Project managers strive to control costs while getting the highest return on investment and other benefits for their business or organization. A cost-benefit analysis (CBA) is just what they need to help them do that.
In a project, there is always something that needs executing, and every task has a cost and expected benefits. Because of the high stakes, good project managers don’t just make decisions based on gut instinct. They prefer to minimize risk to the best of their ability and act only when there is more certainty than uncertainty.
But how can you accomplish that in a world with myriad variables and constantly shifting economics? The answer: consult hard data collected with project management software, reporting tools, charts and spreadsheets. You can then use that data to evaluate your decisions with a process called cost-benefit analysis (CBA).
Intelligent use of cost benefit analysis will help you make cost-effective decisions and maximize gains both for your project and your organization.
- What is Meant by Cost Benefit Analysis?
- What is the Cost Benefit Analysis Process?
- What is a Cost Benefit Analysis Example?
- What is the Formula for Cost Benefit Analysis?
- What is the Process for Cost Benefit Analysis?
What is Meant by Cost Benefit Analysis?
A cost-benefit analysis is a systematic process that businesses use to analyze which decisions to make and which to forgo. The cost-benefit analyst sums the potential rewards expected from a situation or action and then subtracts the total costs associated with taking that action. Some consultants or analysts also build models to assign a dollar value on intangible items, such as the benefits and costs associated with living in a certain town.
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Before building a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs and revenues that a company might generate from the project. The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.
In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-making process. Opportunity costs are alternative benefits that could have been realized when choosing one alternative over another. In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision.
Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis. By considering all options and potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.
Finally, the results of the aggregate costs and benefits should be compared quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company should likely avoid the project.
What is the Cost Benefit Analysis Process?
There is no single universally accepted method of performing a cost-benefit analysis. However, every process usually has some variation of the following five steps.
Identify Project Scope
The first step of a cost-benefit analysis is to understand your situation, identify your goals, and create a framework to mold your scope. The project scope is kicked off by identifying the purpose of the cost-benefit analysis. An example of a cost-benefit analysis purpose could be “to determine whether to expand to increase market share” or “to decide whether to renovate a company’s website”.
This initial stage is where the project planning takes place, including the timeline, resources needed, constraints, personnel required, or evaluation techniques. It is at this point that a company should assess whether it is equipped to perform the analysis. For example, a company may realize it does not have the technical staff required to perform an adequate analysis.
During the project scope development phase, key stakeholders should be identified, notified, and given a chance to provide their input along the process. It may be wise to include those most impacted by the outcome of the analysis depending on the findings (i.e. if the outcome is to renovate a company’s website, IT may be required to hire multiple additional staff and should be consulted).
Determine the Costs
With the framework behind us, it’s time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs. Costs may include the following.
- Direct costs would be direct labor involved in manufacturing, inventory, raw materials, and manufacturing expenses.
- Indirect costs might include electricity, overhead costs from management, rent, and utilities.
- Intangible costs of a decision, such as an impact on customers, employees, or delivery times.
- Opportunity costs such as alternative investments, or buying a plant versus building one.
- Cost of potential risks such as regulatory risks, competition, and environmental impacts.
When determining costs, it’s important to consider whether the expenses are reoccurring or a one-time cost. It’s also important to evaluate whether costs are variable or fixed; if they are fixed, consider what step costs and relevant range will impact those costs.
Determine the Benefits
Every project will have different underlying principles; benefits might include the following:
- Higher revenue and sales from increased production or new product.
- Intangible benefits, such as improved employee safety and morale, as well as customer satisfaction due to enhanced product offerings or faster delivery.
- Competitive advantage or market share gained as a result of the decision.
An analyst or project manager should apply a monetary measurement to all of the items on the cost-benefit list, taking special care not to underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning a value to both costs and benefits for a cost-benefit analysis.
Analysts should also be aware of the challenges in determining both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales quantities, customer demands, and product expectations.
Implicit costs, on the other hand, may be difficult to calculate as there may be no simple formula. For example, consider the example above about increasing employee satisfaction; there is no formula to calculate the financial impact of happier workers.
Compute Analysis Calculations
With the cost and benefit figures in hand, it’s time to perform the analysis. Depending on the timeframe of the project, this may be as simple as subtracting one from another; if the benefits are higher than the cost, the project has a net benefit to the company.
Some cost-benefit analysis require more in-depth critiquing. This may include:
- Applying discount rates to determine the net present value of cash flows.
- Utilizing various discount rates depending on various situations.
- Calculating cost-benefit analysis for multiple options. Each option may have a different cost and different benefit.
- Level-setting different options by calculating the cost-benefit ratio.
- Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes.
Make Recommendations and Implement
The analyst that performs the cost-benefit analysis must often then synthesize findings to present to management. This includes concisely summarizing the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis.
Broadly speaking, if a cost-benefit analysis is positive, the project has more benefits than costs. A company must be mindful of limited resources that might result in mutually-exclusive decisions. For example, a company may have a limited amount of capital to invest; although a cost-benefit analysis of an upgrade to its warehouse, website, and equipment are all positive, the company may not have enough money for all three.
