Definition: Cost-Benefit Analysis is a key decision-making tool that helps determine whether a business decision, such as implementing a scheme or spending money, is worth the literal price. It helps identify whether the cash value gained from a business decision is worth the cash value of the costs incurred in implementing that decision.
How Does Cost-Benefit Analysis Work?
Cost-benefit analysis is a straightforward method for determining whether the gains from a business decision you are considering outweigh the costs required to implement it. It can be a tool for quick decision-making for business owners.
How to Perform Cost-Benefit Analysis
Cost-benefit analysis identifies and sums all positive factors related to the proposed business plan. These are the benefits. Then, all negative factors or costs are identified and subtracted. The difference between the positive and negative factors indicates the viability of the planned action.
Common Mistakes in Cost-Benefit Analysis
Although it seems relatively simple, there are many ways you can stumble while conducting a cost-benefit analysis. Below are two common factors that could either inflate the benefits or underestimate the costs, leading to an inaccurate conclusion from your analysis.
Selecting the Appropriate Accounting Method
Consider the benefits first. Do not use the selling price for units to calculate value. The selling price of any item involves many additional factors that will affect your analysis if you include them, not least of which is the profit margin.
Instead, obtain the activity-based value for the units from accounting and use that figure.
You have added value for the increase in quality by considering the average rejection rate, but you might want to reduce that slightly since the machine will not always be perfect.
Finally, when calculating the replacement value for three employees, ensure to add the infrastructure costs and benefits costs in addition to their salaries. Accounting is your source for the accurate figure of the full labor costs for the company.
You may have overlooked other details. For example, you may be able to purchase raw materials for the machine in bulk rolls instead of the individual sheets required when doing the work manually. This should reduce the material costs, which is another benefit.
Accurately Calculating Costs
Now reconsider the costs. In addition to the purchase price and any taxes you must pay on it, you should add the cost of interest on the purchase. Even if the company purchased the device outright, you will need to add an amount for the lost interest that it would have earned had the money not been spent.
While estimating costs, remember that there are upfront costs and ongoing costs that must be considered in the cost-benefit analysis. You should also consider the cost of intangible factors as well as opportunity costs that may be overlooked.
Check with finance to understand the depreciation period. The machine may last ten years, but the company may not keep it on the books for that long. The company may depreciate the purchase over just four years if it is considered capital equipment. If the price of the device is not enough to qualify as capital equipment, the full cost will be expensed in one year. Adjust the monthly purchase cost of the device to reflect these issues.
There may still be some details that you might have overlooked. The devil is in the details. In this case, here are some overlooked costs: Land space: Will the machine fit in the same space currently occupied by the three workers? Installation: How much will it cost to remove manual stamps and install the new device? Will you have to cut a hole in the wall to get it in, or will it fit through the door? Will you need cylinders or specially skilled mechanics to install it? Operator? Someone will need to operate the machine. Does that person need special training? What is the operator’s salary, including general and delivery items? Environment: Will the new machine be noisy enough that you need to build sound insulation around it? Will it increase the company’s insurance expenses?
How to
Presenting a Cost-Benefit Analysis
Once you have gathered and estimated all the positive and negative factors, you can compile them into a precise cost-benefit analysis.
Some people prefer to collect all the positive factors, then gather all the negative factors, and find the difference between them.
Others prefer to create a list that combines both positive and negative factors. This makes it easier for you or anyone reviewing your work to see that you have included all factors from both sides.
For the example above, a cost-benefit analysis table might look like this:
Cost-Benefit Analysis: Purchasing a New Printing Machine (the expenses presented are monthly and incurred over four years)
- Purchase of the machine …………………………….. – $20,000 (including interest and taxes)
- Installation of the machine ………………………. – $3,125 (including screens and removal of existing stamps)
- Increase in revenue ……………………………………. 27,520 USD (net value of 100 additional units per hour, 1 shift/day, 5 days/week)
- Increase in quality revenue …………………………. 358 USD (calculated at 75% of current rejection rate)
- Reduced material costs ……………………………… 1,128 USD (bulk supply purchase reduces cost by $0.82 per hundred)
- Reduced labor costs ………………………………….. 18,585 USD (salaries of three operators plus labor costs)
- New operator …………………………………………….. – $8,321 (salary plus overhead. Includes training)
- Utilities ………………………………………………….. – $250 (increased energy consumption for the new machine)
- Insurance ………………………………………………… – $180 (increase in expenses)
- Space on the ground ………………………………… 0 USD (no additional space required)
Net savings monthly …………………………………… 15,715 USD
Your cost-benefit analysis clearly shows that purchasing the printing machine is justified for your company. The machine will save your company over $15,000 monthly, nearly $190,000 annually.
Frequently Asked Questions (FAQs)
How does a cost-benefit analysis help in decision-making?
Simply put, a cost-benefit analysis helps the employer determine whether the monetary value gained from a business decision is worth the monetary value of the costs incurred in implementing that decision. Such analysis can help companies decide whether they want to embark on a specific project, choose among multiple competing projects, or even determine the optimal size for a specific project.
What is an example of a cost-benefit analysis?
Suppose a company wants to purchase a machine. The cost-benefit analysis should include determining whether the costs of acquiring the new machine are worth the benefits the company will gain from purchasing it. Benefits may include increased revenue from additional units produced, improved quality, and stability of the product. Costs may include the purchase price, installation costs, operational costs of the machine, labor costs to operate the machine, insurance, etc.
Source: https://www.thebalancemoney.com/cost-benefit-analysis-2275277
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