms of money. Costs can be classified as direct & indirect. All direct costs related to production such as a subcontractor, material, labor costs, machinery costs are calculated at this step. In addition to that, indirect costs such as depreciation, insurance, supervisor’s salaries, etc. should be added to the costs.
3-Calculate the Benefits
Revenues of the products & intangible benefits such as environment, employee satisfaction, or health & safety, historical importance should be determined as a monetary value. Also, the current value of future earnings should be calculated.
4-Compare Costs and Benefits
When all the benefits & costs are calculated, it is time to make a comparison between them. If the costs are less than benefits, the project or the idea can be accepted. If there are more alternatives, the one which has the biggest cost/benefit ratio can be selected.
In order to compare costs and benefits, you should calculate your total costs and your total benefits, and compare both values to identify whether your benefits outweigh your costs. The payback period which is the duration required to recover the cost of an investment is important at this step.
How Accurate is Cost Benefit Analysis?
The quick answer is that it’s only as accurate as of the data you provide it. The more precise your estimates, the more precise your results will be.
Some inaccuracies are caused by the following:
- Using too much data from previous projects, especially when those projects aren’t the same in terms of function, size, or other factors as the one you’re working on.
- Making your assessment based on subjective impressions
- The improper use of heuristics (problem-solving techniques that are not guaranteed) to determine the cost of intangibles.
- Only using data to back up what you want to find is known as confirmation bias.
Advantages of Cost-Benefit Analysis
Performing CBA provides many advantages to an organization for decision-making. Below are a few of them:
- It helps to simplify sophisticated business decisions.
- It provides an objective point of view for comparing alternatives because all the costs & benefits are converted to monetary values. This eliminates biases related to the alternatives.
- Brainstorming sessions encourage participation and decision-making.
- It helps to take correct decisions & select the most rewarding alternative.
Disadvantages of Cost-Benefit Analysis
Although CBA is a very useful technique for decision-making, it has some limitations. The accuracy of this analysis can be affected by inadequate information. If the costs & benefits are not clearly identified and their monetary values are not calculated correctly, the results may be misleading.
- The CBA helps to compare the cost invested with benefits.
- It compares the future earnings with today’s dollar value.
- It helps in selecting the most profitable project.
- Top executives are involved in the cost-benefit analysis.
- Cost-benefit analysis is done before the project charter is developed.