COST BENEFIT ANALYSIS



Cost benefit analysis is, as its name suggests, the exercise of evaluating an action's consequences whereby the pluses are weighed against the minuses. It is the fundamental assessment behind virtually every business decision, and stems from the simple fact that business managers do not spend money unless the resulting benefits are expected to exceed the cost. Managers are generally rational decision makers, and the net economic outcome of a decision is a critical element to be considered.

Although its name seems deceptively simple, there is often a degree of complexity, and subjectivity, to the actual implementation of cost benefit analysis. This is because not all costs or benefits are obvious at first. Take for example the situation where a company is trying to decide if it should make or buy a certain subcomponent of a larger assembly it manufactures. A quick review of the cost accounting numbers may suggest that the cost to manufacture of $5 per piece can easily be beat by an outside vendor who will sell it to the company for only $4, apparently an easy decision. Other factors that need to be considered and quantified (if possible) include:

  1. When a subcomponent's manufacturing is contracted to an outside vendor, the company's own factory will become less utilized, and therefore its fixed overhead costs have less components over which to be spread. As a result, other parts it continues to manufacture may show an increase in costs, consuming some or possibly all of the apparent gain. (Note: one way to avoid this particular problem is to derive the internal cost of manufacturing on an incremental basis; that way no fixed cost effect will be caused by the change in factory utilization.)
  2. The labor force may be concerned about outsourcing of work to which they feel an entitlement. Resulting morale problems and labor unrest could quickly cost the company far more than it expected to save.
  3. Loss of control must be weighed. Once the part is outsourced, the company no longer has direct control over the quality, timeliness, or reliability of the product delivered.
  4. Unforeseen benefits may be attained. For example, the newly freed factory space may be deployed in a more productive manner, making more of the main assembly or even another product altogether.

This list is not meant to be comprehensive, but rather illustrative of the ripple effect that occurs in real business-decision settings. The cost benefit analyst needs to be cognizant of the subtle interactions of other events with the action under consideration in order to fully evaluate the impact.

Capital budgeting has at its core the tool of cost benefit analysis; it merely extends the basic form into a multi-period analysis, with consideration of the time value of money. In this context, a new product, venture, or investment is evaluated on a start-to-finish basis, with care taken to capture all the impacts on both the cost and benefits. When these inputs and outputs are quantified, by year, they can then be discounted to present value to determine the net present value at the time of the decision.

[ Christopher C. Barry ,

updated by David P. Bianco ]

FURTHER READING:

Anthony, Robert N., and others. Accounting: Text and Cases. 9th ed. NP: McGraw-Hill Higher Education, 1994.

Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 5th ed. New York: McGraw-Hill, 1996.

Diamond, Michael A. Financial Accounting. 4th ed. Cincinnati: South-Western Publishing, 1995.

Eskew, Robert K., and Daniel L. Jensen. Financial Accounting. 5th ed. New York: McGraw-Hill, 1995.

Gallinger, George W., and Jerry B. Poe. Essentials of Finance: An Integrated Approach. Englewood Cliffs, NJ: Prentice Hall, 1995.

Solomon, Lanny M., Larry M. Walther, and Richard J. Vargo. Financial Accounting. 3rd ed. New York: West Publishing, 1992.

Spiro, Herbert T. Finance for the Nonfinancial Manager. 4th ed. New York: Wiley, 1996.



Also read article about Cost Benefit Analysis from Wikipedia

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