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Cost Benefit Analysis Example and Calculation Steps (CBA Example)
In today’s economic environment, it is fundamental to use financial tools and techniques to support organizational decision making before you decide to start a new business or make a sweeping change in your current workstream. Organizations across all industries – from construction to the chemical, use various decision-making tools to become successful in their field. Basically, Cost Benefit Analysis Methodology (also known as Benefit Cost Analysis) is a mathematical approach that allows organizations to compare the costs and expected benefits of two or more projects by employing some basic steps. In this article, we will analyze simple but real-world Cost Benefit Analysis Examples and Calculation steps by discussing how net present value is related to it.
What is Cost Benefit Analysis Methodology?
Most probably you have been using the Cost Benefit Analysis Methodology in your life while purchasing a new car or deciding to move to a new apartment. Because calculating the costs and returns of a decision is an integral part of anybody’s life.
Obviously, every project has a list of expenses and incomes. You need to calculate the net present value (NPV) and payback period to evaluate each of them. Basically, cost benefit analysis is a decision-making tool widely used in finance and economics. It is applicable to many industry projects such as IT, software development, construction, education, healthcare, and information technology.
Generally speaking, the main purpose of tracking the Cost Benefit analysis steps is to calculate the ratio of benefits over costs. Simply put, a Cost Benefit Analysis is conducted to identify how well, or how poorly, a project will be concluded.
A Brief History
A French economist and engineer Jules Dupit, who used this tool before in a bridge project, introduced the concept of CBA in his article in 1848. After this date, a famous economist Alfred Marshall structured this approach in his book” Principles of Economics” in 1890. The U.S. Army Corps of Engineers has been using Cost Benefit Analysis since the 1930s for many projects such as federal waterway infrastructure.
What Makes Cost Benefit Analysis Important?
As mentioned above, Cost Benefit Analysis is a systematic approach widely used in economics that takes into consideration the net present value of costs and expected benefits. It helps to minimize risks and maximize incomes both for your project and your company.
For example, you can use it while deciding to purchase a real estate property or undertake a new project.
But, what is the purpose of making a CBA for an investment?
Basically, Cost Benefit Analysis Methodology serves two purposes ;
- To verify that an investment’s (or a project’s) expected benefits are more than its costs.
- To select an investment (or a project) by comparing their benefits over cost ratios.
In order to make a comparison between the positive and negative aspects of the alternatives, a common unit is required. Money is the common unit used for comparison of alternatives.
In financial analysis, the time value of money is an important factor to consider. While performing a CBA calculation future costs and expected benefits of an investment are converted into the present value by using a discount rate.
Conducting a cost benefit analysis provides a methodology to decision-makers for weighing up a decision such as purchasing a new home or expanding sales in a new region.
It can be conducted by big companies as well as individuals while selecting the most effective alternative.
Cost Benefit Analysis Steps
Whether you are working in the private sector or in the public sector, it is essential to write down all the parameters while you are making a decision such as establishing a new program or expanding a current system. Below are essential steps that you can use while performing a cost benefit analysis.
- Build the structure: Analyze the current status of the change and determine all the requirements clearly.
- Determine the stakeholders: Determine who will be impacted by the change, who will bear the costs, and who will obtain the benefits.
- Categorize the costs and benefits: Categorize and classify costs and benefits as direct, indirect, tangible, and intangible in order to determine their effects clearly.
- Project both costs and benefits: Project and evaluate how costs and benefits change over the lifespan of the program/change. Because all the calculations will be affected by duration.
- List the costs as a monetary value
- List the benefits as a monetary value
- Use Net Present Value to adjust the future cash flows and costs to the present day.
- Calculate payback period
- Perform sensitivity analysis
- Evaluate the results
Cost Benefit Analysis and Net Present Value
Before to analyze a cost benefit analysis example and calculation steps, let’s discuss how net present value is related to cost benefit analysis. Whether you are planning to undertake a large project or buying a desktop computer for office works, you need to weigh the expected costs against benefits to take the right decision. Therefore, you must compare both costs and benefits on equal terms. That’s why you need the net present value calculations.
In finance, the time value of money concept holds that 1 USD today has a greater value than 1 USD in the future. Therefore, while making a CBA, you need to bear in mind the time value of money. Using a discount rate adjusts the future cash flows to the present day. However, to provide simplicity, we will use the discount rate as “1” in our example.
Cost Benefit Analysis and Net Present Value Example
Net Present Value (NPV) relies on the following decision;
- The value of money today is greater than the value of money later on.
Because money is a tool to make more money! You can buy and sell goods or start a new business, so that earn more money with your current capital.
