Cost–benefit analysis

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Comparison of the cost of a solution and the economic benefits that would accrue if the solution is put into effect. This analysis is a prerequisite to the installation of an employee benefit plan. Questions to be answered include: (1) will the cost result in greater loyalty of employees? (2) will the cost result in greater productivity; and (3) will the benefits encourage employees to participate in their cost?

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Cost-benefit analysis is the exercise of evaluating an action's consequences by weighing the pluses, or benefits, against the minuses, or costs. It is the fundamental assessment behind virtually every business decision, due to the simple fact that business managers do not want to spend money unless the resulting benefits are expected to exceed the costs. As companies increasingly seek to cut costs and improve productivity, cost-benefit analysis has become a valuable tool for evaluating a wide range of business opportunities, such as major purchases, organizational changes, and expansions.

Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (less tangible, qualitative savings, as in management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.

Although its name seems simple, there is often a degree of complexity, and subjectivity, to the actual implementation of cost-benefit analysis. This is because not all costs or benefits are obvious at first. Take, for example, a situation in which a company is trying to decide if it should make or buy a certain subcomponent of a larger assembly it manufactures. A quick review of the accounting numbers may suggest that the cost to manufacture the component, at $5 per piece, can easily be beat by an outside vendor who will sell it to the company for only $4. But there are several other factors that need to be considered and quantified (if possible):

1. When production of a subcomponent is contracted to an outside vendor, the company's own factory will become less utilized, and therefore its fixed overhead costs have less components over which to be spread. As a result, other parts it continues to manufacture may show an increase in costs, consuming some or possibly all of the apparent gain.
2. The labor force may be concerned about outsourcing of work to which they feel an entitlement. Resulting morale problems and labor unrest could quickly cost the company far more than it expected to save.
3. The consequences of a loss of control over the subcomponent must be weighed. Once the part is outsourced, the company no longer has direct control over the quality, timeliness, or reliability of the product delivered.
4. Unforeseen benefits may be attained. For example, the newly freed factory space may be deployed in a more productive manner, enabling the company to make more of the main assembly or even another product altogether.

This list is not meant to be comprehensive, but rather illustrative of the ripple effect that occurs in real business decision settings. The cost-benefit analyst needs to be cognizant of the subtle interactions of other events with the action under consideration in order to fully evaluate its impact.

A formal cost-benefit analysis is a multi-step process which includes a preliminary survey, a feasibility study, and a final report. At the conclusion of each step, the party responsible for performing the analysis can decide whether continuing on to the next step is warranted. The preliminary survey is an initial evaluation that involves gathering information on both the opportunity and the existing situation. The feasibility study involves completing the information gathering as needed and evaluating the data to gauge the short- and long-term impact of the opportunity. Finally, the formal cost-benefit analysis report should provide decision makers with all the pertinent information they need to take appropriate action on the opportunity. It should include an executive summary and introduction; information about the scope, purpose, and methodology of the study; recommendations, along with factual justification; and factors concerning implementation.

Capital budgeting has at its core the tool of cost-benefit analysis; it merely extends the basic form into a multi-period analysis, with consideration of the time value of money. In this context, a new product, venture, or investment is evaluated on a start-to-finish basis, with care taken to capture all the impacts on the company, both cost and benefits. When these inputs and outputs are quantified by year, they can then be discounted to present value to determine the net present value of the opportunity at the time of the decision.

Further Reading:

Brealey, Richard A. and Stewart C. Myers. Principles of Corporate Finance, 4th ed. McGraw-Hill, 1991.

Dmytrenko, April L. "Cost-Benefit Analysis." Records Management Quarterly. January 1997.

Horngren, Charles T. and Gary L. Sundem. Introduction to Management Accounting. Prentice-Hall, 1990.

Shein, Esther. "Formula for ROI." PC Week. September 28,1998.

Benefit-cost analysis is a technique for assessing the desirability of government projects and policies. The basic idea is simple: Consider alternative policies and identify the one that yields the greatest net gain to society. Benefit-cost analysis has been widely used to compare the positive and negative aspects—measured in terms of reduced mortality, morbidity, property damage, and losses to the natural environment—of policies that affect public health and the environment.

Benefit-cost analysis has been widely used in the design of environmental policies and to help resolve disputes under the U.S. legal system. Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERLA; commonly called the "Superfund" law) governments (local, state, or federal) can seek financial compensation from responsible parties for natural resources that are damaged by releases of hazardous wastes. Benefit-cost analysis can be helpful in putting a price tag on the damaged resources.

Determining the benefits of pollution reduction generally requires assessing the magnitude of the damage caused by that pollution. This involves four key steps: (1) identification of the key types of damage; (2) establishing the physical relationship between the pollutant emissions and the extent of damages caused (dose-response curve); (3) identification of the responses by affected parties to mitigate some (or all) of the damage; and (4) placing a monetary value on the physical damage, including the damage to human health.

All four of these steps can involve difficult technical issues, especially when both scientific and ethical concerns limit the ability to obtain empirical information on the effect of pollution on humans. Expertise in various natural and social science disciplines is required. The focus of economics is on the fourth step of the process (ascertaining the monetary value of the physical damages, including the damage to human health) and on integrating the results of all the steps.

