Cost-Benefit Analysis

Cost-Benefit Analysis (CBA) is a systematic decision-making process weighing the benefits of a course of action versus the associated costs

Written by CFI Team

Reviewed by Jeff Schmidt

What is Cost-Benefit Analysis?

Cost-benefit analysis (CBA) is a process performed by individuals, governments and businesses when considering a course of action or proposed project. It serves as a framework for evaluating the desirability of an action by comparing total benefits against total costs. If the expected net benefits outweigh the expected costs, then it makes sense to undertake the action. If the opposite is true (costs outweigh the benefits), then the action would not be undertaken.

Effectively, CBA assumes that the benefits of an action will always have an associated cost and that these costs can be factored into the analysis. It’s only by understanding all of the direct and indirect benefits and all of the direct and indirect costs that a planned course of action should or should not be taken. From a finance perspective, one subtype of cost-benefit analysis is net present value.

Cost-Benefit Analysis

Key Highlights

Cost-benefit analysis is a process performed by individuals, politicians and businesses when considering a course of action.
For a company to create economic value for its stakeholders, it must invest in beneficial projects. After a thorough consideration of all of the benefits and costs, the company can then make the determination whether the project will add value. If cost-benefit analyses are not performed, then it is possible the company may be investing in value-destructive projects.
A major limitation of cost-benefit analyses is that it may not be possible to adequately understand all potential expected benefits and costs.

Why is Cost-Benefit Analysis Important?

For a company to create value for its stakeholders, it must invest in beneficial projects. After a thorough consideration of all of the benefits and costs, the company can then make the determination whether the project will add value.

If a CBA is not performed, then it is possible the company may be investing in value-destructive projects.

How Does an Analyst Perform a Cost-Benefit Analysis?

Any time a company considers making an investment, a cost-benefit analysis should be performed. Whether that is investing in capital expenditures, making an acquisition or investing excess cash, the action should only be accepted if the benefits are greater than the costs.

While there is no specifically defined cost-benefit analysis process, any analysis should consider the following:

What is the scope? Clarify what is being analyzing. Is it a new business project, an acquisition or cost-saving initiative? Knowing the scope helps an analyst focus on relevant costs and benefits.
Identify the relevant stakeholders. Who will be affected by this decision? Understanding the stakeholders helps an analyst consider different perspectives.
Decide on a time horizon. This will guide in selecting which costs and benefits to include.
Identify the sources for the analyzed data. Is it market research, expert opinions or historical data? The sources should be reliable to ensure the analysis is as accurate as possible.

After deciding on the above considerations, it is then time to economically analyze the direct and indirect benefits as well as the direct and indirect costs (including opportunity costs). Finally, either accept or reject based on the cost-benefit analysis.

How Does an Analyst Make a Recommendation and Implement a Course of Action?

Making a Recommendation

Summarize Findings: The key findings of the CBA must be summarized and presented.
Discuss Non-Quantifiable Factors: While numbers are crucial, qualitative factors like social impact and employee morale must also be considered.
Assess Risks: Acknowledge any uncertainties or risks associated with the project, and how these may affect potential outcomes.
Present Options: The CBA may have included multiple scenarios or alternatives. If so, discuss these and highlight the most favorable option.
Decide on an Action: Based on the analysis, recommend whether to proceed with the project, modify it or abandon it.

Implementing the Decision

Obtain Approval: Once the recommendation is made, it will usually need approval from various stakeholders before proceeding.
Allocate Resources: If the decision is to go ahead, allocate the necessary resources (time, money, workforce, etc).
Develop a Timeline: Create a detailed project timeline with milestones to track progress.
Monitor and Adjust: As the project progresses, continuously monitor its performance against the expected costs and benefits. Prepare to make any adjustments if necessary.

Advantages of Cost-Benefit Analysis

An advantage of cost-benefit analysis is that it allows for a mostly quantitative analysis so that an individual or organization can make the best-informed decisions. Since no individual or organization has unlimited resources, cost-benefit analysis helps determine the optimal resource allocation.

Another main advantage of cost-benefit analysis is that it forces an analyst to think about all potential benefits and costs, not just direct, monetary ones. Through this process, an analyst can better understand the proposed action strategically versus the relatively mechanical discounted cash flow analysis.

A CBA can be used regardless of the projects being mutually exclusive or not. Mutually exclusive choices require the forfeit of one or more other options. However, a CBA can still be used to rank projects.

Limitations of Cost-Benefit Analysis

One of the major limitations of cost-benefit analysis is that it is possible to not adequately understand all of the potential benefits and costs.

