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What is a 'Cost-Benefit Analysis'?

Cost analysis refers to the act of breaking down a cost summary so that you can study and report on each factor of its constituents.

It also refers to comparing costs in order to disclose and report on things that could be improved within a company.

Business Decisions are analyzed using a cost-benefit analysis process. Usually, a summary is given of how beneficial a situation or business-related action is, to which then the costs related to that action are subtracted. Some analysts also build a cost-benefit analysis model to put a monetary figure on intangible items, such as the costs and benefits linked to living in a particular town, and many analysts will also tie in opportunity cost into these equations.

Before starting a new project, wise managers will carry out a cost-benefit analysis in order to evaluate all of the potential revenues and costs that may be incurred if the project is finished. The result of the analysis will tell the manager whether or not the project makes financial sense for the business.

The Cost-Benefit Analysis Process

The process entails, firstly, compiling a list of all of the benefits and the costs that are associated with a decision or project. These costs should include indirect costs, opportunity costs, intangible costs, and the cost of potential risks as well as direct costs. The benefits should comprise all indirect and direct revenues as well as intangible benefits. Examples of intangible benefits are increased sales from customer goodwill, or increased production from better employee morale and safety. A monetary measurement unit that is common throughout should then be applied to each item on the list. The person in charge should take extra care not to overestimate the benefits or underestimate the costs. You could take a conservative approach by making a special effort not to use any subjunctive tendencies when working out estimates. This is most appropriate when assigning value to both benefits and costs for a cost-benefit analysis purpose.

The last step is to compare the aggregate costs and benefits results using a quantitative method to work out if the benefits outweigh the costs. If they do, then it makes sense to undertake the project. If not, you should carry out a review of the project to see whether you can make any adjustments to either decrease costs or increase benefits so that the project will be viable. If not, it is advised to abandon the project.

Limitation of Cost-Benefit Analysis

For smaller projects that only involve small-medium level capital expenditures and take a small amount of time to complete, a cost-benefit analysis done in depth should be sufficient to make a well-informed decision on whether or not to carry the project forward. For bigger projects that have a large time scale, a cost benefit analysis usually fails in including substantial financial concerns like interest rates and the current value of money. For these situations, alternative capital budgeting analysis methods may be more appropriate.