Some have argued, on both moral and technical grounds, that benefit-cost analysis is a flawed environmental management tool. Others have suggested that it is inevitable, since if it is not done explicitly, with a careful consideration of alternative options, it will occur implicitly. In that case, decision making will be driven by public fears, special-interest lobbying, and bureaucratic preferences.

Three major functions of economic analysis in the regulation of health, safety, and the environment have been identified: (1) arraying information about the benefits of proposed regulations;(2) revealing potentially cost-effective alternatives; and (3) showing how benefits and costs are distributed (e.g., geographically, temporally, and among income and racial groups). However, the same economists also argue that "in many cases, benefit cost analysis cannot be used to prove that the economic benefits of a decision will exceed or fall short of the costs … [but] … it can provide illuminating evidence for a decision, even if precision cannot be achieved" (Arrow et al., 1996).

(SEE ALSO: Acceptable Risks; Benefits, Ethics, and Risks; Cost-Effectiveness; Environmental Impact Statement; Risk Assessment, Risk Management)

Bibliography

Arrow, K. et al. (1996). Benefit-Cost Analysis in Environmental, Health, and Safety Regulation: A Statement ofPrinciples. Washington, DC: American Enterprise Institute, The Annapolis Center, and Resources for the Future.

— RICHARD D. MORGENSTERN

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A technique whereby projected public schemes are evaluated in terms of social outcomes as well as the usual profit and loss accounting. The technique begins with an assessment of the costs, benefits, and drawbacks of the scheme, including externalities, such as the generation of noise and other forms of pollution. Financial values are assigned to these, including qualities like aesthetic appearance, which are not usually associated with cost. As most major projects are developed over a long period of time, costs must reflect future conditions. The decision whether to implement the project is made in the light of the comparison between the costs of the project and the likely benefits.

This method is far from trouble free. It is difficult to determine which items should be included, and difficult to put a price on intangibles, such as aesthetic experience (a new power station might be efficient, but extremely ugly; and controversy has raged over ‘costing’ the destruction of Sites of Special Scientific Interest, such as that at Twyford Down, cut through by the M3). The discounting of future costs is particularly problematic, especially as the discount value, which could be based on current interest rates or on a figure set by the government, is often the key variable. Even then, moral judgements have to be made—which group in society should benefit? Should as much weight be given to benefiting the rich as to the poor? These are political questions which cost-benefit analysis cannot answer.

A technique of constructing a balance sheet of the consequences of a project or activity. By definition, it is a method of assessment which uses monetary units. When used by a private company it is essentially a way of calculating what profit or loss can be expected, but it goes beyond simple versions of such a calculation by insisting on a ‘full balance sheet’. On the cost side, for example, this would include the ‘opportunity cost’ of the resources involved, including the income which might be derived from investing available money in assets which carry the minimum risk. Benefits might include good publicity for the company, so that a nominal loss on a project might be shown by cost-benefit analysis to be a real gain.

In the sphere of public investment, cost-benefit analysis takes on extra dimensions of complexity, since it is required to assess the full range of costs and benefits not just to the municipal or nationalized company involved, nor even to the government, but to the whole population. In such a calculation all social costs and benefits must be assessed, including those which are ‘external’ to the transactions involved, which would not be considered by a private company. A calculation as broad as that is tantamount to duplicating the felicific calculus of Benthamite utilitarianism in terms of money, a point which has been generally accepted by enthusiasts and critics alike.

Supporters of cost-benefit analysis argue that it is part of the very idea of rational decision-making. How else are we to find out whether it is better to spend our investment in health or saving lives or alleviating pain? What else can tell us whether the advantages of a new motorway or airport outweigh its disadvantages? Critics regard it as a pseudo-science, a distortion of the values it seeks to assess and an attempt to reduce the serious and evaluative problems of political decision-making to bogus technicalities.

— Lincoln Allison

An analysis of a construction contract with the objective of identifying all the included costs and evaluating their benefits.

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A method by which the benefits of pursuing a particular action can be weighed against the costs of pursuing that action. It is suggested that a cost-benefit analysis could be applied to a number of sport situations. Coaches, for example, have been urged to employ the notion that anticipation has certain benefits and costs, and that whether or not to anticipate in a certain situation should be determined by weighing the probable gains against potential losses.

A process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted. Some consultants or analysts also build the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town. Most analysts will also factor opportunity cost into such equations.

Investopedia Says:
Prior to erecting a new plant or taking on a new project, prudent managers will conduct a cost-benefit analysis as a means of evaluating all of the potential costs and revenues that may be generated if the project is completed. The outcome of the analysis will determine whether the project is financially feasible, or if another project should be pursued.

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n

The comparative study of the service or production costs of a service or item and its value to the subject.

For a list of words related to cost-benefit analysis, see:

• Economics and Economic Theory - cost-benefit analysis: ratio of dollar cost of project to dollar benefit it will produce, used to compare worthiness of various proposed projects

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