Suppose a company wants to expand production to increase sales. The company may need to invest in a new factory. Direct costs to expanding production are readily apparent, for example, the cost of the new factory and additional labor costs. Other costs are more indirect or intangible.

An indirect cost might be administrative overhead or utilities expense. An intangible cost is difficult to measure but may be something like a decrease in productivity when the new factory first begins production. Opportunity costs are typically included as a discount rate or cost of capital (in other words, what would cash earn if it was invested elsewhere instead of the new factory).

A direct benefit to increased production could be an increase in revenue. An indirect benefit could be an increase in customer satisfaction if the product was previously hard to obtain. An intangible benefit might be an improved production process once the factory is up and running. Another intangible benefit might be taking market share aware from a competitor.

Another potential limitation is that the cost-benefit analysis is not static—it may change over time. Inflation may increase the cost of the proposed project and change the monetary value of the project from a net benefit to a net cost.

General Types of Cost-Benefit Analysis

Learn about the different types of cost-benefit analysis below:

1. Ex ante CBA

Ex ante basically means coming before. Therefore, the CBA would be conducted before undertaking the proposed project.

Ex ante CBA helps determine the go/no-go decision and allows a company to better allocate resources. The downside is that the expected benefits and expected costs are based on forecasts which may turn out to be inaccurate.

2. Ex post CBA

Ex post means coming after. In this case, the CBA is conducted after the investment has been made.

The advantage of ex post CBA is that the financial benefits and costs are better known and not based on forecasts. Of course, the disadvantage is that the investment costs may outweigh the benefits and the investment should not have been made.

Types of Cost-Benefit Analysis in Finance and Accounting

Here are the different types of cost-benefit analysis that are often used in finance and accounting:

1. Net Present Value (NPV)

As discussed earlier, calculating the net present value of an investment is an example of cost-benefit analysis. When performing a cost-based analysis, an analyst will need to assign a dollar value to all benefits and costs in order to calculate cash flows and determine the NPV. While the direct benefits and direct costs should be relatively easy, the analysis is only complete by estimating indirect and intangible costs and benefits.

Once all cash flows are calculated, the cash flows are then discounted at the opportunity cost, usually WACC, or some other hurdle rate, to obtain the NPV of an action. If the NPV is positive, then the company should perform the action. Otherwise, the company should not undertake the action.

2. Internal Rate of Return (IRR)

Internal rate of return (IRR) analysis is another type of cost-benefit analysis. The IRR is the discount rate that makes the net present value (NPV) of a project zero. Similar to NPV, an analyst must capture all benefits and costs when performing this analysis.

If the IRR of an action is greater than a company’s cost of capital (or hurdle rate), then the company should undertake the action. If the IRR is less than the cost of capital, then the action should be avoided.

3. Breakeven Analysis

Breakeven analysis is yet another form of cost-benefit analysis. The breakeven point typically refers to a dollar amount or the number of units sold whereby total revenues equals total costs.

This analysis can be expanded by considering the total benefits and total costs (direct, indirect, intangible and opportunity). This way, a company has a more comprehensive look at whether the investment is value-additive or value-destructive.

The Benefit-Cost Ratio can be used to determine the viability of a project. The ratio compares the present value of all benefits generated from a project/asset to the present value of all costs. A benefit-cost ratio exceeding one indicates that the asset/project is expected to generate incremental value.

One drawback of this ratio is that it does not indicate the project’s size or provide a specific value on what the asset/project will generate. For example, two projects may show a benefit-cost ratio of two, but the present value of cash flows can be significantly different.

As with any analysis, it is always a good idea to create a sensitivity analysis to see how different variables impact different outcomes.

Pros and Cons of Cost-Benefit Analysis

Performing a cost-benefit analysis comes with benefits and drawbacks, including:

Pros

The analysis should be data-driven, and ideally be analyzed based on expected cash flows.
This analysis attempts to provide insight into both financial and non-financial outcomes.
Once the analysis is complete, the decision to undertake an action is easily determinable.
Cost-benefit analysis also allows for the comparison of different actions, making it easier to choose the best course.

Cons

Measuring direct benefits and costs is relatively straightforward; however, estimating indirect and intangible benefits and costs can be highly subjective.
Due to the measuring issue mentioned above, cost-benefit analysis can be quite time-consuming, and the analysis is only as good as the data.
This analysis is less useful for longer-term projects as forecasting future costs and benefits is more difficult the further into the future the analysis goes.