In our cost benefit analysis example, your company is deciding to undertake a project which longs for three years. The expected total project cost is $ 15,000 today and the expected income after three years will be $25,000. The discount rate is 10%.
Now we will analyze if that is a good investment or not by using Cost Benefit Analysis and Net Present Value.
The Value of Money Today: $ 15,000.
The Present Value (PV) of $ 25,000 is;
PV= $ 25,000 / (1,10 × 1,10 × 1,10) = $ 18,783 now (to nearest cent)
So, if the discount rate is %10, that investment is worth $ 3783. Your company can undertake the project because $ 3783 is a positive value.
A Simple Cost Benefit Analysis Example and Calculation Steps
Let’s assume that a board chairman of a construction company claims his team to make a comparison between two potential real estate development projects. He also reminds them that the company’s financial health is getting poor so he has to select one of them.
The team works and lists below the potential incomes and costs of each project.
Assumptions
Note: In order to simplify the cost benefit analysis example , we will not use a discount rate for each cost and income.
– 500 housing units will be constructed. – 400 of them will be sold and 100 of them will be rented for 20 years. – Rental Price of each unit is 4,000 USD per year – Rented 100 units will be sold 70,000 USD after 20 years. – Construction Cost of each unit is 100,000 USD. – The sale price of each unit is 120,000 USD. – The project needs a luxury sales office with a price of 2,000,000 USD. – The sales personnel cost is 300,000 USD per year. – The project duration is 3 years. – Project financing cost is 3,000,000 USD per year
– 400 housing units will be constructed. – 350 of them will be sold and 50 of them will be rented for 15 years. – Rented 50 units will be sold 80,000 USD after 15 years. – Rental Price of each unit is 4,500 USD per year – Construction Cost of each unit is 90,000 USD. – The sale price of each unit is 135,000 USD. – The project needs a luxury sales office with a price of 3,000,000 USD. – The sales personnel cost is 250,000 USD per year. – The project duration is 2 years. – Project financing cost is 2,500,000 USD per year
Comparing the Project Parameters
In this cost benefit analysis example , we will calculate the amount of money to be spent and the amount of money to be earned from each project to address economic efficiency.
Below table summarizes all the given project parameters.
Cost Calculations
Below table summarizes the project costs.
Benefit Calculations
Below table summarizes the project benefits.
Costs and Benefits Comparison
Cost Benefit Analysis-Costs and Benefits Comparison
In this simple cost benefit analysis example , there are too many parameters affecting the board’s decision. Financing costs per year, units for sale, units for rent, total units to be constructed are some of them that make decision making difficult.
The above table summarizes the benefits, costs, and profits of each project. Although the income of Project 1 is more than Project 2, the costs of Project 2 are less than the costs of Project 1.
It is obvious that Project 2 is more profitable than Project 1. If the board chairman selects Project 2, the company will earn more profit by spending less money.
This simple example shows that Cost Benefit Analysis is a useful calculation tool in economics. Decision makers often use it while comparing multiple projects.
Another Real-World Cost Benefit Analysis Example
In the following cost benefit analysis example, three basic steps;
- Conducting a brainstorming session to determine all the costs and benefits related to the decision.
- Assigning a monetary value to all the costs.
- Assigning a monetary value to all the benefits.
- Comparing costs and benefits to calculate the payback period.
Assume that you have a software company operating for three years and you are planning to speed up the delivery dates in order to meet the market demand. You have five coders working full time but you need three more coders to facilitate the testing process. Hiring three more coders requires additional investments such as buying additional furniture, computers, and leasing additional workspace.
- Yearly revenue is $100,000 but it will increase by %30 as the capacity increases.
- Every month you are outsourcing an average of 200 hours of work with a cost of $80 per hour to another software company for testing.
- The productivity of team members will increase by %5 with a more comfortable office environment.
In this cost benefit analysis example, payback period can be calculated as;
$175,000 / $213,008 = 0.821 of a year, or approximately 10 months.
It is often difficult to estimate the benefits rather than estimating costs. Because benefits are subjective and can be affected by the estimator’s bias. On the other hand, as a decision-making tool in economics, the cost benefit analysis often guides decision-makers to select the most effective alternative.
Cost Benefit Analysis Excel Examples
ABC Chemical Ltd. is deciding which investment alternative is feasible considering costs and benefits of each of them.
Alternative 1
- Total Costs of Alternative 1 = $ 88.000.000.
- Expected Benefits s of Alternative 1 = $ 108.000.000
Alternative 2
- Total Costs of Alternative 2 = $ 11.000.000.
