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How to Do a Cost-Benefit Analysis & Why It’s Important

• 05 Sep 2019

Are you unsure whether a particular decision is the best one for your business? Are you questioning whether a proposed project will be worth the effort and resources that will go into making it a success? Are you considering making a change to your business, marketing, or sales strategy, knowing that it might have repercussions throughout your organization?

The way that many businesses, organizations, and entrepreneurs answer these, and other, questions is through business analytics —specifically, by conducting a cost-benefit analysis.

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What Is A Cost-Benefit Analysis?

A cost-benefit analysis is the process of comparing the projected or estimated costs and benefits (or opportunities) associated with a project decision to determine whether it makes sense from a business perspective.

Generally speaking, cost-benefit analysis involves tallying up all costs of a project or decision and subtracting that amount from the total projected benefits of the project or decision. (Sometimes, this value is represented as a ratio.)

If the projected benefits outweigh the costs, you could argue that the decision is a good one to make. If, on the other hand, the costs outweigh the benefits, then a company may want to rethink the decision or project.

There are enormous economic benefits to running these kinds of analyses before making significant organizational decisions. By doing analyses, you can parse out critical information, such as your organization’s value chain or a project’s ROI .

Cost-benefit analysis is a form of data-driven decision-making most often utilized in business, both at established companies and startups . The basic principles and framework can be applied to virtually any decision-making process, whether business-related or otherwise.

Related: 5 Business Analytics Skills for Professionals

Steps of a Cost-Benefit Analysis

1. establish a framework for your analysis.

For your analysis to be as accurate as possible, you must first establish the framework within which you’re conducting it. What, exactly, this framework looks like will depend on the specifics of your organization.

Identify the goals and objectives you’re trying to address with the proposal. What do you need to accomplish to consider the endeavor a success? This can help you identify and understand your costs and benefits, and will be critical in interpreting the results of your analysis.

Similarly, decide what metric you’ll be using to measure and compare the benefits and costs. To accurately compare the two, both your costs and benefits should be measured in the same “common currency.” This doesn’t need to be an actual currency, but it does frequently involve assigning a dollar amount to each potential cost and benefit.

2. Identify Your Costs and Benefits

Your next step is to sit down and compile two separate lists: One of all of the projected costs, and the other of the expected benefits of the proposed project or action.

When tallying costs, you’ll likely begin with direct costs , which include expenses directly related to the production or development of a product or service (or the implementation of a project or business decision). Labor costs, manufacturing costs, materials costs, and inventory costs are all examples of direct costs.

But it’s also important to go beyond the obvious. There are a few additional costs you must account for:

• Indirect costs: These are typically fixed expenses, such as utilities and rent, that contribute to the overhead of conducting business.
• Intangible costs: These are any current and future costs that are difficult to measure and quantify. Examples may include decreases in productivity levels while a new business process is rolled out, or reduced customer satisfaction after a change in customer service processes that leads to fewer repeat buys.
• Opportunity costs: This refers to lost benefits, or opportunities, that arise when a business pursues one product or strategy over another.

Once those individual costs are identified, it’s equally important to understand the possible benefits of the proposed decision or project. Some of those benefits include:

• Direct: Increased revenue and sales generated from a new product
• Indirect: Increased customer interest in your business or brand
• Intangible: Improved employee morale
• Competitive: Being a first-mover within an industry or vertical

3. Assign a Dollar Amount or Value to Each Cost and Benefit

Once you’ve compiled exhaustive lists of all costs and benefits, you must establish the appropriate monetary units by assigning a dollar amount to each one. If you don’t give all the costs and benefits a value, then it will be difficult to compare them accurately.

Direct costs and benefits will be the easiest to assign a dollar amount to. Indirect and intangible costs and benefits, on the other hand, can be challenging to quantify. That does not mean you shouldn’t try, though; there are many software options and methodologies available for assigning these less-than-obvious values.

4. Tally the Total Value of Benefits and Costs and Compare

Once every cost and benefit has a dollar amount next to it, you can tally up each list and compare the two.

If total benefits outnumber total costs, then there is a business case for you to proceed with the project or decision. If total costs outnumber total benefits, then you may want to reconsider the proposal.

Beyond simply looking at how the total costs and benefits compare, you should also return to the framework established in step one. Does the analysis show you reaching the goals you’ve identified as markers for success, or does it show you falling short?

If the costs outweigh the benefits, ask yourself if there are alternatives to the proposal you haven’t considered. Additionally, you may be able to identify cost reductions that will allow you to reach your goals more affordably while still being effective.

Related: Finance vs. Accounting: What's the Difference?

Pros and Cons of Cost-Benefit Analysis

There are many positive reasons a business or organization might choose to leverage cost-benefit analysis as a part of their decision-making process. There are also several potential disadvantages and limitations that should be considered before relying entirely on a cost-benefit analysis.

Advantages of Cost-Benefit Analysis

A data-driven approach.

Cost-benefit analysis allows an individual or organization to evaluate a decision or potential project free of biases. As such, it offers an agnostic and evidence-based evaluation of your options, which can help your business become more data-driven and logical.

Makes Decisions Simpler

Business decisions are often complex by nature. By reducing a decision to costs versus benefits, the cost-benefit analysis can make this dilemma less complex.

Uncovers Hidden Costs and Benefits

Cost-benefit analysis forces you to outline every potential cost and benefit associated with a project, which can uncover less-than-obvious factors like indirect or intangible costs.

Limitations of Cost-Benefit Analysis

Difficult to predict all variables.

While cost-benefit analysis can help you outline the projected costs and benefits associated with a business decision, it’s challenging to predict all the factors that may impact the outcome. Changes in market demand, material costs, and the global business environment are unpredictable—especially in the long term.

Incorrect Data Can Skew Results

If you’re relying on incomplete or inaccurate data to finish your cost-benefit analysis, the results of the analysis will follow suit.

Better Suited to Short- and Mid-Length Projects

For projects or business decisions that involve longer timeframes, cost-benefit analysis has a greater potential of missing the mark for several reasons. For one, it’s typically more difficult to make accurate predictions the further into the future you go. It’s also possible that long-term forecasts won’t accurately account for variables such as inflation, which can impact the overall accuracy of the analysis.

Removes the Human Element

While a desire to make a profit drives most companies, there are other, non-monetary reasons an organization might decide to pursue a project or decision. In these cases, it can be difficult to reconcile moral or “human” perspectives with the business case.

In the end, cost-benefit analysis shouldn't be the only business analytics tool or strategy you use in determining how to move your organization into the future. Cost-benefit analysis isn’t the only type of economic analysis you can do to assess your business’s economic state, but a single option at your disposal.

