Cost-Benefit Analysis: The Complete Guide

What is cost-benefit analysis?

A cost-benefit analysis is a procedure used by businesses to assess the value of undertaking a project or making an important decision.

By looking at both what it costs to take a certain action, and the benefits that arise from it, a cost-benefit analysis empowers businesses to apply a data-driven approach to areas such as operations and growth, reducing their risk. More plainly, undertaking a cost-benefit analysis allows a business to be more confident in the outcome of a complex project or decision by assigning monetary values to all the factors, eliminating what may have otherwise been judged on a “gut feel”.

The typical outcome of a cost-benefit analysis is the benefit-cost ratio - an indicator of how much the benefits outweigh the costs (or, in some cases, how much the costs outweigh the benefits). A payback period may also be determined - that is, how long it takes for the monetary value of the benefits to repay the costs.

Use cases for a cost-benefit analysis

Cost-benefit analyses are applicable to a wide variety of use cases in businesses both big and small. Common use cases of a cost-benefit analysis include:

• Deciding whether to hire new staff

• Deciding whether to change company policies and procedures

• Deciding whether to undertake a new project

• Comparing different projects (to determine which provides a better outcome to the business)

• Deciding how to invest company profits (out of a given set of options)

Advantages and disadvantages of cost-benefit analysis

The key advantages of a cost-benefit analysis are:

• Data-driven - It’s superior to “gut feel” decisions or “back of the envelope” calculations

• Simplicity - It’s relatively simple to undertake

• Adaptability - It can be adapted to a wide variety of business cases

These advantages make it a highly valuable tool in the hands of a small-to-medium business owner or project manager. Cost-benefit analyses aren’t without their drawbacks, however. Namely:

• Susceptible to human error - Some costs or benefits may be missed, monetary values may be assigned based on opinion or guess, personal biases or incentives may skew accuracy of data or weight given to certain figures

• Relies on subjective value - Some costs or benefits will not have an objective monetary value, introducing a subjective and uncertain element into the analysis

• Becomes less accurate over time - The inherent uncertainty in costs or benefits like sales projections or cash flow forecasts mean that cost-benefit analyses are not suited to long-term projects

How to do a cost-benefit analysis

There are four steps to undertake a cost-benefit analysis:

1. Frame the decision to be made

2. Identify costs and benefits

3. Assign monetary values to costs and benefits

4. Calculate the benefit-cost ratio and make a decision

It’s worth noting that the cost-benefit analysis is an economic concept, and as such there isn’t only one specific way to undertake it. You will generally see most guides for businesses approach the analysis in similar ways, however guides for economists are likely to be more technical and theoretical than many businesses require.

1. Frame the decision to be made

Before considering the costs and benefits associated with a given project or decision, you need to appropriately frame the decision to be made (or the project to be undertaken). It’s important to be specific - undertaking a cost-benefit analysis of a decision framed as “should we spend our surplus budget on new computers” is achievable. “How should we spend our surplus budget” is not.

Put simply, the format of the decision will be:

• Comparing an undertaking to doing nothing, or

• Comparing various different undertakings (where the business is limited in pursuing all of them at once)

2. Identify costs and benefits

This is a brainstorming exercise. Spend some time noting down all conceivable costs and benefits associated with the project or decision. Consider both during the life of the project and the longer term effects after it is completed, as well as who all possible stakeholders may be. Keep in mind that not all costs or benefits are as tangible as others - strengthening your brand, for example, isn’t as tangible or obvious as payroll costs. Use the following examples to spark your thinking:

• Cost of new products, services, or raw materials

• Manufacturing costs

• Labour costs

• Inventory costs

• Productivity changes (positive and negative)

• Impact on brand (positive and negative)

• Impact on customer experience (positive and negative)

• Impact on employee satisfaction / morale (positive and negative)

• Recruitment, onboarding, training (for hiring staff)

• Rent, utilities, and other company overheads

• Cost of risks such as project delays, environmental impact, regulatory risk

• Opportunity cost

• Revenue growth (from improved production, or new product)

• Competitive advantage

3. Assign monetary value to costs and benefits

With all your costs assembled in one list and your benefits in another, assign a monetary value against each (based on data, rather than assumption). You’ll need to consider these costs and benefits not just at a fixed point in time, but over the life of the project and beyond. As some costs will be incurred immediately, while others may come much further along (e.g. the cost of training your staff in a new system may come after that system is installed and configured, and may be incurred again every time you hire someone new in the future).

The value of some costs may also change throughout the life of the project (looking at the same example, you may become more efficient at delivering new systems training to staff, thus incurring a smaller cost over time). And for costs and benefits that are realised in the future, it’s important to convert them into present value.

It’s critical that you make a conscious effort to be aware of your biases or any uncertainties at this stage of the analysis. Understating or overstating the costs or benefits can easily undermine the validity of the analysis.

4. Calculate the benefit-cost ratio and make a decision

Add up all the monetary value of costs to get a total. Do the same for all the benefits. Your benefit-cost ratio is then:

Any result greater than 1 indicates the benefits outweigh the costs, with a higher benefit-cost ratio indicating even greater benefits relative to the costs. Flipping this formula, we can determine the payback period - that is, how long it takes for the value of benefits to have paid back the costs incurred:

For projects or decisions where the alternative is to do nothing, any cost-benefit analysis that returns a benefit-cost ratio greater than 1 is worth pursuing. When multiple projects or decisions are being considered, the one with the highest benefit-cost ratio gives you the best return and is most worth pursuing.

Conducting a sensitivity test

Due to the subjective nature of assigning monetary value to some intangible costs or benefits, it can be worth conducting a sensitivity test on the results of your cost-benefit analysis.

For each of the costs and benefits that you are not strictly confident in the monetary value of, go back and vary them by an appropriate percentage (e.g. in hiring a new staff member, assign a 10% higher cost to their salary, to account for negotiation in their favour). To minimise your risk of an inaccurate analysis, conservatively increase the value of costs and decrease the value of benefits. Now, when you re-run the analysis, a resultant positive benefit-cost ratio (i.e. >1) indicates you can be confident this is a financially viable project or decision to undertake. If, however, the resultant benefit-cost ratio dips below 1, it could indicate the project or decision is at risk of incurring net losses.

There may be changes that can be made to the project or decision to reduce this risk. In the end, it is up to the risk appetite of the project manager or decision maker in deciding whether to continue with the project or decision.

Cost-benefit analysis example

Hiring a new employee

Costs

Benefits

Benefit-cost ratio

In this example, hiring a new employee makes financial sense for the business in this example. They’ll see nearly 50% return on their investment in this new employee.

Sensitivity test

Let’s say the hypothetical business owner conducting the above cost-benefit analysis wants to be more confident in their decision to hire. They determine that the values they’re least confident in are the employee’s salary (they have a little more experience than required, so could negotiate a higher price) and new revenue generated by the employee (it’s a new industry for them, so it could take a little longer to get up to speed). Giving 10% variation to each, the costs now become:

Note: The recruitment fees scale with salary increase.

And the benefits become:

Which results in a benefit-cost ratio of 1.27 - still a beneficial result to the business. As such, the business owner can remain confident that hiring a new employee is a good idea.