- Expected Benefits s of Alternative 2 = $ 23.000.000
Let’s decide which alternative ABC Chemical Ltd . should choose?
In order to decide which alternative is profitable, we will calculate the benefit-cost ratio for each one through a spreadsheet.
= $ 108.000.000 / $ 88.000.000
Benefit-Cost Ratio = 1,23
= $ 23.000.000 / $ 11.000.000
Benefit-Cost Ratio = 2,09
According to Benefit-Cost Ratio calculations of Alternative 1 and Alternative 2, both investment opportunities have positive outcomes. In other words, both alternatives are beneficial for ABC Chemical Ltd. So the company will be in a good position it selects any of the alternatives. However, in that example, benefit-cost ratio of Alternative 2 is higher than benefit-cost ratio of Alternative 1. So, according to the Cost Benefit Analysis, ABC Chemical Ltd. should select Alternative 2, in the light of the information given above.
Fox Car Maintenance Company is thinking to expand its current repair shop, and for that purpose, it will require additional vehicle mechanics and equipment. The owner of the company decides to make a cost benefit analysis to understand if that investment is beneficial or not. Here below you can find all the parameters related to costs and benefits.
- Hiring 5 more vehicle mechanics will provide a revenue increase by 45 % within one year. This expansion is planning to bring a revenue of $ 220.000.000.
- This expansion will increase the brand awareness of Fox Car Maintenance Company. Thus, this will bring additional revenue of $ 40.000.000.
- The salary of the new vehicle mechanics is around $ 110,000.
- The purchase cost of new equipment is $ 20,000.
- The cost of additional electrical and mechanical infrastructure will be around $ 15,000
Let’s perform a Cost Benefit Analysis for the given example.
Total Benefits (TB)
- Total benefits of the expansion: Increase in revenue of hiring 5 more vehicle mechanics + Increase in revenue of brand awareness
- TB: $ 220.000.000 + $ 40.000.000 = $ 260.000.00
Total Costs (TC)
- Total costs of the expansion: Salary of additional employees + purchase cost of new equipment + cost of additional electrical and mechanical infrastructure.
- TC: $ 110,000 + $ 20,000 + $ 15,000
- TC: $ 145,000
Now we will make the calculations by using Excel.
According to the Benefit-Cost Ratio calculations, the expansion of the current repair shop has positive outcomes. The Fox Car Maintenance Company should expand its business and employ new vehicle mechanics as well as purchasing new equipment and build new infrastructures.
Where to Use Cost Benefit Analysis? Example Scenarios
As discussed above, cost benefit analysis facilitates the course of the decision-making process across a wide variety of areas. It is applied to many disciplines from business to finance. You can take advantage of using cost benefit analysis when;
- Comparing two or more projects
- Deciding whether to start a new business
- Making the right hiring decisions
- Comparing investment opportunities
- Evaluating social benefits
- Evaluating policies
- Making decisions regarding changes
These simple but real-world cost benefit analysis examples show how to conduct cost benefit analysis in different situations. It is important to bear in mind the intangible benefits such as customer satisfaction, environment, employee satisfaction, or health and safety, historical importance while making cost benefit or benefit cost analysis in economics.
Because benefits do not only consist of revenues obtained from business actions but also consist of intangible factors. In order to make a correct cost benefit analysis, you need to calculate the current worth of future earnings with the help of financial techniques such as net present value.
Sometimes it may be difficult to compare the options that have very close values. At this stage, intangible factors affect the final decision.
Generally, these kinds of analyses are evaluated by high-level stakeholders, top management, and board members. After the selection of the project, they start the process of developing the project charter .
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Further Reading
[1] The social CBA
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ensoft, a software house, is considering developing a payroll application for use in academicinstitutions and is currently engaged in a cost-benefit analysis. Study of the market has shownthat, if they target it efficiently and no competing products become available, they will obtain ahigh level of sales generating an annual income of £800,000. They estimated that there is a 1 in10 chance of this happening. However, a competitor might launch a competing applicationbefore their own laun
NEED SOLUTION
The Board of Quest plc is due to meet to consider investing in a new project which will allow the company to diversify its existing product range. Before the meeting the Finance Director, has asked you, to evaluate the project using the following information.
Market research has been undertaken at a cost of HK$500,000 which shows that the project will result in the following cash flows:
Sales volume (units)
Selling price (HK$/unit)
Variable cost (HK$/unit)
Fixed costs (HK$)
These forecasts are after taking account of selling price inflation of 3·0% per year, variable cost inflation of 6·0% per year and fixed cost inflation of 3·5% per year.