What is a Cost Benefit Analysis Example?
Let’s assume that a board chairman of a construction company claims his team to make a comparison between two potential real estate development projects. He also reminds them that the company’s financial health is getting poor so he has to select one of them.
The team works and lists below the potential incomes and costs of each project.
Assumptions
Note: In order to simplify the cost benefit analysis example, we will not use a discount rate for each cost and income.
Project 1
– 500 housing units will be constructed.
– 400 of them will be sold and 100 of them will be rented for 20 years.
– Rental Price of each unit is 4,000 USD per year
– Rented 100 units will be sold 70,000 USD after 20 years.
– Construction Cost of each unit is 100,000 USD.
– The sale price of each unit is 120,000 USD.
– The project needs a luxury sales office with a price of 2,000,000 USD.
– The sales personnel cost is 300,000 USD per year.
– The project duration is 3 years.
– Project financing cost is 3,000,000 USD per year
Project 2
– 400 housing units will be constructed.
– 350 of them will be sold and 50 of them will be rented for 15 years.
– Rented 50 units will be sold 80,000 USD after 15 years.
– Rental Price of each unit is 4,500 USD per year
– Construction Cost of each unit is 90,000 USD.
– The sale price of each unit is 135,000 USD.
– The project needs a luxury sales office with a price of 3,000,000 USD.
– The sales personnel cost is 250,000 USD per year.
– The project duration is 2 years.
– Project financing cost is 2,500,000 USD per year
Comparing the Project Parameters
In this cost benefit analysis example, we will calculate the amount of money to be spent and the amount of money to be earned from each project to address economic efficiency.
Below table summarizes all the given project parameters.
Cost Calculations
Below table summarizes the project costs.
Benefit Calculations
Below table summarizes the project benefits.
Costs and Benefits Comparison
Cost Benefit Analysis-Costs and Benefits Comparison
In this simple cost benefit analysis example, there are too many parameters affecting the board’s decision. Financing costs per year, units for sale, units for rent, and total units to be constructed are some of them that make decision making difficult.
The above table summarizes the benefits, costs, and profits of each project. Although the income of Project 1 is more than Project 2, the costs of Project 2 are less than the costs of Project 1.
It is obvious that Project 2 is more profitable than Project 1. If the board chairman selects Project 2, the company will earn more profit by spending less money.
This simple example shows that Cost Benefit Analysis is a useful calculation tool in economics. Decision makers often use it while comparing multiple projects.
Another Real-World Cost Benefit Analysis Example
In the following cost benefit analysis example, three basic steps;
- Conducting a brainstorming session to determine all the costs and benefits related to the decision.
- Assigning a monetary value to all the costs.
- Assigning a monetary value to all the benefits.
- Comparing costs and benefits to calculate the payback period.
Assume that you have a software company operating for three years and you are planning to speed up the delivery dates in order to meet the market demand. You have five coders working full time but you need three more coders to facilitate the testing process. Hiring three more coders requires additional investments such as buying additional furniture, computers, and leasing additional workspace.
Assumptions
- Yearly revenue is $100,000 but it will increase by %30 as the capacity increases.
- Every month you are outsourcing an average of 200 hours of work with a cost of $80 per hour to another software company for testing.
- The productivity of team members will increase by %5 with a more comfortable office environment.
Costs
| Cost Item | Details | Costs (in First Year) |
| Rental Cost | The additional rental cost of moving to a new office | $15.000 |
| Furnishing Costs | Painting walls and buying new furniture | $10.000 |
| Hiring Costs | Cost of hiring three more coders (inc. salaries, benefits, orientation and training, $40,000 for each and the rate of one hired coder is $17,36/hour (24 Days x 8 hours x 12 Months = 2304 hours)) | $120.000 |
| Software Costs | Buying three computers and software licenses | $10.000 |
| Downtime Costs | Approximately $20,000 will be lost due to downtime | $20.000 |
| Total Costs | $175.000 |
Benefits
| Details | Benefits (within 12 Months) |
| %30 Revenue increase (Yearly revenue is 100,000 USD) | $130.000 |
| The rate of three hired coder is $52,08/hour, Cost of outsourcing is $80/hour. The Difference is (80 – 50,08) x200 hours x 12 months. | $67.008 |
| Improved productivity ($40,000x %5 x 8 Coder) | $16.000 |
| Expected Benefits | $213.008 |
In this cost benefit analysis example, payback period can be calculated as;
$175,000 / $213,008 = 0.821 of a year, or approximately 10 months.
It is often difficult to estimate the benefits rather than estimating costs. Because benefits are subjective and can be affected by the estimator’s bias. On the other hand, as a decision-making tool in economics, the cost benefit analysis often guides decision-makers to select the most effective alternative.
Cost Benefit Analysis Excel Examples
Example #1
ABC Chemical Ltd. is deciding which investment alternative is feasible considering costs and benefits of each of them.
Alternative 1
- Total Costs of Alternative 1 = $ 88.000.000.
