Cost-Benefit Analysis (Encyclopedia of Business and Finance)
Cost-benefit analysis is used for determining which alternative is likely to provide the greatest return for a proposed investment. Sometimes referred to as cost-effectiveness analysis, it is relevant to businesses as well as to not-for-profit entities and governmental units.
A business might find it helpful to use cost-benefit analysis to determine if additional funds should be invested in a facility in the home country or in another country. A community not-for profit organization that provides a variety of programs for children might use cost-benefit analysis to assist management in determining which activities will provide the most services for the costs specified. A federal governmental agency might use cost-benefit analysis to determine which of several projects planned for the national parks is likely to be most used, given the costs, by interested citizens.
Because resources such as money and time are limited, an organization usually cannot undertake every project proposed. To decide whether to undertake a project, decision makers weigh the benefits from the project against the cost of the resources it requires, normally approving a project when its benefits exceed its costs. Cost-benefit analysis provides the structure and support for making such decisions.
Benefits increase the welfare of the organization. Some benefits are monetary benefits, such as the dollar amount of cash inflows from additional sales of a product or the saving in cash outflows that a project enables. Other benefits are important but harder to quantify. For example, a project may increase customer satisfaction; increased customer satisfaction may increase future sales, but the exact relationship between sales and satisfaction is often hard to specify.
Costs are the outlays or expenditures made in order to obtain a benefit. Many costs are measured monetarily, such as the cost of buying a new machine or of hiring an additional employee.
COST-BENEFIT ANALYSIS IN BUSINESS
A cost-benefit analysis is straightforward when all costs and benefits are measurable in monetary terms. Assume that Company A must decide whether to rent an ice cream machine for the summer for $900. The ice cream machine will produce additional cash inflows of $1,000 during the summer. The benefit of additional cash in-flows ($1,000) exceeds the additional cost ($900), so the project should be undertaken. Not all cost-benefit analyses are this simple, however. If the benefits and costs occur in different time periods, it may be necessary to discount the future cash flows to their equivalent worth today.
In another example, cost savings is a benefit. Assume that Company B makes about 100,000 photocopies a year. Company B does not have its own copy machine and currently pays 4 cents per copy, or $4,000 a year, to Copycat Copiers. Company B can lease a copy machine for $2,500 a year. It must also pay 2 cents per page for paper for the leased machine, or $2,000. In this example, the cost of leasing the machine and buying paper ($2,500 $2,000 $4,500) exceeds the benefit of saving the $4,000 normally paid to Copycat Copiers. Company B should continue to use Copycat Copiers for its photocopies. However, Company B must have a pretty good estimate of the number of copies it needs to be comfortable with its decision. If Company B needs 150,000 copies this year instead of 100,000, the cost of the leasing the machine and buying paper ($2,500 $3,000 $5,500) is cheaper than the $6,000 (150,000 $0.04) savings in fees to Copycat Copiers.
A third example involves a project with benefits that are difficult to quantify. Assume that Company C is deciding whether to give a picnic costing $50,000 for its employees. Company C would receive the benefit of increased employee morale from the picnic. Better employee morale might cause employees to work harder, increasing profits. However, the link between increased morale and increased monetary profits is tenuous. The decision maker must use his or her judgment to compare the nonmonetary benefit to the monetary cost, possibly deciding that increased employee morale is worth the $50,000 cost but would not be worth a $100,000 cost.
In the preceding examples, cost-benefit analysis provided a framework for decision making. The range of objectivity related to measurement of the factors is typical. Techniques used in business as a basis for determining costs and benefits, such as return on investment, are generally quantifiable and thus appear to be objective. However, it is not uncommon for qualitative factors to enter into the decision-making process. For example, providing a product that individuals with limited incomes will be able to purchase may not provide the highest monetary return on investment in the short run, but might prove to be a successful long-term investment. Careful decision makers attempt to deal with a difficult-to-quantify factor in as objective a manner as possible. However, cost-benefit analysis in most situations continues to introduce measurement problems.
COST-BENEFIT ANALYSIS IN NONBUSINESS ENTITIES
Cost-benefit analyses are also common in non-business entities. Boards of not-for-profit organizations establish priorities for their programs, and such priorities often specify desired program outputs. For example, assume a not-for-profit organization is interested in reducing the level of illiteracy among the citizens of a rural community in a state that has one of the lowest per- capita incomes in the United States. As alternative programs for those who need to learn to read are considered, there will be cost-benefit analyses that focus on a number of factors, including the extent to which a particular program can attract those who are illiterate. A program in the downtown area of a small town might be considered because a facility is available there at low costand that low cost is appealing. Focus on cost is not sufficient, however. When benefits are considered, it might become clear that those who are eager for such a program do not have cars and that there is no public transportation from where they reside to the center of the small town. Further consideration of relevant factors and of alternatives, undertaken in good faith, should result in cost-benefit analyses that provide valuable information as the agency makes decisions.
