Wednesday, May 5, 2010

What Is Cost/Benefit Analysis?

Basically, this means evaluating whether, over a given time frame, the benefits of the new investment, or the new business opportunity, outweigh the associated costs.

Before beginning any cost/benefit analysis, it's important to understand the cost of the status quo. You want to weigh the relative merits of each investment against the negative consequences, if any, of not proceeding with the investment. Don't assume that the costs of doing nothing are always high: in many cases, even when significant benefits could be gained from a new investment, the cost of doing nothing is relatively low.

Cost/benefit analysis of a particular investment involves the following steps:
1. Identify the costs included in the new purchase/business opportunity.
2. Identify the benefits of additional revenues.
3. Identify the cost savings to be gained.
4. Map out the timeline for expected costs and anticipated revenues.
5. Evaluate the unquantifiable benefits and costs.
The first three steps are fairly straightforward. Begin by identifying all the costs associated with the venture—this year's up-front costs as well as ones you anticipate in subsequent years. Additional revenues could come from more customers or from increased purchases from existing customers. To understand the benefits of these revenues, make sure to factor in the new costs associated with them; ultimately, this means you'll be looking at profit. With cost savings, it's a little simpler, at least in the sense that they are incremental profit—they go straight to the bottom line. However, cost savings are sometimes a little more subtle, more difficult to recognize. They can arise from a variety of sources; for the ones listed below, it isn't hard to quantify the savings.

  • More efficient processing. This could mean that fewer people are required to do the processing, or that the process requires fewer steps, or even that the time spent on each step decreases.
  • More accurate processing. The time required to correct errors and the number of lost customers could both decrease.
Next, map out these two elements—the costs and the revenues or cost savings—over the relevant period of time. When do you expect the costs to be incurred? In what increments? When do you expect to receive the benefits (additional revenues or cost savings)? In what increments?

Once that's done, you're ready to begin the evaluation phase using one or more of the following analytical tools:

  • return on investment (ROI)
  • payback period
  • breakeven analysis
  • net present value (NPV)
  • sensitivity analysis

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