In addition included in the fixed costs is a figure of HK$1,000,000 which represents an apportionment of general overheads. The balance of the fixed costs are incremental fixed costs which are associated with the new project.
The total machinery costs of the project in year 0 are estimated to be HK$40,000,000 and the machinery from the project will be sold for scrap with a value of HK$4,000,000 at the end of year 4.The company will also have to spend HK$ 3,000,000 refurbishing the building before the new machinery can be installed.
Quest plc pays corporation tax of 25% per year. This is paid in the following year (i.e. one year in arrears) Capital allowances on an 18% reducing balance basis are available on the machinery only. A balancing charge or allowance is available at the end of the fourth year of operation.
Quest plc has a real cost of capital of 9% and the general rate of inflation is 3.7%
Recommend to the Board whether the project should be undertaken by: Calculating the nominal after-tax Net Present Value of the new project using the money cost of capital.(Round to the nearest whole number)
Calculating the Internal Rate of Return of the new project.
After the Board meeting, you were asked to consider the risk of the project and you have reported back to the board that the Expected Net Present Value and the Standard Deviation of the project are HK$1,290,000 and HK$1,640,000 respectively.
Calculate the percentage probability that the project will be value destroying (you can assume a normal distribution of outcomes.) and briefly discuss the difficulties of using probability analysis in incorporating risk into investment appraisal.
One of the directors thinks that incorporating inflation into the calculation in the way outlined above is too time consuming and just adds more costs to the business without giving a significant benefit.
Explain one other way that inflation can be incorporated in the NPV calculation and discuss which method you think the company should adopt.(use the figures above to support your answer)
can I have an example of cost-benefit analysis of a road construction project in excel form. please.
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What Is a Cost-Benefit Analysis?
- Understanding CBA
- The Process
- Limitations
- Cost-Benefit Analysis FAQs
The Bottom Line
- Business Essentials
What Is Cost-Benefit Analysis, How Is it Used, What Are its Pros and Cons?
Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
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Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.
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Michela Buttignol / Investopedia
A cost-benefit analysis is a systematic process that businesses use to analyze which decisions to make and which to forgo. The cost-benefit analyst sums the potential rewards expected from a situation or action and then subtracts the total costs associated with taking that action. Some consultants or analysts also build models to assign a dollar value on intangible items, such as the benefits and costs associated with living in a certain town.
Key Takeaways
- A cost-benefit analysis is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action.
- A cost-benefit analysis involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
- A cost-benefit analysis can also include intangible benefits and costs or effects from a decision such as employees morale and customer satisfaction.
- More complex cost-benefit analysis may incorporate sensitivity analysis, discounting of cashflows, and what-if scenario analysis for multiple options.
- All else being equal, an analysis that results in more benefits than costs will generally be a favorable project for the company to undertake.
Cost-Benefit Analysis (CBA)
Understanding cost-benefit analysis.
Before building a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs and revenues that a company might generate from the project. The outcome of the analysis will determine whether the project is financially feasible or if the company should pursue another project.
In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-making process. Opportunity costs are alternative benefits that could have been realized when choosing one alternative over another. In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision.
Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis. By considering all options and the potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.
Finally, the results of the aggregate costs and benefits should be compared quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company should likely avoid the project.
With cost-benefit analysis, there are a number of forecasts built into the process, and if any of the forecasts are inaccurate, the results may be called into question.
The Cost-Benefit Analysis Process
There is no single universally accepted method of performing a cost-benefit analysis. However, every process usually has some variation of the following five steps.
Identify Project Scope
The first step of a cost-benefit analysis is to understand your situation, identify your goals, and create a framework to mold your scope. The project scope is kicked off by identifying the purpose of the cost-benefit analysis. An example of a cost-benefit analysis purpose could be "to determine whether to expand to increase market share " or "to decide whether to renovate a company's website".
This initial stage is where the project planning takes place, including the timeline, resources needed, constraints, personnel required, or evaluation techniques. It is at this point that a company should assess whether it is equipped to perform the analysis. For example, a company may realize it does not have the technical staff required to perform an adequate analysis.
During the project scope development phase, key stakeholders should be identified, notified, and given a chance to provide their input along the process. It may be wise to include those most impacted by the outcome of the analysis depending on the findings (i.e. if the outcome is to renovate a company's website, IT may be required to hire multiple additional staff and should be consulted).
Determine the Costs
With the framework behind us, it's time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs. Costs may include the following.
- Direct costs would be direct labor involved in manufacturing, inventory, raw materials , manufacturing expenses.