Do you want to take your career to the next level? Download our free Guide to Advancing Your Career with Essential Business Skills to learn how enhancing your business knowledge can help you make an impact on your organization and be competitive in the job market.

This post was updated on July 12, 2022. It was originally published on September 5, 2019.

About the Author

An Expert Guide to Cost Benefit Analysis

By Joe Weller | December 8, 2016

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In business today, it’s essential to get the most out of every idea, option, and investment. To accomplish this, many organizations - from large enterprises to startups and small businesses -  use cost benefit analyses to help make important decisions. Using a cost benefit analysis can help teams identify the highest and best return on an investment based on the cost, resources, and risk involved.   In this article, we’ll walk you through the process of cost benefit analysis, and offer insight and tips from industry experts. They’ll shine a light on the risks and uncertainties you should be aware of as you work, and provide real-world examples to show cost benefit analysis in action.

Cost benefit analysis: What is it?

A cost benefit analysis (also known as a benefit cost analysis) is a process by which organizations can analyze decisions, systems or projects, or determine a value for intangibles. The model is built by identifying the benefits of an action as well as the associated costs, and subtracting the costs from benefits. When completed, a cost benefit analysis will yield concrete results that can be used to develop reasonable conclusions around the feasibility and/or advisability of a decision or situation.   Why Use Cost Benefit Analysis? Organizations rely on cost benefit analysis to support decision making because it provides an agnostic, evidence-based view of the issue being evaluated—without the influences of opinion, politics, or bias. By providing an unclouded view of the consequences of a decision, cost benefit analysis is an invaluable tool in developing business strategy, evaluating a new hire, or making resource allocation or purchase decisions.   Origins of Cost Benefit Analysis The earliest evidence of the use of cost benefit analysis in business is associated with a French engineer, Jules Dupuit, who was also a self-taught economist. In the mid-19th century, Dupuit used basic concepts of what later became known as cost benefit analysis in determining tolls for a bridge project on which he was working. Dupuit outlined the principles of his evaluation process in an article written in 1848, and the process was further refined and popularized in the late 1800s by British economist Alfred Marshall, author of the landmark text, Principles of Economics (1890).

Scenarios Utilizing Cost Benefit Analysis

As mentioned previously, cost benefit analysis is the foundation of the decision-making process across a wide variety of disciplines. In business, government, finance, and even the nonprofit world, cost benefit analysis offers unique and valuable insight when:

• Developing benchmarks for comparing projects
• Deciding whether to pursue a proposed project
• Evaluating new hires
• Weighing investment opportunities
• Measuring social benefits
• Appraising the desirability of suggested policies
• Assessing change initiatives
• Quantifying effects on stakeholders and participants

How to Do a Cost Benefit Analysis

While there is no “standard” format for performing a cost benefit analysis, there are certain core elements that will be present across almost all analyses. Use the structure that works best for your situation or industry, or try one of the resources and tools listed at the end of this article. We’ll go through the five basic steps to performing a cost benefit analysis in the sections below, but first, here’s a high-level of overview:  

• Establish a framework to outline the parameters of the analysis
• Identify costs and benefits so they can be categorized by type, and intent
• Calculate costs and benefits across the assumed life of a project or initiative
• Compare cost and benefits using aggregate information
• Analyze results and make an informed, final recommendation

  As with any process, it’s important to work through all the steps thoroughly and not give in to the temptation to cut corners or base assumptions on opinion or “best guesses.” According to a paper from Dr. Josiah Kaplan, former Research Associate at the University of Oxford, it’s important to ensure that your analysis is as comprehensive as possible:   “The best cost-benefit analyses take a broad view of costs and benefits, including indirect and longer-term effects, reflecting the interests of all stakeholders who will be affected by the program.”

How to Establish a Framework

In establishing the framework of your cost benefit analysis, first outline the proposed program or policy change in detail. Look carefully at how you position what exactly is being evaluated in relationship to the problem being solved. For example, the analysis associated with the question, “should we add a new professor to our staff?” will be much more straightforward than a broader programmatic question, such as, “how should we resolve the gaps in our educational offering?”   Example:

Once your program or policy change is clearly outlined, you’ll need to build out a situational overview to examine the existing state of affairs including background, current performance, any opportunities it has brought to the table, and its projected performance in the future. Also make sure to factor in an objective look at any risks involved in maintaining the status quo moving forward.   Now decide on how you will approach cost benefits. Which cost benefits should be included in your analysis? Include the basics, but also do a bit of thinking outside the box to come up with any unforeseen costs that could impact the initiative in both the short and long term.   In some cases geography could play a role in determining feasibility of a project or initiative. If geographically dispersed stakeholders or groups will be affected by the decision being analyzed, make sure to build that into the framework upfront, to avoid surprises down the road. Conversely, if the scope of the project or initiative may scale beyond the intended geographic parameters, that should be taken into consideration as well.

Identify and Categorize Costs and Benefits

Now that your framework is in place, it’s time to sort your costs and benefits into buckets by type. The primary categories that costs and benefits fall into are direct/indirect , tangible/intangible , and real :  

• Direct costs are often associated with production of a cost object (product, service, customer, project, or activity)
• Indirect costs are usually fixed in nature, and may come from overhead of a department or cost center
• Tangible costs are easy to measure and quantify, and are usually related to an identifiable source or asset, like payroll, rent, and purchasing tools
• Intangible cost s are difficult to identify and measure, like shifts in customer satisfaction, and productivity levels
• Real costs are expenses associated with producing an offering, such as labor costs and raw materials

  Now that you’ve developed the categories into which you’ll sort your costs and benefits, it’s time to start crunching numbers.

How to Calculate Costs and Benefits

With the framework and categories in place, you can start outlining overall costs and benefits. As mentioned earlier, it’s important to take both the short and long term into consideration, so ensure that you make your projections based on the life of the program or initiative, and look at how both costs and benefits will evolve over time.

TIP: People often make the mistake of monetizing incorrectly when projecting costs and benefits, and therefore end up with flawed results. When factoring in future costs and benefits, always be sure to adjust the figures and convert them into present value.

Compare Aggregate Costs and Benefits

Here we’ll determine net present values by subtracting costs from benefits, and project the timeframe required for benefits to repay costs, also known as return on investment (ROI).   Example:

The process doesn’t end there. In certain situations, it’s important to address any serious concerns that could impact feasibility from a legal or social justice standpoint. In cases like these, it can be helpful to incorporate a “with/without” comparison to identify areas of potential concern.   With/Without Comparison The impact of an initiative can be brought into sharp focus through a basic “with/without” comparison. In other words, this is where we look at what the impact would be—on organizations, stakeholders, or users—both with, and without, this initiative.   Thayer Watkins, who taught a course on cost benefit analysis during his 30-year career as a professor in the San Jose State University Department of Economics, offers this example of a “with/without” comparison:   “The impact of a project is the difference between what the situation in the study area would be with and without the project. So that when a project is being evaluated the analysis must estimate not only what the situation would be with the project but also what it would be without the project. For example, in determining the impact of a fixed guideway rapid transit system such as the Bay Area Rapid Transit (BART) in the San Francisco Bay Area the number of rides that would have been taken on an expansion of the bus system should be deducted from the rides provided by BART and likewise the additional costs of such an expanded bus system would be deducted from the costs of BART. In other words, the alternative to the project must be explicitly specified and considered in the evaluation of the project.”   TIP: Never confuse with/without with a before-and-after comparison.