- Expected Benefits s of Alternative 1 = $ 108.000.000
Alternative 2
- Total Costs of Alternative 2 = $ 11.000.000.
- Expected Benefits s of Alternative 2 = $ 23.000.000
Let’s decide which alternative ABC Chemical Ltd . should choose?
In order to decide which alternative is profitable, we will calculate the benefit-cost ratio for each one through a spreadsheet.
Benefit-Cost Ratio = Expected Benefits / Total Costs
Alternative 1
= $ 108.000.000 / $ 88.000.000
Benefit-Cost Ratio = 1,23
Alternative 2
= $ 23.000.000 / $ 11.000.000
Benefit-Cost Ratio = 2,09
According to Benefit-Cost Ratio calculations of Alternative 1 and Alternative 2, both investment opportunities have positive outcomes. In other words, both alternatives are beneficial for ABC Chemical Ltd. So the company will be in a good position it selects any of the alternatives. However, in that example, benefit-cost ratio of Alternative 2 is higher than benefit-cost ratio of Alternative 1. So, according to the Cost Benefit Analysis, ABC Chemical Ltd. should select Alternative 2, in the light of the information given above.
Example #2
Fox Car Maintenance Company is thinking to expand its current repair shop, and for that purpose, it will require additional vehicle mechanics and equipment. The owner of the company decides to make a cost benefit analysis to understand if that investment is beneficial or not. Here below you can find all the parameters related to costs and benefits.
- Hiring 5 more vehicle mechanics will provide a revenue increase by 45 % within one year. This expansion is planning to bring a revenue of $ 220.000.000.
- This expansion will increase the brand awareness of Fox Car Maintenance Company. Thus, this will bring additional revenue of $ 40.000.000.
- The salary of the new vehicle mechanics is around $ 110,000.
- The purchase cost of new equipment is $ 20,000.
- The cost of additional electrical and mechanical infrastructure will be around $ 15,000
Let’s perform a Cost Benefit Analysis for the given example.
Total Benefits (TB)
- Total benefits of the expansion: Increase in revenue of hiring 5 more vehicle mechanics + Increase in revenue of brand awareness
- TB: $ 220.000.000 + $ 40.000.000 = $ 260.000.00
Total Costs (TC)
- Total costs of the expansion: Salary of additional employees + purchase cost of new equipment + cost of additional electrical and mechanical infrastructure.
- TC: $ 110,000 + $ 20,000 + $ 15,000
- TC: $ 145,000
Now we will make the calculations by using Excel.
According to the Benefit-Cost Ratio calculations, the expansion of the current repair shop has positive outcomes. The Fox Car Maintenance Company should expand its business and employ new vehicle mechanics as well as purchasing new equipment and build new infrastructures.
What is the Formula for Cost Benefit Analysis?
The output of cost benefit analysis will show the net benefit (benefits minus cost) of a project decision. For example:
Project A: Build a new product will cost 100,000 with expected sales of 100,000 per unit (unit price = 2). The sales of benefits therefore are 200,000. The simple calculation for CBA for this project is 200,000 monetary benefit minus 100,000 cost equals a net benefit of 100,000.
Project B: Enhance the sales portal to position products in a simplified way, add a shopping basket and add a ‘keep shopping feature’ when checking out to allow multiple products in one purchase. The cost is 20,000 with expected increases of sales equal to 200,000 of revenue. The simple calculation for CBA for this project is 200,000 monetary benefit minus 20,000 cost equals a net benefit of 180,000.
Based on a comparison of these two metrics, a project investment board or stakeholder can easily quantify the best use of investment dollars for the greatest return.
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One key issue with the simple calculation though is the concept of time and the impact it can have on value. This is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. In other words, the sooner you put a dollar in the bank, the sooner it starts earning interest.
So when comparing a cost (today’s value) with a benefit (some time in the future’s value) you run the risk that your outputs could be incorrect and therefore misinform decisions. This is where Net Present Value comes in where you convert all values in the calculation to today’s (present) value.
What is the Process for Cost Benefit Analysis?
Like any project process, there are multiple versions out there on what the steps are and it is always best to find what works best for you. Here are some suggested steps to follow to ensure you can get the most out of CBA in your project decision making.
- Define the project (options considered, goals, objectives and other information)
- Quantify costs and benefits and confirm which ones are applicable in a CBA calculator (not all benefits can be and some costs may not be considered investment funds)
- Standardize the metrics in the calculations (define currency, units of value, NPV etc. as required)
- Complete relevant calculations (simple CBA or more advanced NPV depending on how accurate you need to be)
- Perform sensitivity analysis which accounts for uncertainty and shows how changes in different variables could affect the overall costs and benefits. It will be a way to give visibility to stakeholders on the assumptions and variables within the calculation which may be subject to change. A simple way to present this information might be in a best case / worst case analysis which provides the range of outcomes should assumptions change over time
- Complete the business case inclusive of CBA outputs and engage stakeholders
CBA in whatever form is a necessary process all organizations should consider in order to assist decision making and ensure investment funds are spent on projects which promise the greatest return. It will also assist with better ownership and governance over benefits realization once the project starts which is critical.
