Every company has to make certain important decisions every now and then. For example, taking on a new project or deciding on a course of action in the middle of a project. At this critical time, the cost-benefit analysis can come in handy to determine whether that decision will bring profit or loss for the company.
Students who wish to become a strategic CFO must learn cost-benefit analysis so that they are able to evaluate the cost and benefit of a new project. Then the two are tallied to see if the project will be beneficial or not. Performing the analysis can help understand hidden costs and in making any decisions easier and free of bias. This is similar to the benefit-cost ratio (BCR) which is essential in capital budgeting.
The cost-benefit-analysis is a tool or systematic process that helps in bias-free decision-making. It tells the analyst whether the particular decision will have economic benefits or the lack of it. It provides the analyst with an economic view of non-quantifiable and tangible items as well.
For example, it's hard to put a financial value on the experience and work potential of an employee. However, the cost-benefit analysis can even help tell whether a new employee will be good for the company or not.
Some situations where cost-benefit-analysis can be used are -
- Taking up a new project or a business strategy
- Deciding on a particular course of action in the middle of a project
- Deciding on a new business strategy
- Capital budgeting
- Comparison of multiple investment opportunities
- Measuring whether a change in the company structure will have positive impacts
- Understanding whether a sale or a purchase will be favourable or not
- Assessing the future effects of adopting new policies
Many analysts have come up with their own models of the cost-benefit analysis process. In these models, many analysts even include the opportunity cost. The opportunity cost is when other alternative courses of action are also factored into the calculations. This provides better clarity of the situation.
The analysis process
There is no uniform method for the cost-benefit analysis process. However, analysts mainly adopt the following steps in their own way -
Creating a framework for the analysis
The first work will be to create a framework for the analysis. In this framework, the analyst lays down the question the analysis will answer, the current situation of the company, and the factors that need to be counted for the analysis. The factors include the timeline of the project, the resources and additional personnel that will be required, and more.
Determine the estimated costs
After building the framework, the analyst will stay working on figuring out the costs. It's important to note that these costs can either be financial or non-financial, like negative social responses.
The costs can also be either fixed or one-time. The costs will include -
- Opportunity costs
- Potentially risky costs, like competitive or environmental impacts, and more
- Intangible costs, like impacts on brand perception, employees, customers, and more
- Indirect costs which mainly include production costs, like transportation, rent, electricity, and more
- Direct costs, like employees involved in the project, product manufacturing, raw materials, inventory, and more
Determine the estimated benefits
Just like costs, benefits can either be financial or non-financial. This is why it's important to put a numerical value to intangible factors as it makes calculations easier. Benefits mainly include -
- Direct or financial benefits, like the revenue from a new ad, or sale
- Indirect or non-financial benefits, like customer satisfaction from product upgradation or faster delivery time, improved morale in employees, gained market share and competitive advantage, and more
Tallying the two estimated values
The main calculations come after estimating the costs and benefits. The simplest part of this process is subtracting one from the other. The end result will be - if the cost is more than the benefit, then the decision may be harmful to the business. Moreover, the complicated factors in this calculation are -
- Applying discount rates means the analyst factors in how the value of the costs and benefits will change within the timeline. It is basically applying an interest rate to the costs and benefits considering factors, like inflation.
- Calculating and level setting the analysis result for different options. Each option may have different costs and different benefits.
- Performing sensitivity analysis, which means taking into account how uncertainties can affect the results. It can be used to come up with the best and the worst-case scenarios.
Once the calculations are done, the analyst recommends in accordance with the result -
- If the benefit is more than the cost, that would mean that the project is worth taking up. However, if the margin between the two is small, then an alternative approach might be necessary.
- If the cost is more than the benefit, that would indicate that either the business needs to focus on its largest cost inputs or take another approach for the desired result.
- If the cost is more than the benefit owing to large intangible values, then it's important to revisit those costs to determine if they are accurate.
The cost-benefit-analysis process has some benefits that can be crucial for any business. It doesn't only make the decision-making process simple, but it also makes it free of bias. It puts financial or numerical values on all factors and provides the result.
When making a decision, one or two factors can slip the mind. However, when analysts go into details during the cost-benefit analysis process, they uncover those hidden costs and give out the best result. It also helps companies gain a competitive edge as they keep analysing their options or decisions and progress on the best path in accordance with the results of the analysis.
Companies are hiring more analysts as the market gets more competitive these days. The cost-benefit analysis process has become imperative for them, so learning more about it will only help you secure a better future. The CFO Course at Imarticus can help you learn everything you need to learn. Their collaboration with IIM Indore has added that extra flair to this Certificate Programme for Emerging CFOs.