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What is a Cost-Benefit Analysis? Step-by-step Guide & Advantages of CBA

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Analysis of cost benefit is an essential activity that needs to be done during operating the business. An organization has to be aware about the procedure of estimating all costs involved and possible profits to be derived from a business opportunity, which is known as cost benefit analysis.

# What Is Cost-Benefit Analysis?

Under the cost benefit Analysis, we do the comparison between projected or estimated costs and benefits (opportunities) associated with a project decision to determine whether it is in favor of the business or not. If the projected benefits outweigh the costs then the decision is in favor of business growth but if the benefits are underweigh the costs then you should terminate the decision.

With the process of cost benefit analysis, you can analyze decisions, systems, and projects. This model of analysis allows us to identify the benefits & costs to get tangible results, which can be used to develop appropriate conclusions by taking further decisions. 

# Purpose of Cost-Benefit Analysis

The primary reason for conducting a cost analysis is usually to determine the absolute costs and analyze which decisions to make and which to forgo. This can be used to Identify cost-saving opportunities. Few more reasons to do Cost benefit analysis:

  • To Compare the costs & benefits over the long run.

  • To Measure cost and Profit in monetary terms.

  • To Monetize the benefits to indicate whether the cost is worth the work.

  • To Analyze several approaches (taxpayers, victims, etc) to measure the net benefits for society.

#  Why is Cost-Benefit Analysis Important?

Cost-benefit analysis can help you in many things :

  • Provides a framework for policy debates for which you must evaluate all perspectives.

  • Underlines the long-term consequences of policy decisions.

  • Serve as a tool to model the impact of various policy scenarios.

  • Promotes more accountability, as programs focus on results and become data-driven.

  • Moves the dialogue beyond costs and cutting costs.

# How to Conduct a Cost-Benefits Analysis?

A cost-benefit analysis, also known as a cost savings analysis, is important to help determine whether you can proceed with a new decision. These are 6 steps to help you conduct a successful cost-based analysis.

1. Understand the cost of maintaining the status:- It helps you understand the potential costs of doing nothing and can help you determine if it is possible to start a new project. Sometimes it is not right to do anything in haste. In another word, doing anything in a hurry can be disastrous for us if you fall behind your rivals – it’s better to wait and process decisions on time.

2. Identify costs and benefits:- When tallying costs, you probably start with direct costs, including costs directly associated with the production or development of a product or service (or the implementation of a business decision). Labor costs, manufacturing costs, materials costs, & inventory costs are all examples of direct costs. Other cost categories you should include:

  • Indirect Costs: These are usually fixed expenses, such as utilities and rent, which help in the operation of the business.

  • Intangible Costs: These are any costs that are difficult to measure & quantify. Examples may include decreases in the level of productivity while a new business process is rolled out, or reduced customer satisfaction after a change in customer service processes that reduce repeatability.

  • Opportunity Costs: This refers to the loss of either benefit or opportunity, that arises when a business pursues a strategy to take one product or another.

Similarly, benefits can be:

  • Direct: For example, increased revenue & sales generated from a new product

  • Indirect: Such as increased customer interest in your business or brand

  • Intangible: For example, improved employee morale

  • Competitive: For example, being a first-mover within an industry or vertical

3. Assign a monetary value for costs and benefits:- All costs and benefits must be measured in a single monetary unit. If you are doing a cost-benefit analysis for a global company, do not try to separate the costs of a project into different denominations by country or region. If you assign everything in a single currency it is very easy to track the actual costs and returns.

4. Create a timeline for expected costs and revenue:- Map out when you expect costs and benefits and how much they will be. The timeline helps you align, define and track the expectations of all interested parties. Also, periods can help you plan for upcoming cost and revenue impacts, which will let you manage and adjust as necessary to change things.

5. Compare cost and benefits:- Calculate your total cost and your total benefits based on the lists you have made. Be sure to use the same currency for all your calculations. Comparing the two values ​​allows you to determine if the benefits are out of cost.

When comparing costs and benefits, you should also consider the following: inflation, lost return on investment, discount rate, payback period.

# Limitations of Cost-Benefit Analysis?

Cost-benefit analysis has its limitations such as-

1. There are so many benefits that it is difficult to measure and determine objects that are considered without measurement. The probability of inaccuracy is great due to the lack of a correct estimated value.

2.Perceived clarity in determining & listing costs and benefits can prove to be detrimental because the actual outcome is dependent on many variables that you can only know in time.

3. Evaluations are subjective and cannot be considered absolute accurate. Since some benefits and costs are non-monetary, it becomes difficult to estimate, quantify, and identify in a monetary context. This can lead to incorrect evaluations.

4. Sometimes a cost-benefit analysis turns into a project budget & leads to unrealistic goals & errors.

5. The Cost-benefit analysis estimates the value over time and can cause serious miscalculations in present value. This leads to incorrect analysis.

6. The project manager relies on data and any type of information from past projects, but in the current scenario, the facts are ever-changing.

# Formula of cost benefit analysis:

The cost-benefit analysis is simply the measurement of actual costs and benefits to determine where the business stands as per projected decision. If the projected revenue is more than the projected cost, the ratio is positive. Here is the formula to 

Cost benefit Ratio = ∑PV of all the Expected Benefits / ∑PV of all the Associated Costs

Net present value = ∑PV of all the Expected Benefits – ∑PV of all the Associated Costs

# Advantages of Cost-Benefit Analysis

These are some advantages of Cost-benefit analysis-

  1. A cost-benefit analysis simplifies the complex decisions in a project and proposal.
  2. The cost-benefit analysis removes any emotional elements and helps to remove biases.

3. The analysis gives clarity to unpredictable situations. The listing of cost & benefits helps the analyst to identify and subsequently evaluate each cost and benefit.

4. It takes into account a wide spectrum of benefits & costs and converts them into currency to simplify matters.

5. It helps to find out whether the benefits out the cost and is financially strong and stable to pursue it.

6. The cost-benefit analysis helps in rational decision-making by looking at the data expressed in the same units.

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