Costbenefit analysis (CBA), sometimes called benefitcost

analysis (BCA), is a systematic approach to estimating the strengths

and weaknesses of alternatives that satisfy transactions, activities or
functional requirements for a business. It is a technique that is used
to determine options that provide the best approach for the adoption
and practice in terms of benefits in labor, time and cost savings etc.
(David, Ngulube and Dube, 2013). The CBA is also defined as a
systematic process for calculating and comparing benefits and costs
of a project, decision or government policy (hereafter, "project").
Broadly, CBA has two purposes:
1. To determine if it is a sound investment/decision
(justification/feasibility),
2. To provide a basis for comparing projects. It involves comparing the
total expected cost of each option against the total expected benefits,
to see whether the benefits outweigh the costs, and by how much. [1]
CBA is related to, but distinct from cost-effectiveness analysis. In
CBA, benefits and costs are expressed in monetary terms, and are
adjusted for the time value of money, so that all flows of benefits and
flows of project costs over time (which tend to occur at different points
in time) are expressed on a common basis in terms of their "net
present value."
Closely related, but slightly different, formal techniques include cost-
effectiveness analysis, costutility analysis, economic impact
analysis, fiscal impact analysis, and Social return on investment
(SROI) analysis.
Cost-Benefit Analysis
Deciding, Quantitatively, Whether to go Ahead
(Also known as Benefit-Cost Analysis)

You can use Cost-Benefit Analysis to decide whether to go ahead with a decision.
iStockphoto/Henrik5000
Imagine that you've recently taken on a new project, and your people are
struggling to keep up with the increased workload.
You are therefore considering whether to hire a new team member. Clearly, the
benefits of hiring a new person need to significantly outweigh the associated
costs.
This is where Cost-Benefit Analysis (CBA) is useful. We'll look at how you can
carry out Cost-Benefit Analysis in this article.
Note:
Cost-Benefit Analysis is a quick and simple technique that you can use for non-
critical financial decisions. Where decisions are mission-critical, or large sums of
money are involved, other approaches such as use of Net Present Values
and Internal Rates of Return are often more appropriate.
About Cost-Benefit Analysis
Jules Dupuit, a French engineer, first introduced the concept of Cost-Benefit
Analysis in the 1930s. It became popular in the 1950s as a simple way of
weighing up project costs and benefits, to determine whether to go ahead with a
project.
As its name suggests, Cost-Benefit Analysis involves adding up the benefits of a
course of action, and then comparing these with the costs associated with it.
The results of a cost-benefit analysis are often expressed as a payback period
this is the time it takes for benefits to repay costs. Many people who use Cost-
 Benefit Analysis look for payback in less than a specific period for example,
three years.
You can use Cost-Benefit Analysis in a wide variety of situations. For example,
when you are:
3. Deciding whether to hire new team members.
4. Evaluating a new project or change initiative.
5. Determining the feasibility of a capital purchase.
However, bear in mind that Cost-Benefit Analysis is best for making quick and
simple financial decisions. More robust approaches are commonly used for more
complex, business-critical or high cost decisions.

How to Use the Tool

Follow these steps to do a Cost-Benefit Analysis.

Step One: Brainstorm Costs and Benefits

First, take time to brainstorm all of the costs associated with the project, and
make a list of these. Then, do the same for all of the benefits of the project. Can
you think of any unexpected costs? And are there benefits that you may not
initially have anticipated?
When you come up with the costs and benefits, think about the lifetime of the
project. What are the costs and benefits likely to be over time?

Step Two: Assign a Monetary Value to the Costs

Costs include the costs of physical resources needed, as well as the cost of the
human effort involved in all phases of a project. Costs are often relatively easy to
estimate (compared with revenues).
It's important that you think about as many related costs as you can. For
example, what will any training cost? Will there be a decrease in productivity
while people are learning a new system or technology, and how much will this
cost?
Remember to think about costs that will continue to be incurred once the project
is finished. For example, consider whether you will need additional staff, if your
team will need ongoing training, or if you'll have increased overheads.

Step Three: Assign a Monetary Value to the Benefits

This step is less straightforward than step two! Firstly, it's often very difficult to
predict revenues accurately, especially for new products. Secondly, along with
the financial benefits that you anticipate, there are often intangible, or soft,
 benefits that are important outcomes of the project.
For instance, what is the impact on the environment, employee satisfaction, or
health and safety? What is the monetary value of that impact?
As an example, is preserving an ancient monument worth $500,000, or is it worth
$5,000,000 because of its historical importance? Or, what is the value of stress-
free travel to work in the morning? Here, it's important to consult with other
stakeholders and decide how you'll value these intangible items.