3 Steps for Analyzing the Results and Make a Recommendation

In the home stretch of the cost benefit analysis, you’ll be looking at the results of your work and forming the basis to make your decision.   1. Perform Sensitivity Analysis Dr. Kaplan recommends performing a sensitivity analysis (also known as a “what-if”) to predict outcomes and check accuracy in the face of a collection of variables. “Information on costs, benefits, and risks is rarely known with certainty, especially when one looks to the future,” Dr. Kaplan says. “This makes it essential that sensitivity analysis is carried out, testing the robustness of the CBA result to changes in some of the key numbers.”   EXAMPLE of Sensitivity Analysis In trying to understand how customer traffic impacts sales in Bob’s Pie Shop, in which sales are a function of both price and volume of transactions, let’s look at some sales figures:

Bob has determined that a 10% increase in store traffic will boost his pie sales by 5%. This allows Bob to build the following sensitivity analysis, based upon his sales of 400 pies last year, that demonstrates that his pie sales are significantly impacted by fluctuations or growth in store traffic:

2. Consider Discount Rates When evaluating your findings, it’s important to take discount rates into consideration when determining project feasibility.  

• Social discount rates – Used to determine the value to funds spent on government projects (education, transportation, etc.)
• Hurdle rates – The minimum return on investment required by investors or stakeholders
• Annual effective discount rates – Based on a percentage of the end-of-year balance, the amount of interest paid or earned

Here is a template where you can make your Cost Benefit Analysis

Download Simple Cost Benefit Analysis Template

Microsoft Excel | Smartsheet

3. Use Discount Rates to Determine Course of Action After determining the appropriate discount rate, look at the change in results as you both increase and decrease the rate:  

• Positive - If both increasing and decreasing the rate yields a positive result, the policy or initiative is financially viable.
• Negative - If both increasing and decreasing the rate yields a negative result, revisit your calculations based upon adjusting to a zero-balance point, and evaluate using the new findings.

  Based upon these results, you will now be able to make a clear recommendation, grounded in realistic data projections.

The Risks and Uncertainties of Cost Benefit Analysis

Despite its usefulness, cost benefit analysis has several associated risks and uncertainties that are important to note. These risks and uncertainties can result from human agendas, inaccuracies around data utilized, and the use of heuristics to reach conclusions.   Know the Risks Much of the risk involved with cost benefit analysis can be correlated to the human elements involved. Stakeholders or interested parties may try to influence results by over- or understating costs. In some cases, supporters of a project may insert a personal or organizational bias into the analysis.   On the data side, there can be a tendency to rely too much on data compiled from previous projects. This may inadvertently yield results that don’t directly apply to the situation being considered. Since data leveraged from an earlier analysis may not directly apply to the circumstances at hand, this may yield results that are not consistent with the requirements of the situation being considered. Using heuristics to assess the dollar value of intangibles may provide quick, “ballpark-type” information, but it can also result in errors that produce an inaccurate picture of costs that can invalidate findings.   In addressing risk, it’s sometimes helpful to utilize probability theory to identify and examine key patterns that can influence the outcome.   Uncertainties There are several “wild-card” issues that can influence the results of any cost benefit analysis, and while they won’t apply in every situation, it’s important to keep them in mind as you work:  

• Accuracy affects value – Inaccurate cost and benefit information can diminish findings around value.
• Don’t rely on intuition – Always research benefits and costs thoroughly to gather concrete data—regardless of your level of expertise with the subject at hand.
• Cash is unpredictable – Revenue and cash flow are moving targets, experiencing peaks and valleys, and translating them into meaningful data for analysis can be challenging.
• Income influences decisions – Income level can drive a customer’s ability or willingness to make purchases.
• Money isn’t everything – Some benefits cannot be directly reflected in dollar amounts.
• Value is subjective – The value of intangibles can always be subject to interpretation.
• Don’t automatically double up – When measuring a project in multiple ways, be mindful that doubling benefits or costs can results in inconsistent results.

  Controversial Aspects When thinking about the most controversial aspects of cost benefit analysis, all paths seem to lead to intangibles. Concepts and things that are difficult to quantify, such as human life, brand equity, the environment, and customer loyalty can be difficult to map directly to costs or value.    With respect to intangibles, Dr. Kaplan suggests that using the cost benefit analysis process to drive more critical thinking around all aspects of value—perceived and concrete—can be beneficial outcomes. “[Cost benefit analysis] assumes that a monetary value can be placed on all the costs and benefits of a program, including tangible and intangible returns. ...As such, a major advantage of cost-benefit analysis lies in forcing people to explicitly and systematically consider the various factors which should influence strategic choice,” he says.

Cost Benefit Analysis in the Real World

Extending Transport Options in Seattle  

Originally built for the 1962 World’s Fair, the Seattle monorail runs between the Seattle Center and the city’s downtown area. Several times over the past 50+ years, the city has considered extending monorail service to key areas in order to provide more transport options for residents. The following is an excerpt from a cost benefit analysis performed by DJM Consulting and ECONorthwest on behalf of the Elevated Transportation Company to assess an expansion project.   Costs The estimated costs for constructing and operating the monorail are $1.68 billion (in 2002 dollars). This includes a total capital cost of $1.26 billion and a total discounted stream of operating costs of $420 million (at approximately $29 million a year), using the same discount rate (7.95%). Operating costs were discounted over a span of 22 years, from 2008 through 2029.   Benefits

Benefit type                                                     Benefit value (millions, 2002$) Value of travel time savings                           $77.1 Parking savings                                               28.7 Reduced auto operating/ownership costs       11.2 Reliability                                                         7.7 Road capacity for drivers                                 4.6 Reduction in bus-related accidents                 3.7 Reduction in auto-related accidents                2.6 2020 Benefits                                                  $135.6

Benefits accrue for 23 years from 2007 through 2029. A discount rate of 7.95% was used to estimate the total benefits, in 2002 dollars. The net benefits were evaluated to be $2,067,263,000.   Analysis

• Net present value B-C = $390,164,000
• Benefit-cost ratio B/C = 1.23
• Nominal rate of return = 7.95%

