Before taking on a new project or investment prudent professionals conduct Cost-Benefit Analysis. It allows to calculate the potential costs and revenues generated. We want to know, whether it is economically feasible to undertake it or should we pursue a different one.
Cost-Benefit Analysis should start from a full list of all the costs and benefits linked to the new project;
You are likely to begin with Direct Costs. This would include the direct labour involved to the project or development as well as inventory, raw materials and expenses.
However, it is important to go beyond the obvious. Other costs will include:
* Indirect costs - fixed expenses, for example electricity, management overhead costs, utilities or rent.
* Intangible costs - this can be difficult to measure and include the impact on customers or employees, i.e. decrease in productivity or reduced customer satisfaction.
* Opportunity costs - lost benefits or other opportunities when we pursue one project over another.
* Costs associated with risks - such as competition, regulatory and environmental impacts.
Benefits can be:
* Direct - higher revenue and sales generated from service or product
* Indirect - recognition of the business and interest from new potential customers
* Intangible - for example improved employee safety or enhanced customer satisfaction
* Competitive - market share or being the first mover in the industry
Once we have completed the comprehensive list of the costs and benefits, we must assign a monetary value to each one of them. We need to take caution and do not underestimate or overestimate the values. Try to be as objective as possible. Indirect and intangible costs will be difficult to quantify. There is many software options available to perform the evaluation as well as new methodologies that can help with the task.
Finally, the total values of both costs and benefits should be compared. If benefits outnumber the total costs, then there is a solid reason to proceed with the investment. If the costs, however, outnumber the benefits, we should review the project to check adjustments can be made to increase the benefits or decrease the costs.
PROS and CONS
As with many undertakings, there are both advantages and disadvantages using Cost-Benefit Analysis.
For investments with small capital and short times to completion a thorough Cost-Benefit Analysis may be enough to made a rational decision. For large and very large projects with long time to complete a Cost-Benefit may fail for account for other financial impacts, such as inflation rates and interest rates.
Cost-Benefit Analysis involves a high amount of forecast. These include the ROI (Return on Investment), future sales and revenues. If these are not forecasted accurately the results would become invalid. It is difficult to predict all variables.
The analysis can only be as good as the data. Inaccurate data will also generate incomplete results. There also also other elements which might drive us to pursue a project, for example moral motivations.
One of the benefits of using is that it makes decisions simple. Decisions can often be hard by nature and this type of exercise can make them less complex.
Another advantage is that an attempt to conduct Cost-benefit analysis can uncover hidden costs and benefits that could be valuable for the project or new investment.
Finally, the method is data driven. It allows to remove bias or personal opinions. It offers evidence-based evaluation which can help us to become logical in how we operate and make decisions.
The process of conducting the assessment requires understanding of the project and careful evaluation of potential costs and rewards. If there is high chance that the forecasts will be incomplete, data unavailable and the person performing it has little understanding of what is being evaluated, it might not be feasible to attempt the analysis.
If done correctly and with accurate assumptions, it can become a powerful tool to drive the way we operate.
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