Performing a Cost/Benefit Analysis

Last Updated Oct 29, 2007 5:06 PM EDT

When you've put a lot of time and effort into developing an idea for a new project or initiative, you may be eager to get it approved and underway. Before you can get started, though, you must convince the decision-makers the project is worthwhile by determining its economic viability—which you can do through a cost/benefit analysis. By comparing the two, you can calculate if the benefits outweigh the costs, which generally determines if the project is considered viable. To enable this comparison, every aspect of the project is given a financial value.

This technique is extremely quantitative, and it may factor out some excellent ideas that don't present an immediately apparent financial return. While cost/benefit analyses can also take into account qualitative value, this is much more difficult to determine because it's often based on intuition. Nonetheless, this form of analysis is extremely useful because it enables you to frame an argument in terms of costs and benefits. And getting a project's approval is often contingent on that argument.

What You Need to KnowHow can I best perform a cost/benefit analysis on a project that has several non-tangible aspects?

Cost/benefit analyses are rife with assumptions that are not varifiable, and it can be difficult to put a value on the non-tangible aspects of a new project or initiative. One way to deal with this is to try looking at what the cost would be if you didn't implement the plan. This gives you an idea of the worth of the project, including its non-tangible aspects.

Are there circumstances under which a project may be viable even if the benefits don't outweigh the costs?

Yes, sometimes a particular project or program has value far beyond what can be measured in a cost/benefit analysis, and it would be politically unacceptable not to undertake it. In a case like this, it still makes sense to do a cost/benefit analysis to ensure that the project is run as efficiently as possible, with careful cost control.

How can I persuade the decision-makers to take my advice and approve a vital project, even though the costs outweigh the benefits?

Calculating the Net Present Value (NPV) of a project or initiative will help you to determine its viability over the long term. NPV determines the future value of the project in today's financial climate. By looking at the long-term effects of the project you may be able to show the project in a more favorable financial light. Then, if the NPV of a project exceeds the opportunity costs, you should be able to make a case for its serious consideration.

What's the best way to assure an acceptable degree of accuracy in my cost/benefit analysis?

Because they are difficult to calculate, cost/benefit analyses are often inaccurate. Many high-profile projects have ended up costing double, triple, or quadruple the amount used in the cost/benefit calculation. The best way to compensate for this potential for error is to increase the cost side of the equation. Remember that projects rarely come in under budget.

What to DoBe Aware Of the Limitations

Cost/benefit analysis has the same scope for ambiguity that exists with all financial tools. So it is helpful to know what level of accuracy you need, as well as what you can actually expect. As the exact financial value of each input and output is debatable, an element of subjectivity will be introduced. By considering the advantages and disadvantages of a cost/benefit analysis before undertaking this technique, you will make sure it is the right tool for the job.

Advantages
  • By putting a monetary value on the viability of a project or initiative, a cost/benefit analysis can move the project to a point where a decision can be made whether to go ahead with it or not.
  • Many aspects of a project or initiative have to be considered when undertaking a cost/benefit analysis. As awareness of these various aspects increases, new issues may be raised. Roles and responsibilities may also begin to be allocated.
  • Expensive mistakes may be prevented as unexpected costs are brought to light.
  • A cost/benefit analysis that is done well can identify the point at which a project will break even, or when the payback period will begin.
  • A robust cost/benefit analysis can make an excellent case for a project, and thus assist in getting a favorable decision. This is particularly true if the project is one that might not be approved otherwise.
Disadvantages
  • Cost/benefit analyses are sometimes considered to be over-simplistic.
  • Depending on the boundaries that are set, a project's viability can change dramatically. Thus the real value of a project can be distorted by the assumptions and subjective measures used throughout a cost/benefit analysis.
  • Non-tangible costs and benefits of a project will need to be given a value, which often causes contention when the project comes up for approval.
  • Measures of the Net Present Value of a project are often inaccurate. This happens because many of the inputs for long-term project appraisal are overly speculative.
  • Valid projects may be vetoed on the basis of their costs, or important parts may be chipped away in order to reduce costs and thus make them viable.
Clarify the Boundaries

You will be able to make better judgments about the costs and benefits if you understand the boundaries and timeline of the project from a particular stakeholder's perspective. Mixing different viewpoints can lead to a confused analysis, so be clear about why you are doing the project and whose interests you need to keep in mind. This helps you to keep tabs on the analysis and prevent it from spiraling out of control.