At all levels of government in the United States, cost-benefit analyses are used as a basis for allocating resources for the public good to those programs, projects, and services that will meet the expectations of citizens. For example, decision makers at the federal level who have policy responsibility for environmental standards, air-quality rules, or services to the elderly often find information from cost-benefit analyses to be critical to the decision-making task.
CONTINUING EFFORTS TO QUANTIFY COST-BENEFIT FACTORS
As possibilities for the use of funds increase, there is motivation for better measurement of both costs and benefits as well as for speedier ways of accomplishing analyses for alternatives that are appealing. All types of entitiesusinesses, not for-profit organizations, and governmental unitstrive to improve the measurments used in cost-benefit analyses. The capabilities of electronic equipment provide promising assistance in accumulating data relevant for analyses. Wise use of resources is an important goal in every organization; cost-benefit analyses make a key contribution to this goal. Therefore, attention is given to improving both the effectiveness and efficiency of such analyses.
Boardman, Anthony, E. (1996). Cost-Benefit Analysis: Concepts and Practice. Upper Saddle River, NJ: Prentice-Hall.
Nas, Tevik F. (1996). Cost-Benefit Analysis: Theory and Application. Thousand Oaks, CA: Sage Publications.
Cost-Benefit Analysis (Encyclopedia of Small Business)
Cost-benefit analysis is the exercise of evaluating an action's consequences by weighing the pluses, or benefits, against the minuses, or costs. It is the fundamental assessment behind virtually every business decision, due to the simple fact that business managers do not want to spend money unless the resulting benefits are expected to exceed the costs. As companies increasingly seek to cut costs and improve productivity, cost-benefit analysis has become a valuable tool for evaluating a wide range of business opportunities, such as major purchases, organizational changes, and expansions.
Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (less tangible, qualitative savings, as in management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.
Although its name seems simple, there is often a degree of complexity, and subjectivity, to the actual implementation of cost-benefit analysis. This is because not all costs or benefits are obvious at first. Take, for example, a situation in which a company is trying to decide if it should make or buy a certain subcomponent of a larger assembly it manufactures. A quick review of the accounting numbers may suggest that the cost to manufacture the component, at $5 per piece, can easily be beat by an outside vendor who will sell it to the company for only $4. But there are several other factors that need to be considered and quantified (if possible):
- When production of a subcomponent is contracted to an outside vendor, the company's own factory will become less utilized, and therefore its fixed overhead costs have less components over which to be spread. As a result, other parts it continues to manufacture may show an increase in costs, consuming some or possibly all of the apparent gain.
- The labor force may be concerned about outsourcing of work to which they feel an entitlement. Resulting morale problems and labor unrest could quickly cost the company far more than it expected to save.
- The consequences of a loss of control over the subcomponent must be weighed. Once the part is outsourced, the company no longer has direct control over the quality, timeliness, or reliability of the product delivered.
- Unforeseen benefits may be attained. For example, the newly freed factory space may be deployed in a more productive manner, enabling the company to make more of the main assembly or even another product altogether.
This list is not meant to be comprehensive, but rather illustrative of the ripple effect that occurs in real business decision settings. The cost-benefit analyst needs to be cognizant of the subtle interactions of other events with the action under consideration in order to fully evaluate its impact.
A formal cost-benefit analysis is a multi-step process which includes a preliminary survey, a feasibility study, and a final report. At the conclusion of each step, the party responsible for performing the analysis can decide whether continuing on to the next step is warranted. The preliminary survey is an initial evaluation that involves gathering information on both the opportunity and the existing situation. The feasibility study involves completing the information gathering as needed and evaluating the data to gauge the short- and long-term impact of the opportunity. Finally, the formal cost-benefit analysis report should provide decision makers with all the pertinent information they need to take appropriate action on the opportunity. It should include an executive summary and introduction; information about the scope, purpose, and methodology of the study; recommendations, along with factual justification; and factors concerning implementation.
Capital budgeting has at its core the tool of cost-benefit analysis; it merely extends the basic form into a multi-period analysis, with consideration of the time value of money. In this context, a new product, venture, or investment is evaluated on a start-to-finish basis, with care taken to capture all the impacts on the company, both cost and benefits. When these inputs and outputs are quantified by year, they can then be discounted to present value to determine the net present value of the opportunity at the time of the decision.
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