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:
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 ]
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