COST-BENEFIT ANALYSIS



Cost-benefit analysis is the exercise of evaluating an action's consequences by weighing the pluses, or benefits, against the minuses, or costs. It is the fundamental assessment behind virtually every business decision, due to the simple fact that business managers do not want to spend money unless the resulting benefits are expected to exceed the costs. As companies increasingly seek to cut costs and improve productivity, cost-benefit analysis has become a valuable tool for evaluating a wide range of business opportunities, such as major purchases, organizational changes, and expansions.

Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (less tangible, qualitative savings, as in management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.

Although its name seems 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, a situation in which 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 accounting numbers may suggest that the cost to manufacture the component, at $5 per piece, can easily be beat by an outside vendor who will sell it to the company for only $4. But there are several other factors that need to be considered and quantified (if possible):

  1. When production of a subcomponent 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.
  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. The consequences of a loss of control over the subcomponent 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, enabling the company to make 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 its impact.

A formal cost-benefit analysis is a multi-step process which includes a preliminary survey, a feasibility study, and a final report. At the conclusion of each step, the party responsible for performing the analysis can decide whether continuing on to the next step is warranted. The preliminary survey is an initial evaluation that involves gathering information on both the opportunity and the existing situation. The feasibility study involves completing the information gathering as needed and evaluating the data to gauge the short- and long-term impact of the opportunity. Finally, the formal cost-benefit analysis report should provide decision makers with all the pertinent information they need to take appropriate action on the opportunity. It should include an executive summary and introduction; information about the scope, purpose, and methodology of the study; recommendations, along with factual justification; and factors concerning implementation.

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 the company, both 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 of the opportunity at the time of the decision.

FURTHER READING:

Brealey, Richard A. and Stewart C. Myers. Principles of Corporate Finance , 4th ed. McGraw-Hill, 1991.

Dmytrenko, April L. "Cost-Benefit Analysis." Records Management Quarterly. January 1997.

Horngren, Charles T. and Gary L. Sundem. Introduction to Management Accounting. Prentice-Hall, 1990.

Shein, Esther. "Formula for ROI." PC Week. September 28,1998.



Also read article about Cost-Benefit Analysis from Wikipedia

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