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What is cost-benefit analysis and how can it be used?

Study guide




Imagine you have just started a new project. The workload has increased and your people are working hard to finish the project on time. You were wondering if you should hire a new member for your group. The decision is not easy. There are many things to consider, and this is where cost-benefit analysis comes into play.

tip:

CBA or cost-benefit analysis is a quick and easy way you can use to make insensitive financial decisions. Other approaches, such as using net present value and internal rate of return, are often more appropriate when deciding on critical missions or involving large amounts of money.

About tools

The French engineer and economist Jules Dupuit introduced the concepts of the CBA in the 1840s. These concepts became popular in the 1950s as a simple way to measure the costs and benefits of projects, and people used those concepts to determine whether or not to pursue a particular project.

As the name implies, cost-benefit analysis is the calculation of the benefits of a series of activities and then comparing them with the associated costs.

The results of this analysis are often expressed as a repayment period. That is, when these benefits are needed to recoup their costs. Many people who use this method seek repayment in less than a certain period (for example, three years).

You can use this method in many different situations. for example:

  • Deciding to hire a new member for the group;
  • Evaluate new projects with changes in initial steps;
  • Possibility of return on investment to purchase new equipment.

Keep in mind that this method is great for quick and easy financial decisions. Broader approaches are often used for more complex, critical, and costly decisions.

How to use this tool

Follow these steps for cost-benefit analysis:

Step # 1- Discovering Your Purpose

First, take the time to list all the costs associated with this project with a brainstorming session. Then do the same for all the benefits of the project. Can you predict the unexpected cost as well? Are there benefits you may not have anticipated in the beginning?

Once you find the costs and benefits, think about the length of the project. What are the potential costs and benefits of taking too long?

Step # 2- Discovering Your Purpose

By costs we mean the costs of the physical resources required as well as the costs associated with the human resources involved in all stages of the project. Costs (compared to revenues) are often easily, relatively easily estimated.

You need to think about the costs as much as you can. For example, how much will training cost? Will productivity decrease when people are learning a new system or technology? How much does this reduction in efficiency cost?

Think about the costs that will continue after the project is completed. Consider, for example, if your team needs on-the-job training, or if your workload increases, will you need more staff?

Step # 3- Discovering Your Purpose There is no such thing as a “financial value”

This stage is more ambiguous than the previous two stages. Because:

  1. Accurate revenue forecasting is often difficult, especially for new products.
  2. In addition to the financial benefits you anticipate, there are often intangible or quantitative benefits that are important project outcomes.

For example, what is its impact on the environment and employee satisfaction or their health and safety? What is the monetary value of that effect?

For example, is the preservation of an ancient monument worth 500 million tomans or is it worth 5 billion tomans because of its historical significance? Or how much is it worth to go to work in the morning without danger and stress? Here it is important to consult with other stakeholders and decide how to value these sensitive items.

Step 4: Compare the costs and benefits

Finally, compare the value of your expenses with the value of your benefits, and use this analysis to make decisions about your set of actions.

To do this, calculate your final costs and benefits, and compare the two values ​​to determine if your benefits outweigh your costs. At this stage, it is also important to pay attention to the repayment time to understand how long it takes to reach a tie. A situation where the benefits have reimbursed the costs.

For simple examples that receive the same benefits in each period, you can calculate the payback period by dividing the final cost of the project by the final revenue:

The final cost divided by the final income (or benefits) is equal to the length of time (repayment period)

Example

A graphics company has been around for almost a year now, with sales exceeding expectations. Two designers are currently working full-time at the company, and the CEO is considering increasing its capacity to meet demand. (This increase in capacity includes renting more space and hiring two new designers.)

He decides to do a cost-benefit analysis to look at his choices.

assumptions

  • At present, the work entrusted to the company is more than its capacity can be done by its employees, and the CEO of the company outsources some of the work to other design companies for 50,000 Tomans per hour. The company outsources 100 hours of work per month.
  • He estimates that as capacity increases, revenue will increase by up to 50 percent.
  • With a larger workspace, production will increase by up to 10% per person.
  • The horizon for this analysis is one year, meaning he expects to make a profit within a year.

Costs

Grouping Description Cost in the first year
Rent 70 square meters in the neighborhood, 195 thousand tomans per square meter 13 million and 500 thousand
Renovation of rented space Demolish the walls and rebuild the office space 15 million
Hiring two other designers salary and benefits

The cost of hiring

Education

75 million

11 million and 250 thousand

3 million

Workspace for two others Furniture and hardware

Software license

6 million

1 million

Closed due to reconstruction Two weeks and approximately 7 million and five hundred thousand tomans per week 15 million
Total 139 million and 750 thousand

Benefits

Benefit Profit for 12 months
50% increase in revenue 195 million
Pay 15,000 Tomans per hour to the company’s designers for 50,000 Tomans per hour outsourcing (100 hours per month, which is equal to an average of 3 million and five hundred thousand Tomans per month savings) 42 million
10% improvement in return per designer (7500000 + 3750000 = 1125000 Tomans Income per week, which is equal to 10% increase equal to 1125000 Tomans per week) 58 million and 500 thousand
Improve customer service and do 100% in-house design 10 million
Total 305 million and 500 thousand

He calculates the repayment time as follows:

139,750,000 Tomans divided by 305,500,000 Tomans is equal to 0.46 one year or approximately 5.5 months

Benefit estimates are inevitably subjective, and there is some uncertainty about the projected increase in revenue. Given that in the first year the benefits outweigh the costs, the graphic company owner decides to develop the company and hire people.

Disadvantages of cost-benefit analysis

The cost-benefit analysis method, although sometimes a good tool, has its drawbacks; Especially when incomes vary from period to period. In such cases, instead of using cost-benefit analysis, you should use net present value (NPV) and internal rate of return (IRR) calculations together to evaluate the project. (These methods also have the advantage of using the time value of money in calculations.)

On the other hand, it is very difficult to predict the income that can be obtained from a project, and the value that people perceive for the intangible benefits of the project is largely subjective and abstract. This makes valuing potential revenues uncertain. (This flaw exists in many financial valuation approaches)

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