What Is Cost Analysis? (Plus How To Calculate in 7 Steps)
Cost analysis is a helpful tool to enhance project management and predict potential profits for a company. Financial professionals use cost analysis to calculate how much money a project can generate compared to the project's overall costs. If you work in finance or project management, it might be helpful to learn more about cost analysis and how to calculate it.
In this article, we discuss cost analysis and why it's important, provide seven steps you can use to calculate it and review an example of a cost analysis calculation.
What is cost analysis?
Cost analysis, also known as cost-benefit analysis, is the process of calculating the potential earnings from a situation or project and subtracting the total cost associated with completing it. It predicts the profit gained from a project and compares the project's cost to its estimated financial benefits. Many finance professionals use cost analysis to show clients their potential profits from a project.
Related: FAQ: What Is Cost Budget Analysis?
Why is cost analysis important?
Here are several reasons why cost analysis is important for businesses:
Cost analysis allows professionals to make decisions regarding future projects by allowing them to weigh their costs against their profits. If the project cost is higher than the predicted earnings, professionals can make the necessary changes to the project to increase the earnings or lower expenses. This helps maintain profitability without sacrificing essential company projects.
Keeps stakeholders involved
Cost analysis ensures that companies involve stakeholders in the decision-making process. Stakeholders are a necessary part of business operations because they contribute to a company and take an interest in projects. Because of this, companies need to keep them informed of relevant performance data. Sharing cost analysis information can give stakeholders the information they need to make budgeting and financial strategy decisions.
Related: Who Are Stakeholders In A Business?
Cost analysis can help identify financial problems and find solutions. If a company is experiencing difficulty in project management, it can use cost analysis to maintain organization and gain a deeper understanding of its finances and future projects. Regular cost analysis reviews can help you identify which factors impact a project's profitability and address them directly.
How to calculate cost analysis
You can use these steps to calculate a cost analysis ratio:
1. Determine the reason you need a cost analysis
The way you use a cost analysis can vary based on your reason for doing so. Before you start, determine why you need a cost analysis to better understand what variables you can use. For example, you might pull budget information from previous initiatives if you're doing a cost analysis to create a project budget.
2. Evaluate cost
The next step is to evaluate the costs associated with a project. It may be useful to write all of them on a list so that it's available for future steps. Be sure to consider any unexpected costs associated with the project and how the costs might change over time. Here are the factors to consider when evaluating cost:
Direct cost: This is the cost associated with each product variable, like product type, customer, service or activity.
Indirect cost: These expenses are not directly associated with the project but the company needs to include them in the budget. They can include rent, utilities and administrative expenses.
Real cost: This is the cost associated with the actual production of a project, like labor and material costs.
Tangible cost: This is the cost that relates to supporting a project, like purchasing tools and paying employees.
Intangible cost: Factors that impact the outcome of a project, like changes in production levels or decreases in customer satisfaction, are intangible costs.
3. Compare to previous projects
For the next step, compare your current cost analysis project to previous projects. You can use this information to identify similar costs and calculations that you can include in your analysis. Comparing your data to other cost analysis projects can ensure you have enough information to develop a realistic understanding of your costs and income.
4. Define all stakeholders
Identifying the project's stakeholders is important to calculate an accurate cost analysis. Stakeholders are individuals or groups that have an interest in the project. They might invest money in the project or participate in planning it. The project's profit outcome impacts stakeholders, making it essential for analysts to include stakeholder information in the cost analysis.
5. List the potential benefits
Next, it's time to list the potential benefits of a project, especially its expected profits. Some projects may have benefits aside from simple monetary profits and it's important to give these a definite value. Consult with stakeholders and financial analysts to get an accurate appraisal of the expected benefits.
6. Subtract the cost from the outcome
The next step involves finding your cost analysis ratio by subtracting the total costs from the project's estimated benefits. For example, if a project costs $1,000 and the benefits are $2,500, then $2,500-$1,000=$1,500. You can produce several cost analysis ratios if you have multiple different scenarios for how much profit a project could generate.
7. Interpret your results
Once you have the value of your cost analysis, it's important to interpret the results so you can decide if you want to pursue the project. Generally, if your results meet the goal of the income you want to earn from the project, then it's a good idea to pursue the project. If the cost analysis shows that you won't meet your goal, consider lowering the project's cost or finding ways to raise the profits.
Example of cost analysis
Here's an example of cost analysis for a project:
A clothing company wants to determine if they might launch a new clothing line by next spring. They decide that a cost analysis would offer them insight into how much they would earn from the project to compare profit and costs. They've decided that their goal is to generate over $1,000 with the spring clothing line.
Their accountant writes all costs associated with the new clothing line. They determine that their direct costs would total $500, their indirect costs total $400, their real costs total $600, their tangible costs total $200 and their intangible costs total $500. Next, they pull information from previous clothing lines to analyze financial similarities. They find that their winter clothing line from two years prior has similar costs, so they know to analyze how well they profited from that clothing line sale. Upon analyzing the previous sale, they found that they could profit greatly from the sale.
Their next step involves determining all the stakeholders within their upcoming spring clothing line. They identify five separate stakeholders and make them aware of the cost analysis. They also consult with the stakeholders to get advice on maximizing the benefits while minimizing costs.
Next, the company enlists a financial analyst's help to list the clothing line's potential benefits. They find that if they sell out their entire inventory, they can generate $4,000. To finish their cost analysis, they add up all of their costs, which are:
$500 + $400 + 600 + $200 + 500 = $2,200.
Finally, the accountant subtracts the total number of costs from the benefits, which is:
$4,000 - $2,200= $1,800.
This means that the company nets $800 more than it expected. Because of this, the company decides to pursue the project since the cost analysis shows the possibility of an excellent profit margin.
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