  Sensitivity Analysis A team of outside engineers and contractors determined that there is a 60% chance the monorail project would come in at or under budget and a 90% chance the project will come in under 1.15 times the budget. The travel demand forecasters included a 10% range around their estimate of future monorail ridership. For the case where the costs are low and the benefits are high, a 9.9% return is expected. For the case where the costs are higher than expected and the benefits are lower, a 5.2% return is expected.   Read the full analysis here .   Solid Waste Reduction in California California's Department of Resources Recycling and Recovery’s mission is to help state residents achieve the highest waste reduction, recycling and reuse goals in the U.S. The following is an excerpt from a cost benefit analysis performed in 1997 to compare the costs of Cardiovascular Group’s (CVG) solid waste reduction program to its economic benefits.   Costs According to the Environmental Manager, one employee spends eight hours per day on recycling duties. This employee is paid an average of $5.50 per hour. The Environmental Manager spends an estimated 5% of his time ($100,000/per year compensation) directing the solid waste reduction program. Utilizing this cost data, the calculations below demonstrate that CVG spent an estimated $16,440 in 1997 on its solid waste reduction program:   (1 Employee) X ($5.50/hr.) X (8 hrs./day) X (260 work days/year) = $11,440 per year + 5%(100,000) = $16,440 per year   Benefits 1995 Disposal cost reductions (1989 Baseline disposal costs – 1995 disposal costs) = $99,190 - $26,800 = $72,390   1996 Disposal cost reductions (1989 Baseline disposal costs – 1996 disposal costs) = $99,190 - $33,850 = $65,340   Average Annual Disposal Cost Reduction (DCR) (1995 DCR + 1996 DCR)/ 2 = ($72,390 + $65,340)/2 = $68,865   Analysis

• Nominal Rate of Return = 7.95%

  From these data, it is clear that CVG has benefited economically from its solid waste reduction programs. Average annual costs amounted to $16,440 per year, while benefits equaled $1,308,865 per year. Therefore, net savings from CVG’s solid waste reduction program amounted to $1,292,425 per year.

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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.

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.

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.

Michela Buttignol / Investopedia

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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About Cost Benefit Analysis

Cost benefit analysis is a systematic process for calculating and comparing benefits and costs of a project. A cost benefit analysis finds, quantifies, and adds all the positive factors (the benefits). Then it identifies, quantifies, and subtracts all the negatives (the costs). The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them.

• An Introduction to Cost Benefit Analysis San José State University Department of Economics
• Cost Benefit Analysis Examples of techniques designed to determine the feasibility of a project or plan by quantifying costs and benefits, including external costs and benefits.
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What is Cost-Benefit Analysis? Definition, Examples

Appinio Research · 21.12.2023 · 41min read

Are you faced with critical decisions that demand a thorough assessment of costs and benefits? Understanding the art of cost-benefit analysis (CBA) is your key to informed and strategic decision-making.

In this guide, we will demystify the intricacies of CBA, equipping you with the tools and insights to evaluate projects, investments, and initiatives from a financial perspective. Whether you're a business leader, policymaker, or researcher, join us in unlocking the power of CBA and transforming complex choices into clear, data-driven solutions.

What is Cost-Benefit Analysis?

Cost-benefit analysis (CBA) is a systematic and quantitative approach used to evaluate the financial implications of decisions, projects, or policies. At its core, CBA seeks to answer a fundamental question: "Is the expected benefit of an action greater than its expected cost?" By comparing the costs and benefits of different options, CBA provides a structured framework for decision-makers to make informed choices that maximize value.

Importance of Cost-Benefit Analysis in Decision-Making

Cost-benefit analysis plays a pivotal role in informed decision-making across various domains. Its importance lies in the multitude of benefits it offers:

• Objective Evaluation:  CBA provides an objective and structured framework for evaluating decisions, reducing the influence of personal biases and preferences.
• Resource Allocation:  It helps allocate limited resources efficiently by identifying projects or initiatives that yield the greatest net benefit, enhancing overall economic performance.
• Accountability:  CBA fosters accountability in both the public and private sectors, as decisions are based on quantifiable data and analysis, making it easier to justify choices to stakeholders.
• Risk Management:  CBA allows decision-makers to assess the financial implications of various risks and uncertainties, enabling proactive risk management and mitigation.
• Policy Design:  In public policy, CBA aids in designing policies that optimize societal welfare and achieve specific objectives, such as environmental protection or public health.
• Project Prioritization:  In project management, CBA assists in prioritizing projects by quantifying their potential returns and aligning them with organizational goals.
• Environmental and Social Impact:  CBA extends beyond financial metrics to consider broader environmental and social impacts , promoting sustainability and responsible decision-making.
• Informed Choices:  Ultimately, CBA empowers decision-makers with the knowledge and tools to make choices that maximize benefits, enhance efficiency, and lead to better outcomes.

How to Conduct Cost-Benefit Analysis?

Now, let's delve deeper into the key steps of conducting a cost-benefit analysis, providing you with a more comprehensive understanding of each crucial element in this process.

1. Identify and Define the Project or Decision

Before embarking on a CBA journey , you must have a crystal-clear vision of the project or decision at hand. Take the time to thoroughly identify and define the scope, objectives, and boundaries of the undertaking. Here's how:

• Scope Definition:  Clearly outline what the project aims to achieve. Identify its goals, intended outcomes, and the problems or opportunities it addresses.
• Objective Clarity:  Define the specific objectives you intend to accomplish with the project. Ensure that these objectives are quantifiable and align with the project's scope.
• Boundary Establishment:  Determine the project's boundaries by specifying what it includes and excludes. This step helps avoid scope creep and ensures a focused analysis.

2. Identify Stakeholders and Their Interests

Understanding who the key stakeholders are and what interests they hold in the project is vital for a comprehensive CBA. Here's how to go about it:

• Stakeholder Identification:   Identify all parties that have a stake in the project. This includes individuals, groups, or organizations that may be impacted by the project or have influence over it.
• Interest Assessment:  For each stakeholder, assess their interests, concerns, and expectations regarding the project. Recognize potential conflicts or overlaps in interests.
• Prioritization:  Prioritize stakeholders based on their level of influence and interest. This will guide your engagement efforts and ensure you address the concerns of those with the most significant impact on the project.

3. Establish the Timeframe for Analysis

The timeframe you choose for your CBA can significantly affect the results. Consider the following when determining the analysis period:

• Project Duration:  Understand the expected duration of the project. Is it a short-term initiative, a multi-year project, or an ongoing decision?
• Long-Term Impacts:  Recognize that some projects may have long-term impacts that extend beyond the immediate timeframe. Ensure your analysis captures these extended effects.
• Time Units:  Determine the time units you'll use for analysis (e.g., months, years) and the granularity of your assessment.