Step Four: Compare Costs and Benefits

Finally, compare the value of your costs to the value of your benefits, and use
this analysis to decide your course of action.
To do this, calculate your total costs and your total benefits, and compare the two
values to determine whether your benefits outweigh your costs. At this stage it's
important to consider the payback time, to find out how long it will take for you to
reach the break even point the point in time at which the benefits have just
repaid the costs.
For simple examples, where the same benefits are received each period, you
can calculate the payback period by dividing the projected total cost of the
project by the projected total revenues:
Total cost / total revenue (or benefits) = length of time (payback period).

Example
Custom Graphic Works has been operating for just over a year, and sales are
exceeding targets. Currently, two designers are working full-time, and the owner
is considering increasing capacity to meet demand. (This would involve leasing
more space and hiring two new designers.)
He decides to complete a Cost-Benefit Analysis to explore his choices.

Assumptions
Currently, the owner of the company has more work than he can cope with, and
he is outsourcing to other design firms at a cost of $50 an hour. The company
outsources an average of 100 hours of work each month.
He estimates that revenue will increase by 50 percent with increased capacity.
Per-person production will increase by 10 percent with more working space.
The analysis horizon is one year: that is, he expects benefits to accrue within the
year.
Costs
Category Details Cost in First
Year

Lease 750 square feet available next door at $13,500

$18 per square foot

Leasehold Knock out walls and reconfigure office $15,000

improvement space
s

Hire two more Salary, including benefits $75,000

designers
Recruitment costs $11,250
Orientation and training $3,000

Two Furniture and hardware $6,000

additional
workstations Software licenses $1,000

Construction Two weeks at approximately $7,500 $15,000

downtime revenue per week

Total $139,750

Benefits

Benefit Benefit
Within
12 Months

50 percent revenue increase $195,000

Paying in-house designers $15 an hour, versus $50 an $42,000

hour outsourcing (100 hours per month, on average:
savings equals $3,500 a month)

10 percent improved productivity per designer ($7,500 + $58,500

$3,750 = $11,250 revenue per week with a 10 percent
increase = $1,125/week)
Improved customer service and retention as a result of $10,000
100 percent in-house design

Total $305,500
He calculates the payback time as shown below:
$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.
Inevitably, the estimates of the benefit are subjective, and there is a degree of
uncertainty associated with the anticipated revenue increase. Despite this, the
owner of Custom Graphic Works decides to go ahead with the expansion and
hiring, given the extent to which the benefits outweigh the costs within the first
year.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows
that come in over a number of periods of time, particularly where returns vary
from period to period. In these cases, use Net Present Value (NPV) and
Internal Rate of Return (IRR) calculations together to evaluate the project,
rather than using Cost-Benefit Analysis. (These also have the advantage of
bringing "time value of money" into the calculation.)
Also, the revenue that will be generated by a project can be very hard to predict,
and the value that people place on intangible benefits can be very subjective.
This can often make the assessment of possible revenues unreliable (this is a
flaw in many approaches to financial evaluation). So, how realistic and objective
are the benefit values used?

Key Points
Cost-benefit analysis is a relatively straightforward tool for deciding whether to
pursue a project.
To use the tool, first list all the anticipated costs associated with the project, and
then estimate the benefits that you'll receive from it.
Where benefits are received over time, work out the time it will take for the
benefits to repay the costs.
You can carry out a Cost-Benefit Analysis using only financial costs and benefits.
However, you may decide to include intangible items within the analysis. As you
must estimate a value for these items, this inevitably brings more subjectivity into
the process.
This site teaches you the skills you need for a happy and successful career; and
this is just one of many tools and resources that you'll find here at Mind Tools.
Click here for more, subscribe to our free newsletter, or become a member for
just $1.
 Cost-Benefit Analysis
Cost-benefit analysis is a process intended to determine
whether the total expected benefits that will be produced
as a result of implementing change outweigh the total
expected cost involved. Both the benefits and the costs
are usually expressed in terms of financial values, and
values may be adjusted to reflect the period of time over
which the costs are incurred, or the benefits realised.
Whilst the monetary costs of an undertaking are usually
relatively easy to determine in terms of materials, capital
expenditure, overheads and the estimated cost of labour,
the financial value of the benefits is often more difficult to
quantify. The more tangible benefits of a venture could
be manifested as a reduction in operating costs (for
example, being able to maintain current output with
fewer employees) or as an increase in income (for
example, increasing output with no associated increase
in labour costs due to improvements in process
efficiency). Less tangible benefits could take the form of
greater flexibility, enabling the organisation to adapt
more quickly to a volatile business environment or take
advantage of new technologies to market its products
and services.

