Cost-Benefit Analysis: Definition and Advantages
Updated January 26, 2023
Cost-benefit analysis is an important tool that project managers and company executives use to help them make decisions that can influence the success of their businesses. If you're hoping to use cost-benefit analysis for an upcoming project, it's important to understand its advantages for the company and how to navigate the analysis process. In this article, we discuss what a cost-benefit analysis is, why it's important and the pros and cons of using cost-benefit analysis for a major project or company decision.
What is cost-benefit analysis?
Cost-benefit analysis is a process that project managers and business executives use to determine the expenses and incentives of a major company project. When companies perform a cost-benefit analysis, they calculate the costs and benefits for the project or decision and determine which calculation is larger. If the benefits exceed the costs, the project or decision is generally a positive one for the company to make. However, if the costs exceed the benefits, the company often evaluates that project's plan and determines if there's a way to adjust it or save money.
Why might a company perform a cost-benefit analysis?
Companies and businesses often use a cost-benefit analysis to determine and evaluate all the expenses and revenues that a project might generate. The analysis helps companies examine the feasibility of the project in terms of finances and other important factors, such as opportunity costs. Opportunity costs consider alternative benefits that the company might give up if they proceed with the project or project decision. Once the company understands all of its major costs and benefits, it can better understand the decision's pros and cons. However, it doesn't always make the decision perfectly clear.
For example, if the project manager determines that the project's outcome might only have slightly higher benefits than costs, they might have to consult further with company executives and colleagues to see if the project is still worth the resources. It's possible that the slightly higher benefits still help the company with future projects, or the company might hope that potential costs are actually lower once the project is complete. Using cost-benefit analysis can provide businesses with helpful data to make the decision a little easier and understand its possible results.
Related: Learn About Being a Project Manager
Process of conducting a cost-benefit analysis
When performing a cost-benefit analysis on your project, it's important to analyze a comprehensive list of expenses and positive outcomes the project will create. Costs or expenses that the project creates can include:
Direct costs: Direct costs are purchases that a business makes that directly relate to the creation of its goods and services. These costs can include material purchases, employee salaries and equipment or tool rentals.
Indirect costs: Indirect costs are other expenses that help keep the business or company operating, including insurance, facility rentals and utility costs.
Intangible costs: Intangible costs are costs that companies can't easily quantify. These costs can include customer satisfaction, employee morale or overall productivity.
Potential risks: Potential risks are any challenges or issues that a company might face during a project or after the project's completion. These can include other direct or indirect costs, such as spending more than the company expected, and intangible costs, such as loss of business or profit.
Opportunity costs: Opportunity costs are the loss of potential benefits or profit from making one decision over another. For example, if a company decides to sell some property, they might be missing out on potential profit from renting the property on a monthly basis.
Once a company understands the major costs of a project or decision, it can then compare those expenses to the project's benefits. A project's benefits are often fairly similar to the costs and can include direct benefits, such as an increase in profit, as well as intangible benefits, such as increased customer or employee satisfaction. After comparing the benefits and the costs, the company can then choose whether the benefits outweigh the costs and if the project or decision will be positive for the business overall.
Cost-benefit analysis advantages
The most common cost-benefit analysis advantages include:
Focuses on data-driven decision-making
Cost-benefit analysis often focuses on facts and data to help companies and businesses make decisions more easily and free them from personal biases or preferences. Examining the exact expenses the business will accrue and if those expenses will lead to beneficial results can help businesses clearly identify if the choice is good for them to make. It also can provide project managers with fact-based evidence to support their new project ideas and effectively present them to company executives.
Discovers hidden costs
Analyzing the total cost that a project will create can help companies discover any hidden costs or expenses they might not have known about previously. These types of costs can include opportunity costs, such as a potential loss in profit from choosing one project over another, and intangible costs, like the temporary loss of customer satisfaction from focusing additional resources on the project itself. However, the cost-benefit analysis can also help companies discover hidden benefits, such as an increase in employee satisfaction, which might increase productivity and quality of work.
Makes some decisions easier
Though some decisions made with cost-benefit analysis might need some careful consideration, the process often simplifies a lot of decisions for companies and businesses because they can clearly see the correlation between the expenses and project results. If you know that a project will generate more costs than benefits, you can quickly determine that the project might not be worth your company's time and resources. Alternatively, if you see that the benefits are greater than the costs, you can more efficiently determine how those benefits will affect your company in the long term.
Provides a competitive advantage
Cost-benefit analysis can help companies develop an advantage over competing businesses because it can help them quickly create innovative ideas and determine how they can stay relevant in the current market. Continuously generating new ideas and performing a cost-benefit analysis on them can help companies stay competitive and create products and services that are more attractive to potential customers. Using cost-benefit analysis can also help them avoid any projects that might provide them with various challenges or issues, causing a loss in profit or competitiveness.
Related: What Is a Competitive Analysis?
Cost-benefit analysis disadvantages
Here are some of the disadvantages to cost-benefit analysis and how to overcome them:
Though cost-benefit analysis can help companies make better-informed decisions, it can sometimes be challenging for them to predict certain variables, such as customer demand and material prices. When conducting a cost-benefit analysis, it's important to take unpredictable variables into consideration and understand how the results of your project might change depending on different outcomes. For example, it's beneficial for businesses to see what their different benefits might be for a project if customer demand is high, low or unchanging.
Not as effective for long-term projects
Cost-benefit analysis is a great tool for companies to use for shorter projects, but it can become a little risky when using it for long-term projects due to unpredictable variables that have a higher probability of changing over time. When using cost-benefit analysis for longer projects, it's important to understand that the potential risks for the project might be higher than they would be for a short-term project. Consider making a list of all the risks or variable changes the project might encounter, and then develop strategies to help overcome those challenges if they present themselves.
Requires extensive data
When conducting cost-benefit analysis, it's beneficial for companies to have an extensive amount of data to ensure they're making the most accurate prediction. If a company doesn't have enough data for the analysis, it can lead to false information and possibly cause businesses additional challenges in the future. As you perform a cost-benefit analysis, it's important to communicate with different company departments and talk with officials who can help you find all the information you need and understand if the benefits are truly greater than the costs.
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