- Indirect costs might include electricity, overhead costs from management, rent, utilities.
- Intangible costs of a decision, such as the impact on customers, employees, or delivery times.
- Opportunity costs such as alternative investments, or buying a plant versus building one.
- Cost of potential risks such as regulatory risks, competition, and environmental impacts.
When determining costs, it's important to consider whether the expenses are reoccurring or a one-time cost. It's also important to evaluate whether costs are variable or fixed; if they are fixed, consider what step costs and relevant range will impact those costs.
"Costs" can be financial (i.e. expenses recorded on an income statement) or non-financial (i.e. negative repercussions on the community).
Determine the Benefits
Every project will have different underlying principles; benefits might include the following:
- Higher revenue and sales from increased production or new product.
- Intangible benefits, such as improved employee safety and morale, as well as customer satisfaction due to enhanced product offerings or faster delivery.
- Competitive advantage or market share gained as a result of the decision.
An analyst or project manager should apply a monetary measurement to all of the items on the cost-benefit list, taking special care not to underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning a value to both costs and benefits for a cost-benefit analysis.
Analysts should also be aware of the challenges in determining both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales quantities, customer demands, and product expectations. Implicit costs, on the other hand, may be difficult to calculate as there may be no simple formula. For example, consider the example above about increasing employee satisfaction; there is no formula to calculate the financial impact of happier workers.
Compute Analysis Calculations
With the cost and benefit figures in hand, it's time to perform the analysis. Depending on the timeframe of the project, this may be as simple as subtracting one from another; if the benefits are higher than the cost, the project has a net benefit to the company.
Some cost-benefit analysis require more in-depth critiquing. This may include:
- Applying discount rates to determine the net present value of cashflows.
- Utilizing various discount rates depending on various situations.
- Calculating cost-benefit analysis for multiple options. Each option may have a different cost and different benefit.
- Level-setting different options by calculating the cost-benefit ratio.
- Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes.
Make Recommendation and Implement
The analyst that performs the cost-benefit analysis must often then synthesize findings to present to management. This includes concisely summarizes the costs, benefits, net impact, and how the finding ultimately support the original purpose of the analysis.
Broadly speaking, if a cost-benefit analysis is positive, the project has more benefits than costs. A company must be mindful of limited resources that might result in mutually-exclusive decisions. For example, a company may have a limited amount of capital to invest; although a cost-benefit analysis of an upgrade to its warehouse, website, and equipment are all positive, the company may not have enough money for all three.
Not all cost-benefit analysis that result in net benefit should be accepted. For example, a company must consider the project's risk, coherence to its company imagine, or capital limitations,
Advantages of Cost-Benefit Analysis
There's plenty of reasons to perform cost-benefit analysis. The technique relies on data-driven decision-making; any outcome that is recommended relies on quantifiable information that has been gathered specific to a single problem.
A cost-benefit analysis requires substantial research across all types of costs. This means considering unpredictable costs and understanding expense types and characteristics. This level of analysis only strengthens the findings as more research is performed on the state of outcome for the project that provides better support for strategic planning endeavors.
A cost-benefit analysis also requires quantifying non-financial metrics (i.e. what is the financial benefit of increased employee satisfaction?). Although this may be difficult to assess, it forces the analyst to consider aspects of the project that are more difficult to measure. The ultimate result of a cost-benefit analysis is to deliver a simple report that makes it easier to make decisions.
Limitations of the Cost-Benefit Analysis
For projects that involve small- to mid-level capital expenditures and are short to intermediate in terms of time to completion, an in-depth cost-benefit analysis may be sufficient enough to make a well-informed, rational decision. For very large projects with a long-term time horizon, a cost-benefit analysis might fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money.
One of the benefits of using the net present value for deciding on a project is that it uses an alternative rate of return that could be earned if the project had never been done. That return is discounted from the results. In other words, the project needs to earn at least more than the rate of return that could be earned elsewhere or the discount rate.
However, with any type of model used in performing a cost-benefit analysis, there are a significant amount of forecasts built into the models. The forecasts used in any cost-benefit analysis might include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If one or two of the forecasts are off, the cost-benefit analysis results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis.
Cost-Benefit Analysis
Requires data-driven analysis
Limits analysis to only the purpose determined in the initial step of the process
Results in deeper, potentially more reliable findings
Delivers insights to financial and non-financial outcomes
May be unnecessary for smaller projects
Requires capital and resources to gather data and make analysis
Relies heavily on forecasted figures; if any single critical forecast is off, estimated findings will likely be wrong.
What Are the 5 Steps of Cost-Benefit Analysis?