Cost benefit analysis is usually carried out before any

decision is made as to whether or not to go ahead with
the project, and it will inform that decision. The process
may take into account only the financial costs and
expected benefits, or it may be extended to include an
analysis of the more intangible costs and benefits. Either
way, because of the complex issues that are usually
involved, the degree of uncertainty over the actual costs
that will be incurred, and the real value of any perceived
benefits, the process can at best only provide
approximate figures. The estimates that are arrived at
may ultimately prove to be wide of the mark.
Nevertheless, it is a necessary process if the decision on
whether to proceed or not is to be an informed one, and
should at least identify significant cost drivers and
potential benefits.

Fairly obviously, since the benefits of any undertaking

cannot be realised until that undertaking has been
completed and the deliverables are available for use, the
costs of the project (which start to be incurred as soon
as work on the project commences) will not be matched
by an immediate return on investment. The financial
benefits will only start to materialise at some future point
in time. The period of time over which the project is
adjudged to have paid for itself (i.e. covered its costs) is
known as the payback period, and the point in time
where the project costs have been recovered is known
as the break-even point. Many organisations take the
payback period into account when making a decision on
whether or not to proceed with a project. If the required
return on investment will take too long to achieve, the
decision may be to shelve the project. Complicating the
equation is the fact that the real value of a sum of money
earned at some future point in time will be less than its
value in the present thanks to inflation, and the fact that
the money has not been working for the organisation
(e.g. earning interest or financing ongoing operations) in
the intervening period.

Let's look at a simple example of a cost benefit analysis.

A commercial director is deciding whether or not to
invest in a new computer-based customer service
system. The sales department currently has only a
handful of computers, and the customer service
operatives are not especially computer literate, but he
can see the potential value of being able to reach a
significantly larger number of customers and provide
more efficient customer services, and feels that the new
system would enable this to happen. The director carries
out a cost benefit analysis, with the results shown below.
It can be seen from these figures that (providing the
estimates are accurate, of course) the system would pay
for itself within the first year of operation - within the first
eight months, in fact.
 Simple example of cost-benefit analysis

Discounted Cash Flow (DCF) and Net

 Present Value (NPV)
Discounted cash flow (DCF) analysis is a way of
calculating the value of money flowing into and out of an
organisation over time (the cash flows) based on the
concept of its present value. Future cash flows are
estimated and then discounted to give their net present
values (NPVs). The discount rate used varies, but one
commonly used method of discounting is to calculate
how much money would have to be invested in the
present at a given rate of rate of return in order to
achieve the cash flow in the future. The rate of return
may be based on current interest rates plus a risk
premium that reflects the risk that the future cash flow
may not be forthcoming. The future value (FV) of an
investment can be calculated as:

FV = NPV x (1 + i)n

Where NPV is the net present value of the future cash

flow, i is the interest rate (including any risk premium),
and n is the time in years until the cash flow occurs (the
unit of time used can be adjusted to reflect the time
within which a return on investment is anticipated).
Rearranging the formula to get the net present value, we
get:

NPV = FV/(1+i)n

This formula represents a relatively simplistic approach

that assumes that the interest rate (including the risk
premium) remains constant. The formula is applied to
both positive and negative cash flows. In a typical project
scenario, the cash flows are likely to be negative until
some point after the project is completed. The important
thing to remember is that at some point in the future (the
break-even point), the NPV (represented by the sum of
the discounted cash flows up to that point) should
acquire a positive value (i.e. it should be greater than
zero). Essentially, if the NPV has a positive value at
some point the project will have paid for itself. If not, it
will have lost money. To take a simple example, let's
assume a project has a total cost of 100,000 over a
twelve month period (Year 0). The project is expected to
produce cost benefits in the form of an additional annual
income of 25,000.00 per annum, and is expected to pay
for itself within five years from completion of the project.
If a value for i of 7.5% is used, the result will be a small
positive NPV, as illustrated below (note that increasing
the value of i to 8.0% results in a small negative NPV).
 Example NPV calculation

The calculations involved can be set up in any

spreadsheet program in a few minutes, enabling a range
of outcomes to be calculated by varying factors such as
the value of i. The notion of discounted cash flow can be
used to calculate how much value a project will add to
the organisation over a given period of time. If the net
present value at some pre-determined future date is
greater than zero, then the project has added value to
the organisation. If not, there will be no point (from a
financial point of view at least) in continuing with the
project. The example given is a relatively simple one and
has been used in order to demonstrate the basic
principles. In reality such calculations can be affected by
a great number of variables, but it is beyond the scope of
these pages to consider the implications of this any
further. Bear in mind also that even if the calculations
result in an unfavourable outcome from a purely
monetary point of view, the project may still have long
term intangible benefits that cannot be measured in
purely financial terms. There could be serious negative
consequences as a result of not going ahead with a
project.