In the course of starting and running a company, you will make thousands of decisions that will affect your business. During the decision-making process, taking the time to perform a cost benefit analysis can help determine what the best course of action is for a certain situation.
In a business context, a cost benefit analysis outlines and analyzes the expected potential revenues against the expected potential costs, helping determine if an action has an acceptable risk-to-reward ratio. It can also be used to compare projects to decide which one is smarter and potentially more profitable. This process is also often referred to as “running the numbers.”
How to Calculate Cost Benefit Analysis
A cost benefit analysis is essentially a pros-and-cons list with numbers attached to each factor. To begin, you need to determine a unit of measurement, which is typically dollars (although it’s occasionally used for non-financial decisions, such as environmental impact or employee happiness). Each factor should be calculated using this predetermined unit of measurement.
After determining your unit of measurement, follow these steps:
- Determine and itemize costs. This needs to be your best guess at the cost forecast of the project. Be sure to consider and include all factors, such as labor, materials, reallocation of resources, training, drops in sales, etc. Determine whether the costs will be ongoing and for how long.
- Determine and itemize benefits. This will include not only your profit margin, but lowered material and labor costs, quicker turnaround time and other savings.
- Calculate by subtracting the costs from the benefits. This measurement will tell you the value of the project and if it is a worthwhile action.
- Compare your alternatives, including other project options as well as the status quo. Also, consider the payback time for all options.
- Compile your findings, and then plan your action. Sometimes, you may need to wait to gain more capital, and doing nothing may be your best option.
The most efficient way to complete a cost benefit analysis is to refer to and implement a cost benefit analysis worksheet, which will ensure that you don’t miss any necessary steps. Be as thorough as possible, and don’t leave anything out. Every little bit counts, even though it may not seem like it when you are itemizing.
Also, consider non-monetary costs and benefits, including impacts on the community, the environment, your reputation, team morale, product quality and more. Although you may not be able to adequately assign a monetary value to these factors, they may have an effect on your business over time.
Keep in mind that these numbers must be as accurate as possible. While you may have to estimate some figures, do everything in your power to narrow them down to an accurate prediction of your costs and losses. A cost benefit analysis can be very beneficial, but if the numbers are incorrect, it could be a very costly mistake. If you are still on the fence, consider the pros and cons of using a cost benefit analysis.
When Is It Used?
Cost benefit analyses are typically used when comparing projects and/or making important business decisions. These decisions are usually heavily related to finances and spending money and are used early in the project-development phase. Some common applications include:
- Relocating or opening a new location
- Hiring a costly employee
- Acquiring more capital
- Entering a new partnership
- Purchasing new equipment
- Launching a new product
- Selling equity
- Implementing a new computer system
A cost benefit analysis can occasionally be measured using intangible factors that are given weighted scores, but in this case, you must be careful because results can be skewed by your own biases, and number guesses could be off by a large margin.