What Is a Cost-Benefit Analysis in Accounting?
Cost-benefit analysis involves weighing the potential rewards and total costs expected from a project to determine which decisions to make or forgo. It is also not uncommon for analysts or consultants to build dollar value cost-benefit models for intangible items.
Ultimately, if the benefits of a project outweigh the cost, it is considered a good business decision. On the other hand, if the costs outweigh the benefits, the project may be considered a poor business decision.
Understanding the Cost-Benefit Analysis
As a prudent business owner, it is critical to perform a cost benefit analysis before undertaking any new project. The outcome of this analysis, often presented as a ratio, helps you determine whether the project is feasible.
Your cost-benefit analysis should also consider the opportunity cost, which are alternative benefits you might miss based on that business decision. Considering opportunity costs allows you to weigh all options and is more thorough.
It is also important to remember that when doing a cost benefit analysis, the results may not be considered valid if any of the projected forecasts are inaccurate.
How To Conduct a Cost-Benefit Analysis
Follow the steps outlined below to conduct a thorough cost-benefit analysis
1. Establish a Cost-Benefit Analysis Framework
To get an accurate cost-benefit analysis, you must identify your goals. Establish what you need to achieve for your project to be successful.
This project scope should also identify the purpose of the cost-benefit analysis, for instance, to determine whether to buy additional assets.
As you plan your project, include factors such as personnel required, resources needed, timeline, and constraints, among others. This helps you assess whether you are equipped to perform an analysis.
You may also identify key stakeholders and notify them to get their input. At this point, you should also decide which metrics you will use to measure the cost-benefit analysis. Typically, this should be a common currency, such as a dollar.
2. Identify Potential Costs and Benefits
The next step is to compile two lists detailing projected costs and expected benefits. You may begin with direct costs, such as expenses directly related to the proposed project. These may include labor costs, cost of materials, inventory, and manufacturing costs, among others.
Other costs that you may consider include:
- Indirect Costs: These may include utilities that contribute to overhead costs.
- Intangible Costs: Although difficult to quantify, intangible costs include the impact on employees, customer satisfaction levels, and even productivity levels.
- Opportunity Costs: These are benefits or opportunities that might be missed due to pursuing the proposed project.
- Potential Risks: These are also difficult to quantify and include costs associated with regulatory risks, environmental impact, or competition.
As you identify potential costs, consider whether the expenses are recurrent or a one-time cost and whether they are variable or fixed. Remember that costs can also be non-financial, such as negative environmental impact.
At this stage, evaluate possible benefits such as:
- Direct benefits: Increased sales and revenue
- Indirect benefits: Increased customer satisfaction
- Intangible benefits: Improved employee productivity
- Competitive benefits: Vertical movement within the industry
3. Assign Value to Each Cost and Benefit in a Common Currency
Assign a dollar value to each cost to compare them more accurately. If you are uncertain about some of the costs, consider obtaining a range that includes the highest and lowest costs.
Verify when each cost is likely to be incurred and develop a present value using a discount rate which is the weighted average or current market rate.
Direct costs and benefits are easy to evaluate. However, intangible, and indirect costs and benefits might be more difficult to quantify. There are different methods and software that you can use to assign the values.
4. Compute Total Costs and Benefits
Once you have evaluated all your costs and benefits in a common currency, compute each list for comparison.
If the benefits outweigh the costs, the project benefits your business. If the costs outweigh the benefits, reconsider the project. Consider alternatives to your project and identify cost-reduction strategies that may help you achieve your goals more effectively.
Evaluate your project framework and determine whether you are likely to achieve your goals and markers for success.
5. Consider Whether to Implement the Project
Using your findings, summarize the costs, benefits, and overall impact of the proposed project. Present your report to the management and make your recommendations.
It is also important to note that even if the report indicates more benefits than costs, it may not end in implementation.
If a company has limited resources, it may result in a mutually exclusive decision. For instance, even if projected results are positive, if a company does not have enough money or the project poses a risk to its image, it cannot be implemented.
Advantages and Disadvantages of a Cost-Benefit Analysis
Some of the advantages and disadvantages of a cost-benefit analysis include:
Pros:
1. Data-Driven Approach
A cost-benefit analysis allows you to evaluate the proposed project without bias. This evidence-based approach is also more logical and helps you make data-driven decisions.
2. Makes Business Decisions Simpler
Business decisions can be complex. However, this dilemma is less complex with accurate costs versus benefits figures. This level of analysis strengthens your findings, providing better support for planning.
3. Uncovers Hidden Costs and Potential Benefits
A cost-benefit analysis often requires in-depth research across various types of costs and benefits. As a result, you can uncover hidden costs and benefits associated with intangible or indirect costs.
Cons:
1. Challenging to Predict All Variables
Predicting factors such as material costs and market demand may be difficult. Depending on your timelines, some factors, such as the global business environment are also unpredictable long-term.
2. Incorrect Data May Negatively Affect Your Findings
Incomplete or inaccurate data can skew your results.
3. Not Suitable for Long-Term Projects
A cost-benefit analysis is better suited for short and mid-length projects. Projects with longer time frames have the potential to be inaccurate because it is difficult to make accurate projections too far into the future. Factors such as inflation are also difficult to forecast.
4. No Human Element
Cost-benefit analysis does not factor in the human element of a business. This makes it difficult to reconcile the human element and non-monetary reasons in the analysis.
Ultimately, aside from the cost-benefit analysis, there are other tools to plan your business projects. We recommend using different types of economic analysis to evaluate your proposed projects.
