Cost-Benefit Analysis (CBA) is a systematic decision-making process weighing the benefits of a course of action versus the associated costs
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.
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.
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:
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.
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.
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.
Learn about the different types of cost-benefit analysis below:
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.
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.
Here are the different types of cost-benefit analysis that are often used in finance and accounting:
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.
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.
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.
Performing a cost-benefit analysis comes with benefits and drawbacks, including:
Cost-benefit analysis is a tool used in many scenarios to determine the best course of action:
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.
Already have a Full-Immersion membership? Log in