Cost Benefit Analysis
Cost benefit analysis is a technique used to compare different courses of action based upon assigning a dollar value to both the expenditure and its results. A cost benefit analysis is a rather simple tool to use and is a great way to analyze actions whether you are one single consumer, a small business or a large corporation.
It should be noted that a cost benefit analysis can be used when solving either simple, moderate or highly complicated analyses. The cost benefit analysis does not focus on finding a solution to the problem, instead a cost benefit analysis will ask the simple, but important question of whether a problem is worth solving monetarily.
The two major components of a cost benefit analysis are obviously the cost and the benefits. It should be noted that costs can be categorized as one time costs or long term costs in which a cost must be paid or an investment must be made over a period of time. Benefits can be immediate or may also take long periods of time to be realized. When initiating a cost benefit analysis, these factors must be known and considered.
An Example Cost Benefit Analysis
Corporation XYZ is in the technology business signing up individuals over the phone for conventions. One of the owners would like to implement a new Internet based system that will include powerful software in which any individual from around the world would be able to sign up over the web for a convention. However, while it sounds like a great idea, XYZ corporation would like to know how much is the cost of implementing and using the new software compared to the system in place and what will be the benefits over the next three years of having the new software implemented over the existing system.
Figure out the Costs
First figure out the costs of implementing the new computer software in your firm, for example you may want to take into consideration the cost of the software license for each computer you intend to run it on, the cost of purchasing a new server to run the software properly. The cost of installation and the cost of consulting fees.
| License for 10 computers at $500 each | $5,000 |
| Cost of new server | $2,000 |
| Cost of installation | $1,500 |
| Cost of consulting fees | $1,000 |
You will also want to figure out any costs associated with labor and implementing your new system such as training and the time taken away from productivity due to training.
| Training costs for 10 employees x 20 hours | $4,000 |
| Cost of lost labor for 10 employees x 20 hours | $4,000 |
Now simply add up all the costs you can came up with for purchasing and implementing your new software. In this case, the total cost will be $17,500.
Figure Out the Benefits
Now think about the benefits of implementing this system. For instance, you might come to the conclusion (using good evidence and analysis) that you will be able to sign up twice as many people in the same amount of time. So if you are normally able to make a profit of $500 for signing up individuals over a 40 hour period, with this system implemented, you will be able to make a profit of $1,000 ($500 more) over the same 40 hour period.
Compare the Costs to the Benefits
It's easy to calculate that if you can double your profit in a 40 hour work week from $500 to $1,000, the implementation of a $17,500 software system will be paid for in exactly 35 weeks, in which case, from this point your profits will jump 100% to $1,000 per 40 hour period. Obviously, this is an easy case study, but it shows how using a cost benefit analysis can help all types of business determine the best path of action.
Short Term and Long Term
There are some cost benefit analyses where the benefits will be immediate; others, like the example above, require a period of time to invest in the technology in order to realize a profit. Obviously, an analysis with an immediate benefit are extremely easy decisions to make, some are even no-brainers. However, those analyses that require a fairly long period of time to repay their initial investment in order to first start seeing benefits require a degree of risk.
The better your analysis and evidence to determine the repayment period and benefits achieved once the repayment period is complete, the less risk you will ultimately require. However, nothing is a sure thing and many times a well thought out cost benefit analysis in the end can cost more money than anticipated, take longer to achieve repayment (if ever) and produce a smaller profit.
Intangibles
While many cost benefit analysis are done with objects of financial value, they can include any type of investment including emotional, educational, etc. When doing a cost benefit analysis on these items, the values of both the cost and benefits will ultimately be subjective.