Cost benefit analysis how to

Step One: Brainstorm Costs and Benefits

First, take time to brainstorm all of the costs associated with the project, and make a list of these. Then, do the same for all of the benefits of the project. Can you think of any unexpected costs? And are there benefits that you may not initially have anticipated?

When you come up with the costs and benefits, think about the lifetime of the project. What are the costs and benefits likely to be over time?

Step Two: Assign a Monetary Value to the Costs

Costs include the costs of physical resources needed, as well as the cost of the human effort involved in all phases of a project. Costs are often relatively easy to estimate (compared with revenues).

It's important that you think about as many related costs as you can. For example, what will any training cost? Will there be a decrease in productivity while people are learning a new system or technology, and how much will this cost?

Remember to think about costs that will continue to be incurred once the project is finished. For example, consider whether you will need additional staff, if your team will need ongoing training, or if you'll have increased overheads.

Step Three: Assign a Monetary Value to the Benefits

This step is less straightforward than step two! Firstly, it's often very difficult to predict revenues accurately, especially for new products. Secondly, along with the financial benefits that you anticipate, there are often intangible, or soft, benefits that are important outcomes of the project.

For instance, what is the impact on the environment, employee satisfaction, or health and safety? What is the monetary value of that impact?

As an example, is preserving an ancient monument worth $500,000, or is it worth $5,000,000 because of its historical importance? Or, what is the value of stress-free travel to work in the morning? Here, it's important to consult with other stakeholders and decide how you'll value these intangible items.

Step Four: Compare Costs and Benefits

Finally, compare the value of your costs to the value of your benefits, and use this analysis to decide your course of action.

To do this, calculate your total costs and your total benefits, and compare the two values to determine whether your benefits outweigh your costs. At this stage it's important to consider the payback time, to find out how long it will take for you to reach the break even point – the point in time at which the benefits have just repaid the costs.

For simple examples, where the same benefits are received each period, you can calculate the payback period by dividing the projected total cost of the project by the projected total revenues:

Total cost / total revenue (or benefits) = length of time (payback period).

Example

Custom Graphic Works has been operating for just over a year, and sales are exceeding targets. Currently, two designers are working full-time, and the owner is considering increasing capacity to meet demand. (This would involve leasing more space and hiring two new designers.)

He decides to complete a Cost-Benefit Analysis to explore his choices.

Assumptions

• Currently, the owner of the company has more work than he can cope with, and he is outsourcing to other design firms at a cost of $50 an hour. The company outsources an average of 100 hours of work each month.
• He estimates that revenue will increase by 50 percent with increased capacity.
• Per-person production will increase by 10 percent with more working space.
• The analysis horizon is one year: that is, he expects benefits to accrue within the year.

Costs

Category	Details	Cost in First Year
Lease.	750 square feet available next door at $18 per square foot	$13,500
Leasehold improvements.	Knock out walls and reconfigure office space	$15,000
Hire two more designers.	Salary, including benefits Recruitment costs Orientation and training	$75,000 $11,250 $3,000
Two additional workstations.	Furniture and hardware Software licenses	$6,000 $1,000
Construction downtime.	Two weeks at approximately $7,500 revenue per week	$15,000
Total		$139,750

Benefits

Benefit	Benefit Within 12 Months
50 percent revenue increase.	$195,000
Paying in-house designers $15 an hour, versus $50 an hour outsourcing (100 hours per month, on average: savings equals $3,500 a month.)	$42,000
10 percent improved productivity per designer ($7,500 + $3,750 = $11,250 revenue per week with a 10 percent increase = $1,125/week.)	$58,500
Improved customer service and retention as a result of 100 percent in-house design.	$10,000
Total	$305,500

He calculates the payback time as shown below:

$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.

Inevitably, the estimates of the benefit are subjective, and there is a degree of uncertainty associated with the anticipated revenue increase. Despite this, the owner of Custom Graphic Works decides to go ahead with the expansion and hiring, given the extent to which the benefits outweigh the costs within the first year.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows that come in over a number of periods of time, particularly where returns vary from period to period. In these cases, use Net Present Value (NPV) and Internal Rate of Return (IRR) calculations together to evaluate the project, rather than using Cost-Benefit Analysis. (These also have the advantage of bringing "time value of money" into the calculation.)

Also, the revenue that will be generated by a project can be very hard to predict, and the value that people place on intangible benefits can be very subjective. This can often make the assessment of possible revenues unreliable (this is a flaw in many approaches to financial evaluation). So, how realistic and objective are the benefit values used?

Key Points

Cost-benefit analysis is a relatively straightforward tool for deciding whether to pursue a project.
To use the tool, first list all the anticipated costs associated with the project, and then estimate the benefits that you'll receive from it.
Where benefits are received over time, work out the time it will take for the benefits to repay the costs.
You can carry out an analysis using only financial costs and benefits. However, you may decide to include intangible items within the analysis. As you must estimate a value for these items, this inevitably brings more subjectivity into the process.

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