4. Identify Costs

Identifying and categorizing costs accurately is fundamental to a reliable CBA. Here's how to do it effectively:

• Cost Categories:  Break down the project's costs into categories such as initial investment costs, operating and maintenance costs, and any recurring expenses.
• Cost Sources:  Seek out the sources of cost data, which may include quotes from suppliers, historical records, and expert opinions.
• Hidden Costs:  Be vigilant in uncovering hidden or indirect costs that might not be immediately apparent but are essential for a comprehensive analysis.

5. Identify Benefits

Just as with costs, identifying and categorizing benefits is a critical step. Here's how to go about it:

• Benefit Categories:  Distinguish between various categories of benefits, including financial gains, improvements in quality of life, environmental benefits, and any other positive outcomes.
• Benefit Sources:  Collect data and information from sources that can help estimate the potential benefits of the project. This may involve surveys, market research, or expert insights.
• Intangible Benefits:  Don't overlook intangible benefits such as improved reputation, enhanced employee morale, or community goodwill. These can have significant value.

6. Quantify Costs and Benefits

Quantifying costs and benefits involves attaching specific numerical values to each item. Here's how to approach this quantitative aspect:

• Measurement Units:  Define the measurement units for costs and benefits. For instance, use dollars for financial values and relevant units (e.g., quality-of-life score) for non-monetary benefits.
• Data Precision:  Strive for data precision by using accurate and up-to-date information. Avoid rough estimates whenever possible.
• Consistency:  Ensure consistency in how you measure costs and benefits across the entire analysis. Use a common currency and time units.

7. Assign Monetary Values to Costs and Benefits

To make an apples-to-apples comparison, you'll need to bring all costs and benefits to a common monetary basis. Here's how to do it:

• Discount Rate Selection:  Choose an appropriate discount rate that reflects the time value of money. The discount rate accounts for the fact that future cash flows are worth less than present ones.
• Discounting Formula: Calculate the present value (PV) of future costs or benefits. We'll discuss how to calculate it more in detail.

8. Discounting Future Costs and Benefits

Applying the discount rate to future costs and benefits is essential for fair and accurate comparisons. Here's how to discount future values:

• Applying the Formula:  Use the present value formula mentioned earlier to discount each future cost and benefit back to its equivalent present value.
• Time-Dependent Analysis:  Recognize that the further into the future a cost or benefit occurs, the more it diminishes in present value terms. Ensure that your analysis accounts for this temporal effect.

9. Sensitivity Analysis

Sensitivity analysis is a valuable tool for understanding the robustness of your CBA results in the face of uncertainty. Here's how to conduct it:

• Parameter Variation:  Identify key assumptions, parameters, or variables in your analysis that are subject to uncertainty.
• Scenario Testing:   Create multiple scenarios by varying these uncertain factors. Assess the impact of different scenarios on the project's net present value (NPV) or other relevant metrics.
• Risk Assessment:  Use sensitivity analysis to identify potential risks and opportunities associated with your project. This helps decision-makers understand the range of possible outcomes and make informed choices.

By thoroughly understanding and applying each of these steps, you'll be well-equipped to conduct a robust cost-benefit analysis for any project or decision you encounter. These steps lay the foundation for a comprehensive assessment that can guide your decision-making process effectively.

Types of Costs and Benefits

Cost-benefit analysis involves assessing a wide array of costs and benefits, each falling into distinct categories. Understanding these categories is crucial for a comprehensive analysis. Here, we explore the various types of costs and benefits in detail.

Direct Costs

Direct costs  are the expenses directly attributable to a project or decision. These costs are explicit and easily traceable to the project's activities. Examples of direct costs include:

• Labor Costs:  The wages and salaries paid to employees directly involved in the project, such as project managers, engineers, or construction workers.
• Material Costs:  Expenses related to the purchase of raw materials, supplies, and equipment essential for the project's execution.
• Equipment Costs:  Costs associated with the acquisition or rental of machinery and tools necessary for the project.
• Travel and Transportation Costs:  Expenses incurred for travel , accommodation, and transportation directly linked to project activities.
• Contractor Fees:  Fees paid to external contractors or consultants for their services on the project.

Direct costs are typically straightforward to identify and quantify, making them a fundamental component of any CBA.

Indirect Costs

In contrast to direct costs,  indirect costs  are not directly tied to the project but are essential for its execution. These costs are often shared among multiple projects or activities within an organization. Identifying and allocating indirect costs accurately is necessary for an accurate CBA. Examples of indirect costs include:

• Administrative Overhead:  Costs associated with general administrative functions, such as office rent, utilities, office supplies, and administrative staff salaries.
• General Maintenance Costs:  Expenses for the upkeep and maintenance of facilities and equipment that serve multiple projects.
• Insurance Costs:  Costs related to insuring project assets and liabilities against potential risks and accidents.
• Indirect Labor Costs:  Wages and benefits paid to employees not directly involved in the project but who contribute indirectly to its success, such as administrative staff or support personnel.

Indirect costs can sometimes be challenging to allocate accurately to specific projects, requiring careful consideration in the CBA.

Tangible Benefits

Tangible benefits  are the measurable and quantifiable outcomes that result from a project or decision. These benefits are often expressed in monetary terms, making them relatively straightforward to evaluate. Examples of tangible benefits include:

• Increased Revenue:  A direct boost in income or sales resulting from the project. For instance, the launch of a new product can lead to increased sales revenue.
• Cost Savings:  Reductions in operational costs due to project implementation, such as energy savings from energy-efficient equipment.
• Profit Margins:  Improvements in profit margins, which can result from increased efficiency or reduced production costs.
• Market Share Growth:   Expansion of market share due to successful project outcomes.

Tangible benefits are critical for demonstrating the financial viability of a project, as they contribute directly to the project's return on investment.

Intangible Benefits

While  intangible benefits  may be challenging to measure in monetary terms, they hold significant value. These benefits are not easily quantifiable but are essential for a comprehensive CBA. Examples of intangible benefits include:

• Enhanced Reputation:  A positive impact on the organization's reputation or brand image , which can lead to increased customer trust and loyalty.
• Employee Morale:  Improved job satisfaction and motivation among employees, potentially resulting in higher productivity and reduced turnover.
• Environmental Preservation:  Benefits related to environmental conservation, such as reduced pollution or biodiversity preservation.
• Community Well-being:  Positive effects on the overall quality of life and well-being of the community in which the project operates.

Intangible benefits may not appear on the balance sheet, but they can contribute significantly to the overall success and sustainability of a project.

