Cost-benefit Analysis: Process, Benefits and Limitations

  • Neelam Tyagi
  • Sep 01, 2021
  • Business Analytics
  • Statistics
Cost-benefit Analysis: Process, Benefits and Limitations title banner

In today’s business world, it certainly becomes essential to obtain most of every idea, option and investment. All organizations from large corporations to small businesses heavily rely on cost-benefit analysis to accomplish their maximum potential while maintaining efficiency of decision-making

 

Deploying cost-benefit analysis support teams to spot the highest yet fruitful return on investment on the basis of cost, resources and risk accounted for. Our discussion will emphasize on the importance of cost-benefit analysis through this blog.


 

What is Cost-benefit analysis?

 

“A cost-benefit analysis is a systematic approach designed to estimate the cost-effective benefits associated with effective and efficient decision making, also to find cost-effective alternatives. The method is extensively deployed for businesses, projects and public-policy making”. 

 

Multiple organizations deploy the method of cost-benefit analysis in order to inspect decisions, systems, projects, or employees’ policies, or to determine the core value for assets. The model is designed via recognizing the benefits of actions and the cost associated with it, and withholding costs from benefits. Once accomplished, the analysis provides precise results that can be used to make logical conclusions, these outcomes considers expediency and suitability of a decision or situation.

 

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The cost-benefit analysis compares the costs and benefits of a project and then makes a decision on whether or not to proceed with the project. The project’s costs and benefits are measured in monetary terms after adjusting for the time value of money, thus providing a true picture of the costs and benefits. Net Present Value and Benefit-Cost Ratio are the two most common methods of doing a cost-benefit analysis. The NPV model chooses the project with the highest NPV. The benefit-cost ratio model chooses the project with the highest benefit-cost ratio. (Cost-benefit analysis definition)

 

Such organizations count on cost-benefit analysis to seek support over decision making, the CBA provides an omnipresent, evident-based perception being evaluated without the domination of opinions, politics and biases. 

 

Being a conductive tool, cost-benefit analysis gives a crystal-fair picture of ramifications regarding a decision for making business decisions/strategies, inspecting fresh hiring decisions, allocating resources or purchasing decisions.

 

The below video gives an example of cost-benefit analysis, explaining how a rational agent examines all explicit and implicit costs and decides whether to undertake an action or not.


The Cost-benefit analysis follows the following principles;

 

  • Marginalizing the cost and benefits: Every single point associated with cost and benefit of a project must be explained in terms of equivalent monetary value over a particular period. 

  • Detailing area of study: Impact assessment for a particular region should be defined, for example, a city, state, or a nation. Also, the specification of area might be subjective leading to impact the evaluation upto significant level.

  • Exemplifying uncertainties: Despite considering every facet, business decisions are often crowded with some uncertainties, there are requirements to uncover the areas of ambiguities and thus clearly define how to address each uncertainty, assumption, or skepticism. 

  • Preventing the double count of cost and benefits: Though, each benefit or cost is considered as distinct feature, yet possibilities are there that both may produce the same economic benefits or values leading to coupled count of elements. Therefore, dual count of cost and benefits must be evaded.(Source)

 

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The cost-benefit analysis process

 

From compiling a extensive list of all costs to evaluating benefits associated with a business decision or a project, CBA has the following sort of costs;

 

  • Direct costs include labor cost from manufacturing, inventory, raw ingredients, production equipment and maintaining.

  • Indirect costs involve expenses such as electricity, overhead cost form management, rent, utilities.

  • Intangible costs are a particular type of decision, such as reduction of customer trust, impact on customers and employees, delivery times.

  • Opportunity costs include alternative investments, purchasing a plant vs building one.

  • Costs of potential risks are regulatory risks, environmental influences, competition, operations, productivity.

 

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The process of cost benefit analysis has the following form of benefits;

 

  • A huge amount of revenue and a good pitch of sales that are increased from optimized production or new products. 

  • Competitive advantage, new market, international association, healthy competition, market share gained as a result of a decision-making process.