The broad process for a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform analysis of both costs and benefits, and to make a final recommendation. These steps may vary from one process to another.
What Is the Main Goal of Using a Cost-Benefit Analysis?
The main goal of cost-benefit analysis is to determine whether it is worth undertaking a project or task. This decision is made by gathering information on the costs and benefits of that project. Management leverages the findings of a cost-benefit analysis to support whether there are more benefits to a project or if it is more detrimental to a company.
How Do You Weigh Costs vs. Benefits?
Cost-benefit analysis is a systematic method for quantifying and then comparing the total costs to the total expected rewards of undertaking a project or making an investment. If the benefits greatly outweigh the costs, the decision should go ahead; otherwise, it should probably not. Cost-benefit analysis will also include the opportunity costs of missed or skipped projects.
What Are Some Tools or Methods Used in Cost-Benefit Analysis?
Depending on the specific investment or project being evaluated, one may need to discount the time value of cash flows using net present value calculations. A benefit-cost ratio (BCR) may also be computed to summarize the overall relationship between the relative costs and benefits of a proposed project. Other tools may include regression modeling, valuation, and forecasting techniques.
What Are the Costs and Benefits of Doing a Cost-Benefit Analysis?
The process of doing a cost-benefit analysis itself has its own inherent costs and benefits. The costs involve the time needed to carefully understand and estimate all of the potential rewards and costs. This may also involve money paid to an analyst or consultant to carry out the work. One other potential downside is that various estimates and forecasts are required to build the cost-benefit analysis, and these assumptions may prove to be wrong or even biased.
The benefits of a cost-benefit analysis, if done correctly and with accurate assumptions, are to provide a good guide for decision-making that can be standardized and quantified. If the cost-benefit analysis of doing a cost-benefit analysis is positive, you should do it!
Some complex problems require deeper analysis, and a company can use cost-benefit analysis when it isn't abundantly clear whether or not to pursue an undertaking. By determining the expenses and identifying what will be favorable, a company can simplify the decision-making process by synthesizing a cost-benefit analysis.
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Cost-Benefit Analysis for Projects: A Step-by-Step Guide
Table of Contents
What is a cost-benefit analysis, cost-benefit analysis in project management, the purpose of cost-benefit analysis, how to do a cost-benefit analysis, cost-benefit analysis example.
- Cost-Benefit Analysis Templates
When managing a project, one is required to make a lot of key decisions. Project managers strive to control costs while getting the highest return on investment and other benefits for their business or organization. A cost-benefit analysis (CBA) is just what they need to help them do that.
In a project, there is always something that needs executing, and every task has a cost and expected benefits. Because of the high stakes, good project managers don’t just make decisions based on gut instinct. They prefer to minimize risk to the best of their ability and act only when there is more certainty than uncertainty.
But how can you accomplish that in a world with myriad variables and constantly shifting economics? The answer: consult hard data collected with project management software, reporting tools , charts and spreadsheets. You can then use that data to evaluate your decisions with a process called cost-benefit analysis (CBA). Intelligent use of cost-benefit analysis will help you make cost-effective decisions and maximize gains both for your project and your organization.
Before we explain how to do a cost-benefit analysis, let’s briefly define what it is.
A cost-benefit analysis (CBA) is a process that is used to estimate the costs and benefits of decisions in order to find the most cost-effective alternative. A CBA is a versatile method that is often used for the business, project and public policy decisions. An effective CBA evaluates the following costs and benefits:
- Direct costs
- Indirect costs
- Intangible costs
- Opportunity costs
- Costs of potential risks
- Total benefits
- Net benefits
Our free cost-benefit analysis template can help you manage and analyze all these project details. Download yours today.
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Cost Benefit Analysis Template
Use this free Cost Benefit Analysis Template for Excel to manage your projects better.
In project management, a cost-benefit analysis is used to evaluate the cost versus the benefits in your project proposal and business case . It begins with a list, as so many processes do.
There’s a list of every project expense and what the expected benefits will be after successfully executing the project. From that, you can calculate the cost-benefit ratio (CBR), return on investment (ROI), internal rate of return (IRR), net present value (NPV) and the payback period (PBP).
Whether the benefits outweigh the costs or not will determine if action is warranted or not. In most cases, if the cost is 50 percent of the benefits and the payback period is not more than a year, then the action is worth taking.
The purpose of cost-benefit analysis in project management is to have a systemic approach to figure out the pluses and minuses of various paths through a project, including transactions, tasks, business requirements and investments. The cost-benefit analysis gives you options, and it offers the best approach to achieve your goal while saving on investment.
