Cost/Benefit Analysis

Evaluating Quantitatively Whether to Follow a Course of Action

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You may have been intensely creative in generating solutions to a problem, and rigorous in your selection of the best one ava ilable. This solution may still not be worth implementing, as you may invest a lot of time and money in solving a problem that is not worthy of this fort. ef Cost Benefit Analysis or cba is a relatively* simple and widely used technique for deciding whether to make a chnge. As its name suggests, to use a the technique simply add up the value of the benefits of a course of action, and subtract the costs associated with it. Costs are either one-off, or may be ongoing. Benefits are most often received over time. We build thi effect of time into our analysis by calculating a s payback period. This is the time it takes for the benefits of a change to repay its costs. Many companies look for payback ovr a specified period of e time e.g. three years. In its simple form, cost-benefit analysis is carried out using only financial costs and financial benefits. For example, a simple cost/benefit analysis of a road scheme would measure the cost of building the road, and subtract this from the economic benefit of improving transport inks. It would not l measure either the cost of environmental damage or the benefit of quicker and easier travel to work. A more sophisticated approach to cost/benefit measurement models is to try to put a financial value on intangible costs and enefits. This can be b highly subjective is, for example, a historic water meadow worth $25,000, or is it worth $500,000 because if its environmental importance? What is the value of stress-free travel to work in the morning? These are all questions that people have to answer, and answers that people have to defend. The version of cost/benefit analysis we explain here is necessarily simple. Where large sums of money are involved (for exampe, in financial market l transactions), project evaluation can become an extremely c omplex and sophisticated art. The fundamentals of this are explained inPrinciples of Corporate Finance by Richard Brealey and Stewart Myers this is something of an authority on the subject.

Example:
A sales director is deciding whether to implement a new computerbased contact management and sales processing system. His department has only a few computers, and his salespeople are not computer literate. He is aware that computerized sales forces are able to contact more customers and give a higher quality of reliability and service to those customers. They are more able to meet commitments, and can work more eff iciently with fulfillment and delivery staff. His financial cost/benefit analysis is shown below: Costs: New computer equipment:

y y y y y y y y y y y

10 network-ready PCs with supporting software @ $2,450 each 1 server @ $3,500 3 printers @ $1,200 each Cabling & Installation @ $4,600 Sales Support Software @ $15,000 Computer introduction 8 people @ $400 each Keyboard skills 8 people @ $400 each Sales Support System 12 people @ $700 each Lost time: 40 man days @ $200 / day Lost sales through disruption: estimate: $20,000 Lost sales through inefficiency during first months: estimate: $20,000

Training costs:

Other costs:

Total cost: $114,000 Benefits:

y y y y

Tripling of mail shot capacity: estimate: $40,000 / year Ability to sustain telesales campaigns: estimate: $20,000 / year Improved efficiency and reliability of follow-up: estimate: $50,000 / year Improved customer service and retention: estimate: $30,000 / year

y y

Improved accuracy of customer information: estimate: $10,000 / year More ability to manage sales effort: $30,000 / year

Total Benefit: $180,000/year Payback time: $114,000 / $180,000 = 0.63 of a year = approx. 8 months Tip: The payback time is often known as the break even point. Sometimes this is is more important than the overall benefit a project can deliver, for example because the organization has had to borrow to fund a new piece of machinery. The break even point can be found graphi ally by plotting c costs and income on a graph of output quantity against $. Break even occurs at the point the two lines cross. Inevitably the estimates of the benefit given by the new system are quite subjective. Despite this, the Sales Director is ver likely to introduce it, y given the short payback time.

Key Points:
Cost/Benefit Analysis is a powerful, widely used and relatively easy tool for deciding whether to make a change. To use the tool, firstly work out how much the change will cost to make. Then calculate the benefit you will from it. Where costs or benefits are paid or received over time, work out the time it will take for the benefits to repay the costs. Cost/Benefit Analysis can be carried out using only financial costs and financial benefits. You may, however, decide to inclu intangible items de within the analysis. As you must estimate a value for these, this inevitably brings an element of subjectivity into the process.

Pri i g Products and Services:

After studying this chapter you should be able to:

. 2. 3. 4.

Compute the profit maximizing price of a product and service using the price elasticity of demand and variable cost. Compute the selling price of a product using the absorption costing approach. Calculate the target cost for a new product or service. Calculate and use billing rates used in time and material pricing.

Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern. Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered. the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price. Selling price = Cost + (Markup Cost) For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products. Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists. Price Elasticity of Demand--Economists' Approach to Pricing: If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. Click here to read full article. Absorption Costing Approach to Cost Plus Pricing: The absorption costing approach to cost plus pricing differs from the economists' approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the

cost base is theabsorption costing unit product cost rather than variable costing. Click here to read full article. Target Costing: Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. Click here to read full article. Time and Material Pricing in Service Companies : Some companies--particularly in service industries-- use a variation of cost plus pricing calledtime and material pricing. Under this method, two pricing rates are established-one based on direct labor time and other based on the cost of direct materials used. Click here to read full article. In Business| Do Consumers Really Respond To Prices? You Bet They Do:
Jess Stone street Jackson is the founder of Kendall -Jackson (K-J) winery, which specializes in making popular wines that are good enough to command a premium price. Jackson, who is now a billionaire, prices his wines a few dollars high than other mainstream wines. For example, if a Clos du Bois chardonnay costs $9 at retail, Jackson will charge $11 for his chardonnay. When chardonnay became the range in the late 1990s, Jackson tried pushing up his prices by another few dollars over the comp etition. But unit sales dropped by 18%. Jackson rolled back his prices and the the volume recovered. Source: Tim W. Ferguson, "Harvest Time," Forbes, October 16,