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What Is a Cost-Benefit Analysis?
Cost-benefit analysis (or CBA) is a business process wherein a company or individual tries to reduce the value of a project into pure monetary terms by comparing the net costs to the net benefits. A benefit-cost analysis can be as simple or exhaustive as you would like, but it generally factors in direct and tangible costs and benefits, as well as intangible benefits and potential opportunity costs. CBA takes the guesswork out of business decisions by providing a businessperson with a repeatable and comparable rubric for any sort of investment.
What Is the Purpose of a Cost-Benefit Analysis?
Part of the beauty of cost-benefit analyses is their versatility and possible applications across the business and finance worlds. A few places that you might find CBAs used include:
- To help a business expand: Cost-benefit analyses are routinely used in the private sector as a way to determine a monetary value and rate of return for a potential investment. Before a business rolls out a new product, makes a new hire, or builds a new facility, its leaders must calculate the costs and benefits of the choice to determine how this potential business decision will affect long term profitability and short term cash flow.
- To guide public policy: Though you might think of cost-benefit analysis as being mostly used in the private sector, government decisionmakers in the United States and abroad use CBAs to determine the cost-effectiveness of potential public policies all the time. In the case of social policy, the future benefits are weighed not in terms of customer satisfaction, but rather in broad social benefits. When conducting a hypothetical CBA for a law, the benefits of the project might include monetary return on investment as well as non-monetary social benefits like an increase in human life expectancy or general quality of living.
- To inform personal financial planning: Individuals make business decisions all the time, and whether they know it or not, most are conducting at least an informal CBA as part of their decision-making process. Every time you consider buying a product, you try to decide if its tangible and intangible benefits outweigh its cost.
How to Perform a Cost-Benefit Analysis
The simple formula for a basic CBA is also known as the benefit-cost ratio: benefit divided by cost. Here’s a step-by-step breakdown of how to perform a cost-benefit analysis:
- Make a cost list: Make an exhaustive list of potential costs that are likely to arise.
- Make a benefit list: Make a list of both tangible and intangible benefits that can be expected to be derived from this hypothetical business decision.
- Assign a monetary value to each list: Calculate the total benefits and total costs in purely monetary terms. Make sure to factor in the length of time a project might take and the rate of inflation and interest rates. You’ll likely also consider net present value. NPV is a form of analysis that seeks to determine future benefits in terms of present value.
- Punch these values into the equation: Once you have your numbers, it’s time to do some simple division. Divide your benefits by your cost. If the ratio you’re left with is higher than one, it demonstrates that the benefits outweigh the costs. In that case, you’ll most likely decide to proceed with your investment. If the cost is larger than the benefits, chances are you’ll pull the plug.