There are two main purposes in using CBA:
- To determine if the project business case is sound, justifiable and feasible by figuring out if its benefits outweigh costs.
- To offer a baseline for comparing projects by determining which project’s benefits are greater than its costs.
Keeping track of all these figures is made easier with project management software. For example, ProjectManager has a sheet view, which is exactly like a Gantt but without a visual timeline. You can switch back and forth from the Gantt to the sheet view when you want to just look at your costs in a spreadsheet. You can add as many columns as you like and filter the sheet to capture only the relevant data. Keeping track of your costs and benefits is what brings in a successful project. Use our tool to get the control you need by taking this free trial.
According to the Economist , CBA has been around for a long time. In 1772, Benjamin Franklin wrote of its use. But the concept of CBA as we know it dates to Jules Dupuit, a French engineer, who outlined the process in an article in 1848.
Since then, the CBA process has greatly evolved. Let’s go through this checklist to learn how to do a cost-benefit analysis:
1. What Are the Goals and Objectives of the Project?
Create a business case for your project and state its goals and objectives.
2. What Are the Alternatives?
Before you can know if the project is right, you need to compare it to similar past projects to see which is the best path forward. You can quickly check their success metrics such as their return on investment, internal rate of return, payback period and benefit-cost ratio.
3. Who Are the Stakeholders?
List all stakeholders in the project. They’re the ones affected by the costs and benefits. Describe which of them are decision-makers.
4. How Will You Measure Costs and Benefits?
You need to decide on the metrics you’ll use to measure all costs and benefits. Some of them will have a dollar value, while others will need other metrics. Also, how will you be reporting on those metrics?
The process can be greatly improved with project management software. ProjectManager has one-click reporting that lets you can create eight different project reports. Get data on project status, variance and more. Reports can be easily shared as PDFs or printed out for stakeholders. Filter any report to display only the data you need at the time.
5. What Is the Outcome of Costs and Benefits?
Look over what the costs and benefits of the project are, assign them a monetary value and map them over a relevant time period. It’s important to understand that CBA estimates the monetary value of present and future costs and benefits.
6. What Is the Common Currency?
As mentioned in the last step, you can’t compare the current monetary value of costs and benefits with future rates. That’s why you’ll have to calculate the time value of money, discount rate, and the net present value of cash flows.
However, in some cases, the benefits of a project are not measurable in monetary value. If you find yourself in that position, you should do a cost-effectiveness analysis.
7. What Is the Discount Rate?
The discount rate is used to calculate the present value of the future cash flows coming in or out of your project.
8. What Is the Net Present Value of the Project?
The net present value of a project is a measurement of profit that is calculated by subtracting the present values of cash outflows from the present values of cash inflows over a period of time.
9. What Is the Sensitivity Analysis?
A sensitivity analysis is a probability method used in management and business to determine how uncertainty affects your decisions, costs and profits. In a project management CBA, sensitivity analysis is used to determine the benefit-cost ratio of probable scenarios. You can use Excel or more specialized software to do sensitivity analyses.
10. What Do You Do Once Your CBA Is Complete?
The final step after collecting all this data is to make the choice that is recommended by the CBA, which is the one with the highest benefit-cost ratio.
Now let’s put that theory into practice. For our cost-benefit analysis example, we’ll do an assessment of a project that involves delivering a product as its main goal.
- Direct costs: These are all the costs that are directly related to the manufacturing of the product. Such as materials, equipment, labor, etc.
- Indirect costs: Other expenses that are not directly related to the product such as rent, utilities, or transportation costs.
- Intangible costs: Any other costs that can’t be quantified, such as the brand damage if the market doesn’t respond positively to the product.
- Opportunity costs: The loss of opportunities that occurs when a decision is made instead of another. For example, you could have chosen to manufacture a product that could have been more profitable than the one you chose to make.
- Costs of potential risks: Any project is susceptible to a variety of risks. You should always consider that you might have unexpected costs at some point.
- Direct Benefits: The measurable benefits in monetary value that you get from the project. In this case, the revenue, sales and profit obtained from your product.
- Indirect Benefits: Benefits that you can perceive but not necessarily measure such as increased brand awareness.
Now that you have the costs and benefits of your project, it’s time to assign a monetary value to them. In this case, we can only do that with our direct and indirect costs and our direct benefits. However, you should assign other metrics like key performance indicators to those that can’t be measured with a dollar amount.
Once you estimate the dollar value of your costs and benefits using past-project data, you’ll have to compare them to see if the costs outweigh the benefits.
