Cost-benefit analysis is used for determining which alternative is likely to provide the greatest return for a proposed investment. Sometimes referred to as cost-effectiveness analysis, it is relevant to businesses as well as to not-for-profit entities and governmental units. A business might find it helpful to use cost-benefit analysis to determine if additional funds should be invested in a facility in the home country or in another country. A community not-for-profit organization that provides a variety of programs for children might use costbenefit analysis to assist management in determining which activities will provide the most services for the costs specified. A federal governmental agency might use costbenefit analysis to determine which of several projects planned for the national parks is likely to be most used by interested citizens, given the costs. This post gives a general overview of the cost-benefit analysis both for business and non-business analysis. Enjoy!
Because resources such as money and time are limited, an organization usually cannot undertake every project proposed. To decide whether to undertake a project, decision makers weigh the benefits from the project against the cost of the resources it requires, normally approving a project when its benefits exceed its costs. Cost-benefit analysis provides the structure and support for making such decisions.
Benefits increase the welfare of the organization. Some benefits are monetary benefits, such as the dollar amount of cash inflows from additional sales of a product or the saving in cash outflows that a project enables. Other benefits are important but harder to quantify. For example, a project may increase customer satisfaction; increased customer satisfaction may increase future sales, but the exact relationship between sales and satisfaction is often hard to specify. Costs are the outlays or expenditures made in order to obtain a benefit. Many costs are measured monetarily, such as the cost of buying a new machine or of hiring an additional employee.
Cost-Benefit Analysis In Business
A cost-benefit analysis is straightforward when all costs and benefits are measurable in monetary terms:
- Assume that Company A must decide whether to rent an ice cream machine for the summer for $900. The ice cream machine will produce additional cash inflows of $1,000 during the summer. The benefit of additional cash inflows ($1,000) exceeds the additional cost ($900), so the project should be undertaken. Not all cost benefit analyses are this simple, however. If the benefits and costs occur in different time periods, it may be necessary to discount the future cash flows to their current equivalent worth.
- In another example, cost savings is a benefit. Assume that Company B makes about 100,000 photocopies a year. Company B does not have its own copy machine and currently pays 4 cents per copy, or $4,000 a year, to outsource copiers. Company B can lease a copy machine for $2,500 a year. It must also pay 2 cents per page for paper for the leased machine, or $2,000. In this example, the cost of leasing the machine and buying paper ($2,500+$2,000=$4,500) exceeds the benefit of saving the $4,000 normally paid to outsource copiers. Company B should continue to use an outsource copiers for its photocopies. However, Company B must have a pretty good estimate of the number of copies it needs to be comfortable with its decision. If Company B needs 150,000 copies this year instead of 100,000, the cost of the leasing the machine and buying paper ($2,500+$3,000=$5,500) is cheaper than the $6,000 (150,000 x $0.04) savings in fees to the outsource copiers.
- A third example involves a project with benefits that are difficult to quantify. Assume that Company C is deciding whether to give a picnic costing $50,000 for its employees. Company C would receive the benefit of increased employee morale from the picnic. Better employee morale might cause employees to work harder, increasing profits. However, the link between increased morale and increased monetary profits is tenuous. The decision maker must use his or her judgment to compare the nonmonetary benefit to the monetary cost, possibly deciding that increased employee morale is worth the $50,000 cost but would not be worth a $100,000 cost.
In the preceding examples, cost-benefit analysis provided a framework for decision making. The range of objectivity related to measurement of the factors is typical. Techniques used in business as a basis for determining costs and benefits, such as return on investment, are generally quantifiable and thus appear to be objective. However, it is not uncommon for qualitative factors to enter into the decision-making process. For example, providing a product that individuals with limited incomes will be able to purchase may not provide the highest monetary return on investment in the short run, but might prove to be a successful long-term investment. Careful decision makers attempt to deal with a difficult-to-quantify factor in as objective a manner as possible. However, cost-benefit analysis in most situations continues to introduce measurement problems.
Cost-Benefit Analysis In Non-business Entities
Cost-benefit analyses are also common in nonbusiness entities. Boards of not-for-profit organizations establish priorities for their programs, and such priorities often specify desired program outputs. For example, assume a not-for-profit organization is interested in reducing the level of illiteracy among the citizens of a rural community in a state that has one of the lowest per-capita incomes in the United States. As alternative programs for those who need to learn to read are considered, there will be costbenefit analyses that focus on a number of factors, including the extent to which a particular program can attract those who are illiterate. A program in the downtown area of a small town might be considered because a facility is available there at low cost, and that low cost is appealing.
Focus on cost is not sufficient, however. When benefits are considered, it might become clear that those who are eager for such a program do not have cars and that there is no public transportation from where they reside to the center of the small town. Further consideration of relevant factors and of alternatives, undertaken in good faith, should result in cost-benefit analyses that provide valuable information as the agency makes decisions.
At all levels of government in the United States, costbenefit analyses are used as a basis for allocating resources for the public good to those programs, projects, and services that will meet the expectations of citizens. For example, decision makers at the federal level who have policy responsibility for environmental standards, air-quality rules, or services to the elderly often find information from cost-benefit analyses to be critical to the decisionmaking task.
As possibilities for the use of funds increase, there is motivation for better measurement of both costs and benefits as well as for speedier ways of accomplishing analyses for alternatives that are appealing. All types of entities, including businesses, not-for-profit organizations, and governmental units, strive to improve the measurements used in cost-benefit analyses. The capabilities of electronic equipment provide promising assistance in accumulating data relevant for analyses. Wise use of resources is an important goal in every organization; cost-benefit analyses make a key contribution to this goal. Therefore, attention is given to improving both the effectiveness and efficiency of such analyses.
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