Social Costs and Benefits

In some instances, the impacts of a project extend beyond financial considerations and delve into broader societal consequences.  Social costs and benefits  encompass these effects on the community, environment, or society at large. Examples include:

• Environmental Impact:  Costs associated with pollution, habitat destruction, or resource depletion, as well as benefits from reduced emissions or conservation efforts.
• Healthcare Costs:  Costs related to increased healthcare demands or benefits from improved public health outcomes resulting from a project.
• Community Development:  Costs associated with disruptions to local communities or benefits from increased employment opportunities and infrastructure development.

Assessing social costs and benefits requires a holistic perspective, as their effects can be far-reaching and have significant societal implications.

Private Costs and Benefits

Private costs and benefits pertain specifically to individuals or entities directly involved in the project or decision. Distinguishing between private and social costs and benefits is crucial for understanding the broader impact of a project. Examples include:

• Private Financial Costs:  Costs borne by individual stakeholders, such as project investors or employees.
• Private Financial Benefits:   Financial gains accrued by individuals or organizations directly associated with the project, such as suppliers or contractors.
• Private Non-Financial Costs:  Non-monetary burdens experienced by individuals involved in the project, such as increased workload or stress.
• Private Non-Financial Benefits:  Non-monetary advantages received by project participants, like skill development or networking opportunities.

Understanding the distinction between private and social costs and benefits helps ensure that your CBA comprehensively captures the implications of the project for all stakeholders involved.

By recognizing and categorizing these various types of costs and benefits, you can conduct a more thorough and insightful cost-benefit analysis that accounts for both the financial and non-financial aspects of your decision or project. This holistic approach enables you to make more informed choices and understand the full impact of your actions.

Cost-Benefit Analysis Data Collection and Analysis

To conduct a robust cost-benefit analysis, you must pay careful attention to data collection and analysis. This phase is critical for obtaining accurate and reliable information to support your decision-making process. Here, we delve into the intricacies of gathering data for cost estimation, collecting data for benefit estimation, ensuring data quality and reliability, and analyzing data effectively.

Gathering Data for Cost Estimation

Before you can estimate costs accurately, you need to gather relevant data related to the project's expenses. This step involves a systematic approach to ensure that you capture all cost elements. Here's how to do it effectively:

• Quotes and Estimates:  Reach out to suppliers, contractors, and vendors to obtain detailed quotes and estimates for materials, labor, equipment, and services required for the project. These quotes serve as valuable benchmarks.
• Historical Data:  Review historical cost data from similar projects within your organization or industry. This can provide insights into cost patterns and trends that are likely to apply to your project.
• Expert Input:  Consult with subject matter experts within your organization or industry. Their expertise can help identify potential cost drivers and nuances specific to the project.
• Contingency Planning:  Account for contingencies by considering unforeseen costs that may arise during the project's execution. A contingency budget can help mitigate unexpected financial setbacks.
• Detailed Documentation:  Maintain meticulous records of all cost-related data, including invoices, receipts, and cost breakdowns. This documentation will be essential for transparency and accountability.

Gathering Data for Benefit Estimation

Estimating benefits accurately is equally crucial to the success of your CBA. Benefits can take various forms, so a comprehensive data collection approach is necessary:

• Market Research:   Conduct market research to understand customer demand and potential revenue streams. Surveys , focus groups , and customer feedback can provide valuable insights.
• Benchmarking:  Compare your project's potential benefits to industry benchmarks and standards. This can help you set realistic expectations and identify areas for improvement.
• Environmental Studies:  For projects with environmental impacts, gather data from environmental assessments and studies. This may include data on emissions reductions, energy savings, or ecosystem restoration.
• Economic Models:  Employ economic models and analysis techniques to project potential benefits accurately. These models can simulate various scenarios and their corresponding outcomes.
• Scenario Analysis:  Consider multiple scenarios for benefit estimation, ranging from optimistic to pessimistic. This approach allows you to assess the range of potential outcomes and their associated probabilities.

Data Quality and Reliability

Ensuring the quality and reliability of the data you collect is paramount. Inaccurate or unreliable data can lead to flawed conclusions. Here's how to maintain data integrity:

• Source Verification:  Verify the credibility and trustworthiness of data sources. Use reputable sources, official records, and reliable industry databases.
• Data Consistency:  Ensure consistency in data units and formats. Use standardized metrics and measurement units to prevent data discrepancies.
• Data Validation:  Cross-check data for accuracy and completeness. Look for inconsistencies, outliers, or missing information that may need validation or correction.
• Sampling Techniques:  If you cannot collect data from an entire population, use appropriate sampling techniques to ensure representativeness and reduce sampling bias .
• Peer Review:  Engage experts or colleagues to review and validate your data collection methods and assumptions. External validation can help identify potential blind spots.

Analyzing Data for Decision-Making

Analyzing data effectively is the cornerstone of a successful CBA. It involves crunching numbers, identifying patterns, and drawing meaningful insights from the collected data.

• Data Segmentation:  Segment data into relevant categories or variables to gain a deeper understanding of cost and benefit components. This segmentation can reveal insights into different aspects of the project.
• Statistical Tools:  Utilize statistical tools and software to perform quantitative analysis. Statistical techniques can help identify trends, correlations, and potential outliers.
• Sensitivity Analysis:  Incorporate sensitivity analysis into your data analysis process. This involves varying key parameters or assumptions to assess the impact on outcomes, helping you understand the robustness of your results.
• Comparative Analysis :  Compare different scenarios, projects, or alternatives to evaluate their relative merits. Comparative analysis can assist in choosing the most favorable course of action.
• Visualization:  Present your data using visual aids such as charts, graphs, and tables. Visual representations can make complex data more accessible and facilitate communication with stakeholders.
• Interpretation:  Interpret the data findings in the context of the project's objectives and goals. What do the numbers mean for the project's feasibility and desirability?
• Risk Assessment:  Consider the inherent risks associated with the data and analysis. Identify potential sources of error or uncertainty and communicate these risks transparently.

Effective data collection and analysis are the backbone of a sound CBA. By adhering to best practices and maintaining data integrity, you can enhance the accuracy and reliability of your analysis, ultimately leading to more informed and confident decision-making.

Discounting and Present Value

Understanding the concept of discounting and calculating present value is a pivotal aspect of cost-benefit analysis. We will explore the principles of the time value of money, the factors involved in discount rate selection, and the methods for calculating present value.

What is TVM (Time Value of Money)?

The  time value of money (TVM)  is a fundamental financial principle that underpins CBA. It recognizes that the value of money changes over time due to factors such as inflation, opportunity cost, and risk. To grasp this concept fully, consider the following:

• Inflation:  Inflation erodes the purchasing power of money over time. A dollar today is worth more than a dollar in the future because you can buy more with it now.
• Opportunity Cost:  Money invested or used for one purpose cannot be used for another. The opportunity to earn a return on investment is an essential consideration in CBA.
• Risk:  The future is uncertain, and investments or benefits expected in the future are riskier than those received today. Risk must be factored into discounting.

