Cost-benefit analysis (also known as benefit-cost analysis) is 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 project managers, project teams, and experts to demonstrate to board members or high-level management which of multiple alternatives is best or which project should be selected.
Based on the results provided by the cost-benefit analysis, those in charge can recognize which project will bring more profit and which alternative best suits the organization‘s goals.
Why Should We Use Cost-Benefit Analysis?
Cost-benefit analysis can be done for every action, but it is most commonly used for answering financial questions.
In this case, it is a systematic measurement used to calculate the cost to manufacture a product or produce a service and then compare it with the benefits to be obtained. The CBA method also takes into consideration the current worth of future earnings when measuring benefits.
What Does Cost-Benefit Analysis Calculate?
- Profit to be gained from the alternative
- Costs required for realizing the alternative
- Time value of costs, incomes, and profits
Cost-benefit analysis also 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 necessary to perform cost-benefit analysis:
- Calculating the Costs
- Calculating the Benefits
- Comparing Costs and Benefits
1 – Brainstorming
As the first step, brainstorming can be conducted by team/group members based on the available inputs and prior experiences. The brainstorming session helps to determine and list all direct and indirect costs.
During brainstorming, all tangible and intangible costs and benefits should be converted into 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 expenses related to the project or product and all benefits to be gained in terms of money. Costs can be classified as direct or indirect. All direct costs related to production, such as the use of a subcontractor, materials, labor costs, or machinery costs are calculated at this step. Likewise, indirect costs such as depreciation, insurance, supervisor salaries, etc. should be added to the costs.
3 – Calculating the Benefits
Product revenues and any intangible benefits such as environmental improvement, employee satisfaction, health and safety, or historical importance should be determined as a monetary value. The current value of future earnings should also be calculated.
4 – Comparing Costs and Benefits
When all the benefits and costs have been calculated, it is time to make a comparison between them. If the costs are less than benefits, the project or idea can be accepted. If there are more alternatives, the one which has the best cost/benefit ratio can be selected.
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 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 as the one you’re working on in terms of function, size, or other factors.
- 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; this is known as confirmation bias.
Example of Cost-Benefit Analysis
Here is an example of cost-benefit analysis, including how to calculate cost-benefit ratio. Suppose that you are considering two projects. Project one will incur a total cost of $10,000 and earn total benefits of $14,000, whereas project two will incur a cost of $13,000 and earn benefits of $22,000. After applying cost-benefit analysis, you will find that the cost-benefit ratio of the first project is 1.4 ($10,000/$14,000) and the ratio of the second project is 1.69 ($13,000/$22,000). This means that project two is more feasible, having a higher cost-benefit ratio.
Advantages of Cost-Benefit Analysis
Performing CBA provides many advantages to an organization in terms of their 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 of the costs and benefits are converted to monetary values. This eliminates biases related to the alternatives.
- Brainstorming sessions encourage participation and decision-making.
- It helps to make correct decisions and 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 and benefits are not clearly identified and their monetary values are not calculated correctly, the results may be misleading.
- CBA helps to compare the cost invested with the benefits.
- It compares future earnings with today’s dollar value.
- It helps in selecting the most profitable project.
- Top executives are involved in cost-benefit analysis.
- Cost-benefit analysis is done before a project charter is developed.