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Cost-benefit analysis

What is a Cost-benefit analysis?

A cost-benefit analysis (CBA) is the process of calculating the benefits of a decision or action minus the costs associated with that decision or action. A CBA includes measurable financial metrics such as revenue earned or costs saved as a result of the project decision. Intangible benefits and costs, as well as the effects of a decision, such as employee morale and customer satisfaction, can be included in a CBA.

Managers conduct a cost-benefit analysis before embarking on a new project or building a new plant to evaluate all of the potential costs and revenues that a company may generate from the project. The analysis' findings will determine whether the project is financially viable or whether the company should pursue another project.

A cost-benefit analysis will often include the opportunity cost in the decision-making process in many models. Opportunity costs are the benefits that could have been realised if one alternative had been chosen over another.


What is the Cost-benefit analysis process?

A cost-benefit analysis should begin with a thorough list of all the costs and benefits associated with the project or decision.

The following costs may be incurred as a result of a CBA:


  • Direct costs include manufacturing labour, inventory, raw materials, and manufacturing expenses.
  • Indirect costs may include electricity, management overhead, rent, and utilities.
  • Intangible costs associated with a decision, such as the impact on customers, employees, or delivery times.
  • Alternative investments, for example, buying a plant versus building one, are examples of opportunity costs.
  • Costs associated with potential risks such as regulatory risks, competition, and environmental impacts

Cost-benefit analysis


What are the benefits of Cost-benefit analysis?

  • Increased revenue and sales as a result of increased production or the introduction of a new product.
  • Intangible benefits include increased employee safety and morale, as well as increased customer satisfaction as a result of improved product offerings or faster delivery.
  • Competitive advantage or market share gained as a result of the decision.


What are the limitations of Cost-benefit analysis?

  • An in-depth cost-benefit analysis may be sufficient to make a well-informed, rational decision for projects that involve small- to mid-level capital expenditures and are completed in a short to intermediate time frame. A cost-benefit analysis may fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money for very large projects with a long time horizon.
  • There is a significant amount of forecasting built into any type of model used in performing a cost-benefit analysis. Forecasts used in any CBA may include future revenue or sales, alternative rates of return, expected costs, and future cash flows. If one or two of the forecasts are incorrect, the CBA results will almost certainly be called into question, highlighting the limitations of performing a cost-benefit analysis.


What are the tools and methods used in Cost-benefit analysis?

Depending on the specific investment or project under consideration, net present value calculations may be required to discount the time value of cash flows. A benefit-cost ratio (BCR) can also be calculated to summarise the overall relationship between a proposed project's relative costs and benefits. Regression modelling, valuation, and forecasting techniques are examples of additional tools.

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