Discount Rate Selection

Selecting an appropriate  discount rate  is critical for discounting future costs and benefits to their present value. The discount rate reflects the rate of return that could be earned on alternative investments with similar risk profiles. Here's how to approach discount rate selection:

• Risk Assessment:  Assess the risk associated with the project or decision. Projects with higher risk typically require a higher discount rate to account for the added uncertainty.
• Opportunity Cost:  Consider the opportunity cost of capital. This is the return you could earn by investing the money elsewhere. Your discount rate should at least match this opportunity cost.
• Market Rates:  Examine market interest rates for investments with similar risk characteristics. These rates can serve as a benchmark for your discount rate.
• Timeframe:  The discount rate should match the duration of the analysis. Short-term projects may use short-term interest rates, while long-term projects require long-term rates.
• Public vs. Private Projects:  In public projects, discount rates may be determined by government guidelines or policies. For private projects, market-based rates are often used.
• Sensitivity Analysis:  Consider conducting sensitivity analysis with varying discount rates to understand how changes in this key parameter impact your results.

How to Calculate Present Value?

Calculating present value (PV) involves converting future costs and benefits into today's monetary terms. The formula for calculating the present value is:

PV = FV / (1 + r)^n 

• PV  is the Present Value
• FV  is the Future Value
• r  is the Discount Rate
• n  is the Number of Time Periods

Here's how you can apply this formula:

• Single Future Value:  When you have a single future cash flow (e.g., a future benefit or cost), plug in the values for FV, r, and n to calculate the present value.
• Multiple Future Values:  For projects with numerous future cash flows occurring at different time periods, calculate the present value of each cash flow separately and sum them to get the total present value.
• Excel or Financial Calculators:  Excel and financial calculators often have built-in functions for present value calculations. Utilize these tools for efficiency and accuracy.
• Continuous Cash Flows:  For projects with continuous cash flows (e.g., annual benefits or costs), use annuity formulas or financial software to calculate the present value.

By calculating present value accurately, you ensure that all costs and benefits are expressed in terms of today's dollars, allowing for meaningful comparisons and informed decision-making in your cost-benefit analysis. Understanding the time value of money and selecting an appropriate discount rate are crucial components of this process.

Cost-Benefit Analysis Tools and Software

Utilizing the right tools and software is essential for streamlining the cost-benefit analysis process, enhancing accuracy, and facilitating decision-making.

What is CBA Software?

Cost-benefit analysis software plays a pivotal role in simplifying complex calculations, automating data processing, and generating insightful reports. Here's why CBA software is an invaluable asset:

• Efficiency:  CBA software significantly reduces the time and effort required for complex calculations. It automates many of the mathematical tasks, allowing analysts to focus on interpretation and decision-making.
• Accuracy:  Automation reduces the risk of human error in calculations, ensuring that your CBA results are more accurate and reliable.
• Scenario Analysis:  CBA software often allows you to conduct scenario analysis with ease. You can explore different assumptions and scenarios, providing decision-makers with a range of possible outcomes.
• Visualization:  Many CBA tools offer visualization features, such as charts and graphs, making it easier to present data in a comprehensible and engaging manner.
• Consistency:  CBA software enforces consistency in calculations and data management, reducing the likelihood of inconsistencies or discrepancies.
• Documentation:  These tools often provide built-in documentation capabilities, allowing you to maintain comprehensive records of your analysis.

Popular CBA Tools and their Features

Several CBA tools and software applications are available, each offering unique features and capabilities. Understanding their strengths and functionalities is essential for choosing the right tool for your specific needs. Here's an overview of some popular CBA tools:

Microsoft Excel

• Features:  Excel is a versatile spreadsheet software that can handle various financial calculations and data management tasks.
• Strengths:  Widely accessible and familiar to many analysts. Offers a wide range of financial functions and the ability to create customized templates.
• Limitations:  May require advanced knowledge to set up complex CBA models.
• Features: Appinio  is a real-time market research platform that simplifies data collection for CBA. It provides lightning-fast insights, democratized research capabilities, global reach, precise targeting, and guidance from dedicated research consultants.
• Strengths:  Real-time insights, user-friendly interface, global reach, and expert guidance make it an invaluable tool for efficient and informed decision-making.
• Limitations:  Not a dedicated CBA tool, but its real-time insights can complement CBA analysis for well-informed decision-making.

Crystal Ball

• Features:  Crystal Ball is specialized software for risk analysis and Monte Carlo simulation, making it valuable for sensitivity analysis in CBA.
• Strengths:  Allows for comprehensive risk assessment and modeling of uncertain variables. Offers advanced simulation capabilities.
• Limitations:  May have a steeper learning curve, and licensing costs can be substantial.

Online CBA Calculators

• Features:  Numerous free and paid online CBA calculators are available, offering basic CBA functionalities through web-based platforms.
• Strengths:  Accessibility, ease of use, and cost-effectiveness. Suitable for simple CBA calculations.
• Limitations:  Limited in terms of advanced features and customization options.

Dedicated CBA Software

• Features:  Specialized CBA software solutions are designed for in-depth analysis, offering comprehensive modeling and reporting capabilities.
• Strengths:  Tailored specifically for CBA tasks, allowing for sophisticated modeling, extensive scenario analysis, and in-depth reporting.
• Limitations: May require specific training, and some solutions can be costly.

Best Practices for Using CBA Software

To make the most of CBA software, make sure to follow these best practices:

• Training:  Invest in training for your team to ensure they are proficient in using the chosen CBA software effectively.
• Standardization:  Establish standardized templates and procedures for conducting CBA within your organization to promote consistency.
• Data Quality:  Ensure that the data input into the software is accurate, reliable, and up to date. Garbage in, garbage out applies to CBA software.
• Documentation:  Maintain thorough documentation of your CBA process, including assumptions, data sources, and model configurations.
• Validation:  Validate your software-generated results manually to verify their accuracy and ensure they align with your project's objectives.
• Sensitivity Analysis:  Leverage the software's capabilities for sensitivity analysis to explore the impact of varying assumptions on your results.
• Collaboration:  Encourage collaboration among team members by using collaborative features offered by some CBA software.

By selecting the right CBA software, adhering to best practices, and leveraging the tools effectively, you can enhance the efficiency and accuracy of your cost-benefit analysis, ultimately aiding decision-makers in making informed choices.

How to Interpret Cost-Benefit Analysis Results?

After conducting a thorough cost-benefit analysis, effectively interpreting and communicating the results is crucial. Let's see how you can present CBA findings, interpret the Net Present Value (NPV), and communicate uncertainty and risks associated with your analysis.

