There’s a saying that people make decisions based on emotions and rationalize them later. That might work for choosing dessert or even buying a car, but it’s dicey in business.
A cost-benefit analysis (sometimes called CBA) is a useful decision-making process that is often used by businesses, helping financial advisors make informed internal decisions or offer clients sound advice.
By directly comparing potential costs to potential benefits, this method aids financial advisors in determining if the decisions they're making are in stakeholders’ best financial interests.It can also be applied to large life decision with financial implications, just don’t tell your significant other that’s how you set the budget for the wedding ring.
What is cost-benefit analysis?
Put simply, cost-benefit analysis weighs the pros of a decision against the cons.
Businesses use CBA to help choose a course of action by calculating the sum of the benefits and costs of a decision in a dollar amount. It’s a useful calculation because it helps make complicated decisions more straightforward by boiling multiple factors into a straightforward ratio and offers a unit of measurement to intangible benefits like time savings and opportunity cost.
How to calculate cost-benefit analysis
The cost-benefit calculation is quite simple on the surface:
The calculation should take into account the costs and benefits throughout the duration of the effects of the decision. And while the equation itself is uncomplicated, you’ll need to spend time getting data and variables lined up to produce reliable measurements.
Here’s a list of what you’ll need for your cost-benefit analysis:
A list of costs and benefits
This is the first and most important step because you’ll need to make sure you think long-term and include any potential costs and benefits for the short and long-term. Some items will be more obvious than others. It’s usually easiest to begin with direct costs, which may include things like the cost of new software, hiring and training employees, or material costs. Beyond direct costs, there are also indirect costs, intangible costs, and opportunity costs.
Fixed expenses like office utilities, payroll, and other costs associated with day-to-day operations.
Temporary impacts on efficiency and customer service or satisfaction levels are examples of intangible costs.
This should include any potential benefits of alternate decisions ruled out by the decision at hand.Next, you can move to direct benefits. The most obvious example of a direct benefit is increased revenue. However, like costs, there are many benefits beyond the most direct examples. These include…
Future benefits such as better brand reputation, more customer interest, competitive advantage, etc.
These are business concepts that are the most difficult to assign value to, such as improved employee morale.
It’s important to make sure benefits and costs that overlap are not counted twice.
For example, let’s consider a manufacturing project that will lower the cost of materials to produce a product. Due to the lower cost of materials, the product’s margins will be higher. However, to include both the lower material cost AND the higher product margins in the benefit calculation would render the CBA inaccurate because the same benefit would essentially be counted twice.
Give costs and benefits a monetary value
Once you have a comprehensive list of all benefits and costs, you can begin assigning monetary values to each line item. Estimating monetary value for direct costs and benefits should be fairly straightforward. However, projects also have indirect costs and benefits, intangible costs and benefits, and opportunity costs. It’s difficult to assign a monetary value to these categories, but important to do so. These less obvious areas can add up and truly make a difference when deciding whether or not you should pursue the path ahead.
Financial records and known costs should form the basis of estimates, alongside variables like interest and depreciation. These calculations can get rather complicated, so it’s important to take your time on this step. For this reason alone, having a solid team of financial professionals, including a financial advisor and an accountant, are extremely helpful when estimating costs.
Complete the calculation and check results
Finally, total the costs and benefits and complete the CBA equation to determine the cost-benefit ratio. It’s ideal to have multiple people review the results. This way, you are more likely to catch any mistakes or oversights.
Once you have completed the cost-benefit analysis, you should have a solid idea of the viability of your project. However, the analysis doesn’t stop there.
Accurately interpreting the cost-benefit analysis
It’s great when the math is tidy, but cost-benefit analysis usually deals with changing variables. CBA is fairly reliable for shorter-term projects. For long-term projects, costs and benefits are harder to estimate, leaving more room for error.
Additionally, factors like inflation or the cost of materials can be hard to predict in advance. If you can, check on your data and analysis a few times leading up to a big decision to identify how your calculations shift over the course of a week, month, quarter, or more. It might take more time, but sometimes it’s best to measure twice, and cut once.
Human bias can also affect the outcome of a cost-benefit analysis. There can be unintentional or even deliberate miscalculations when someone is invested in a project and is hoping for a certain outcome. It’s easy to overlook potential costs that can derail the ROI of a project.
One way many companies correct for the limitations of cost-benefit analysis is by conducting a sensitivity analysis. Sensitivity analysis is a financial modeling technique that examines how the values of a series of independent variables influence a dependent variable. It can help you prevent issues from variables like material costs or inflation, and is considered a best practice CBA because it can help you predict more possible outcomes.
Getting cost-benefit analysis right with Causal
By understanding and planning for the benefits and potential issues of cost-benefit analysis, financial advisors can give informed recommendations to businesses facing business-critical decisions. Using a data and spreadsheet platform like Causal could help with your cost-benefit analysis in several ways.
For example, our visualization tool helps bring out the data in ways you can easily interpret and analyze. Also, Causal is collaboration-friendly, helping you share information across the financial team and other decision makers.