  • Intangible benefits incorporate improved safety and morale of employees, customer satisfaction due to rapid delivery of a product, employees satisfaction due to product offerings.

 

 

Benefits and limitations of cost-benefit analysis

 

Ofcourse, there are multiple reasons for a business or an organization to choose cost-benefit analysis as a part of their decision-making process. CBA includes several potential benefits and limitations that must be considered before leaning at the cost-benefit analysis. Some are listed below its benefits;

 

  • Data-driven decision: In order to evaluate the effectiveness of a decision, cost-benefit analysis enables an individual or organization to proceed with the speculation free of opinions or personal biases. CBA offers a strong and testified inspection such that companies can rely on this data-driven process to prompt logical business decisions.

  • Make simplified dexterity decisions: Business decisions are complex in nature, CBA makes procedural decisions less complex by correlating a decision to costs vs benefits.

  • Unearth latent costs and benefits: CBA assists in depicting every potential costs and benefits associated with a project/policy that can be used to uncover hidden beneficiary factors including indirect or intangible costs.

 

Undoubtedly, CBA continues to radiate as a prioritized tool deployed for economic evaluation, but at the same time, a sufficient employment of such tools also demand for a deep knowledge of its limitations and pitfalls. Major limitations of cost-benefit analysis;

 

  • Market fallibility: Accounting for the perfect blend of competitive markets with enormous sellers and buyers who are not dominating the market position, CBA works well in such scenarios. But, this condition is hard to meet in actual practice.

 

Some monopolies and government judgements have already been introduced in the market serving as interventions and making obstacles. Therefore, market prices are required to be adjusted before experimenting with CBA over them.

 

  • Intangibles’ measurement: Huge efforts are being made to measure/quantify the items that are immeasurable, remain approximations or aren’t a perfect depiction of a real value.

 

For example, the monetary value of benefits including employee or client satisfaction, and costs such as reduction of trust is difficult to ascertain. The deployment of value perceptions and assumptions tends to become inevitable. Therefore, quantifying intangibles is sensitive to manipulation. 

 

  • Dispersion of net income: A part of economic analysis determines economic efficiency that can be measured irrespective of who will get benefits and who will bear costs. And the income distribution related queries are not taken into account.

 

For example, CBA can be integrated with income distribution by allocating weight to benefits obtained and cost carried via various socio-economic groups such as providing higher weight/benefits to underprivileged categories, and many more.

 

  • Ascertaining discounted rates: Conventional mode of CBA focuses on costs and converges to short-term gains, this occurs due to high rates of discount that yield a lower value to beneficiaries amassing after a longer period of time.

 

Presently, the standard arena of making discounts for a present value highly depends on timing of cost and benefits. CBA considers discounting for all costs and benefits to occur at the end of the year (or at the time of ease of calculation). Thus, the timing of discounting the costs and benefits are necessitated to adjust in accordance with the span of the project. 

 

  • Suitable for short and mid-term projects: For the underlying projects or business decisions consisting of a long timeframe, the cost-benefit analysis shows a greater potential to be wrong, for many reasons. It becomes typically hard to make informed decisions or accurate predictions as we go through the long-term projects.

 

Additionally, there are possibilities that long-term anticipations won’t be accounted for correctly variables such as inflation that can affect overall efficiency and productivity.

 

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Endnotes

 

Putting our discussion towards the end, it can be concluded that a cost benefit analysis facilitates  businesses to rectify complicated business decisions and to measure the benefits of a decision (benefits of considering an action from the cost associated while looking at that action). 

 

Executing CBA aids in comparing distinct projects in terms of net benefits irrespective of dissimilarities along with considering indirect assistance/costs such as customer satisfaction or executive’s spirit.

 

The CBA procedure itself involves some costs and benefits, the costs incorporate the time required to interpret and anticipate all pieces of the rewards and costs. In addition to this, cost also intakes amount paid to analysts or consultants to conduct the work. CBA benefits, if conducted correctly with factual assumptions, in providing a worthwhile guide for decision making to be standardized and quantified.

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