However, to do a more reliable CBA, you’ll need a sensitivity analysis to evaluate different scenarios and how those affect your cost-benefit ratio. For example, try different demand levels on your linear programming equation.
It’s important that you keep in mind that depending on the timeframe of your project, you might have cash flows coming in and out at different times. For this reason, you’ll need to consider the time value of money, discount rate, net present value when comparing cost-benefit cash flows.
Capture all the costs and benefits with project management software. But unlike many apps with inferior to-do lists, ProjectManager has a list view that is dynamic. It adds priority, customized tags and you can assign team members to own each item. Our cloud-based tool will also automatically track in real time the percentage complete for each item. All the data you collect in our list view is also visible throughout the tool. Use whatever view you want, they’re all updated live and ready for you to work with.
How Accurate Is Cost-Benefit Analysis?
How accurate is CBA? The short answer is it’s as accurate as the data you put into the process. The more accurate your estimates, the more accurate your results.
Some inaccuracies are caused by the following:
- Relying too heavily on data collected from past projects, especially when those projects differ in function, size, etc., from the one you’re working on
- Using subjective impressions when you’re making your assessment
- The improper use of heuristics (problem-solving employing a practical method that is not guaranteed) to get the cost of intangibles
- Confirmation bias or only using data that backs up what you want to find
Are There Limitations to Cost-Benefit Analysis?
Cost-benefit analysis is best suited to smaller to mid-sized projects that don’t take too long to complete. In these cases, the analysis can help decision-makers optimize the benefit-cost ratio of their projects.
However, large projects that go on for a long time can be problematic in terms of CBA. There are outside factors, such as inflation, interest rates, etc., that impact the accuracy of the analysis. In those cases, calculating the net present value, time value of money, discount rates and other metrics can be complicated for most project managers.
There are other methods that complement CBA in assessing larger projects, such as NPV and IRR. Overall, though, the use of CBA is a crucial step in determining if any project is worth pursuing.
Templates to Help With Your Cost-Benefit Analysis
As you work to calculate the cost-benefit analysis of your project, you can get help from some of the free project management templates we offer on our site. We have dozens of free templates that assist every phase of the project life cycle. For cost-benefit analysis, use these three.
RACI Matrix
One of the steps when executing a cost-benefit analysis (as detailed above) includes identifying the stakeholders in your project. You need to list those stakeholders, but our free RACI matrix template takes that one step further by outlining who needs to know what. RACI is an acronym for responsible, accountable, consulted and informed. By filling out this template, you’ll organize your team and stakeholders and keep everyone on the same page.
Project Budget
You can’t do a cost-benefit analysis without outlining all your expenses first. That’s where our free project budget template comes in. It helps you capture all the expenses related to your project from labor costs, consultant fees, the price of raw materials, software licenses and travel. There’s even space to capture other line items, such as telephone charges, rental space, equipment for the office, admin and even insurance. A thorough budget makes for a more accurate cost analysis.
Project Risk Register
You have your stakeholders identified and your budget outlined, but there’s always the unknown to contend with. You can’t just leave that up to chance: you must manage risk, which is why our free project risk register is so essential. Use it to outline the risks inherent in the project. There are places to list the description of the risk, its impact, the level of risk and who is responsible for it. By maintaining a good risk register you can control the variables in your project and make a better cost-benefit analysis.
Make Any Project Profitable with ProjectManager
No matter how great your return on investment might be on paper, a lot of that value can evaporate with poor execution of your project. ProjectManager is an award-winning project management software that has the tools you need to realize the potential of your project. First, you need an airtight plan.
Our online Gantt charts have features to plan your projects and organize your tasks, so they lead to a successful final deliverable. If things change, and they will, the Gantt is easy to edit, so you can pivot quickly.
Resource Management
Another snag that can waylay a project is your resources. ProjectManager has resource management tools that track your materials, supplies and your most valuable resource: the project team. If they’re overworked, morale erodes and production suffers.
The workload page on ProjectManager is color-coded to show who is working on what and gives you the tools to reassign to keep the workload balanced and the team productive.
Real-Time Cost Tracking
The surest way to kill any project is for it to bleed money. ProjectManager lets you set a budget for your project from the start. This figure is then reflected in reports and in the charts and graphs of the real-time dashboard, so you’re always aware of how costs are impacting your project. ProjectManager has the features you need to lead your project to profitability.
Cost benefits analysis is a data-driven process and requires project management software robust enough to digest and distribute the information. ProjectManager is a cloud-based project management software with tools, such as a real-time dashboard, that can collect, filter and share your results in easy-to-understand graphs and charts. Try it today with this free 30-day trial.
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