Calculate and Assign All Costs

The costs of all the inputs must be identified and assigned. This includes both the variable costs of the required materials or resources, as well as the direct costs of employing people and the overheads of office space. There may be other costs as well, so be sure to investigate as many aspects as you can. In order to get a more accurate picture of the costs and benefits, you need to extend the scope of your analysis to include any add-on expenses. For instance, it may seem possible to add a new product to your production line without incurring punitive costs, but the additional costs of packaging, marketing, or distribution could prove to be prohibitive.

When calculating costs, try to be as clear as possible with the assumptions you make about both tangible and intangible aspects of your project.

Don't forget to factor in ongoing costs as well as start-up expenses. Costs have a habit of recurring when you least expect them!

Learn To Give a Cost Estimate to Intangible Values

As mentioned above, some of the outputs will undoubtedly be intangible benefits. You will need to make assumptions and use the best estimate of the monetary value of these benefits. When the proposal comes up for consideration and the cost-benefit analysis is discussed, this is where many of the decision-makers will focus their arguments.

Consider Future Costs and Benefits

If the project is long term, you will need to calculate its Net Present Value (NPV), which is the sum of the initial project cost plus the present value of expected future cash flows. By putting its future value in today's terms, you are calculating the current value of any future costs and benefits, adjusted to allow for inflation and/or interest.

You also need to consider the opportunity costs. These are the costs of not doing the project or of allocating the funds elsewhere. Another thing to think about is the likely rate of return if the money were invested differently. When looking at time-related costs, it's important to look at the likely effects of time on the value of money—such as inflation—and also at the depreciation of any related capital assets.

Analyze Your Assumptions

In calculating the figures for your cost/benefit analysis, it's extremely important to analyze thoroughly any and all assumptions you have made. If the project proves to be contentious, your figures will be scrutinized and any unrealistic assumptions used to squash your initiative.

Remember that any long-term predictions, with their many variables, carry a higher level of uncertainty. Consult as widely as you can with people who you think have a good grasp of the patterns and trends that relate to your project, so that you can get a reasonable idea of any future implications. You will never by 100% correct but at least you'll be stacking the odds in your favor. Keep a reality check on your analysis and use your intuition, veering on the side of caution rather than optimism. Ask yourself whether you are being realistic in your assumptions, and if you may have become too invested in a particular outcome. If you want to sell your idea, you need to know whether your desired outcome is coloring your cost or benefit arguments.

Once you have completed your cost/benefit analysis, it's important to establish the prospective project's viability or desirability from a wider perspective. For instance, if it veers away from your core business there are likely to be additional costs or other unforeseen implications. You should also take into account any associated organizational, cultural, or political issues.

What to AvoidYou Try Too Hard To Make a Favorite Project Look Desirable

If you want to keep out of trouble, try to avoid this common mistake. Your heart may be set on a particular project, tempting you to manipulate the data in order to make it look more desirable. You might try changing your assumptions, taking liberties with the discount rates, or overestimating the value of the intangible benefits. While this may lead to a positive outcome initially, in the long term, the project is unlikely to yield the predicted value.

You Look Only At Short-term Implications

Focusing solely on the immediate costs and benefits of implementing a project, to the exclusion of all else, will not give a clear picture of its worth. It is important to factor in the opportunity costs—the costs of not doing a project, or of doing a different project. This will allow you to show the project in a completely different light.

You Neglect to Test Your Assumptions Thoroughly

Using the cost/benefit analysis as a selling tool is only useful if the underlying assumptions prove to be accurate. While you may choose to highlight certain costs or benefits to ensure that you get a favorable decision for your proposal, be sure to test your own assumptions and undertake the analysis process rigorously.

Another way to increase your chances of getting a positive decision on a project is to find similar initiatives that have already been approved in your organization. Then examine them to see what the underlying assumptions are. In the process, you may even find something useful that you can import into your own cost/benefit analysis to help weigh your argument favorably. It is much harder to reject a project if your analysis incorporates a basis similar to one that has already been accepted.

Where to Learn MoreBooks:

Atrill, Peter, and E. J. McLaney. Accounting and Finance for Non-Specialists. FT Prentice Hall, 2006.

Barrow, Colin, and John A. Tracy. Understanding Business Accounting for Dummies. Wiley, 2004.

Boardman, Anthony E., David H. Greenberg, Aidan R. Vining, and David Leo Weimer. Cost Benefit Analysis: Concepts and Practice. FT Prentice Hall, 2005.

Brown, Richard P. C., and Harry F. Campbell. Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. Cambridge University Press, 2003.

Web Sites:

MindTools: www.mindtools.com/pages/article/newTED_08.htm

An introduction to cost/benefit analysis: www.sjsu.edu/faculty/watkins/cba.htm