Presenting Cost-Benefit Analysis Findings

Presenting CBA findings in a clear and concise manner is essential for decision-makers to grasp the implications of your analysis.

• Executive Summary:  Begin with an executive summary that provides a high-level overview of the project, its objectives, and the key findings of the CBA. This summary should be accessible to non-experts.
• Visual Aids:  Utilize charts, graphs, and tables to visually represent your data. Visual aids make complex information more digestible and engaging.
• Narrative Explanation:  Accompany visual aids with a narrative explanation of the results. Explain the methodology, assumptions, and any notable trends or patterns in the data.
• Key Metrics:  Highlight key metrics such as the Net Present Value (NPV), Benefit-Cost Ratio (BCR), and Internal Rate of Return (IRR). These metrics provide a brief summary of the project's financial viability.
• Sensitivity Analysis:  If you conducted a sensitivity analysis, communicate the range of possible outcomes and their associated probabilities. This helps decision-makers understand the level of uncertainty.
• Recommendations:  Conclude with clear and actionable recommendations based on your analysis. Discuss the implications of your findings and offer guidance on whether the project should proceed.

Interpreting the Net Present Value (NPV)

The  Net Present Value (NPV)  is a pivotal metric in CBA, representing the difference between the present value of benefits and the present value of costs. Interpreting NPV correctly is essential for decision-making:

• Positive NPV:  A positive NPV indicates that the project is expected to generate more benefits than costs. This suggests that the project is financially viable and likely to be a favorable investment.
• Negative NPV:  A negative NPV indicates that the project is expected to incur more costs than benefits. In such cases, the project may not be economically viable from a financial perspective.
• Zero NPV:  A zero NPV signifies that the benefits and costs are expected to be equal over time. This implies that the project is expected to break even but may not generate a surplus.
• Magnitude of NPV:  The magnitude of the NPV indicates the magnitude of the project's net benefit. A higher positive NPV suggests a more financially attractive project, while a lower positive NPV may be less appealing.
• NPV and Decision-Making: The decision to proceed with a project often hinges on its NPV. A positive NPV generally supports project approval, while a negative NPV may warrant reconsideration or project modification.

By effectively presenting your CBA findings, interpreting the NPV, and communicating uncertainty and risks, you provide decision-makers with the necessary information to make informed choices. Transparency and clarity in your communication are vital to ensuring that the implications of your analysis are well understood and can guide effective decision-making.

Cost-Benefit Analysis Examples

Cost-benefit analysis is a versatile tool that can be applied to various scenarios across various industries.

Example #1: Investment in Energy-Efficient Equipment

Scenario:  A manufacturing company is considering investing in energy-efficient equipment to replace its outdated machinery. The new equipment is expected to reduce energy consumption and maintenance costs. The project's lifespan is 10 years.

• Initial Investment (Cost): $500,000
• Annual Energy Savings: $60,000
• Annual Maintenance Savings: $20,000
• Annual Operating Cost Increase: $5,000 (due to new equipment)
• Discount Rate (r): 5% (representing the company's cost of capital)

Calculation:

• Calculate the Net Cash Flow (NCF) for each year: NCF = Annual Energy Savings + Annual Maintenance Savings - Annual Operating Cost Increase
• Calculate the Net Present Value (NPV) of the project: NPV = Σ [NCF / (1 + r)^t], where t represents the year.
• Determine the Benefit-Cost Ratio (BCR): BCR = Σ [NCF / (1 + r)^t] / Initial Investment
• Calculate the Internal Rate of Return (IRR) using trial and error or financial software.
• NPV = $117,512.56 (positive NPV indicates a favorable investment)
• BCR = 1.235 (BCR > 1 signifies a beneficial project)
• IRR ≈ 10.18% (IRR > Discount Rate indicates a financially attractive project)

Example #2: Launching a New Product

Scenario:  A consumer goods company is considering launching a new product line. Market research indicates potential annual revenues and costs associated with the new product.

• Initial Investment (Cost): $1,000,000
• Expected Annual Revenue: $400,000
• Annual Variable Costs: $150,000
• Annual Fixed Costs: $50,000
• Project Lifespan: 5 years
• Discount Rate (r): 8% (representing the company's cost of capital)
• Calculate the Net Cash Flow (NCF) for each year: NCF = Expected Annual Revenue - Annual Variable Costs - Annual Fixed Costs
• NPV = -$231,366.78 (negative NPV indicates a less favorable investment)
• BCR = 0.769 (BCR < 1 suggests a less beneficial project)
• IRR ≈ 4.91% (IRR < Discount Rate indicates a less attractive project)

Interpretation:

In the first example, the investment in energy-efficient equipment yields a positive NPV, BCR greater than 1, and an IRR exceeding the discount rate, indicating that it is a financially attractive project . It is expected to generate net positive cash flows over its lifespan.

In the second example, launching the new product line results in a negative NPV, a BCR less than 1, and an IRR lower than the discount rate, suggesting that it may not be a financially viable project . The company should carefully reconsider this investment or explore alternative strategies.

These examples illustrate how CBA can quantitatively assess the financial viability of projects, guiding decision-makers in choosing the most economically advantageous options.

Cost-benefit analysis (CBA) serves as a powerful compass in the realm of decision-making. It empowers individuals and organizations to weigh the financial pros and cons of various choices, enabling sound investments, effective policies, and informed strategies. By mastering CBA, you can navigate the complex landscape of costs and benefits with confidence, ensuring that your decisions are grounded in data, logic, and the pursuit of maximum value.

Remember, CBA is not just a calculation; it's a mindset that fosters better choices. It encourages us to consider not only the immediate gains and losses but also the long-term impacts on society, the environment, and our future.

How to Conduct Cost-Benefit Analysis in Minutes?

In cost-benefit analysis (CBA), timing is everything, and Appinio , the real-time market research platform, understands the need for swift and data-driven decision-making. With Appinio, you can conduct your own market research in minutes, revolutionizing how you approach CBA. Appinio redefines market research, making it exciting, intuitive, and seamlessly integrated into your daily decision-making.

Here's why Appinio is your gateway to more informed choices:

• Lightning-Fast Insights:  Say goodbye to lengthy research processes. Appinio's platform delivers insights in real-time, allowing you to make decisions swiftly and stay ahead in the competitive landscape.
• Democratized Research:  You don't need a Ph.D. in research to use our platform. It's designed to be intuitive and user-friendly, empowering anyone to harness the power of market research.
• Global Reach, Precise Targeting:  With access to over 90 countries and the ability to define target groups based on 1,200+ characteristics, Appinio ensures your data collection is both expansive and precise.

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Cost-benefit analysis: 5 steps to make better choices

A cost-benefit analysis is a process that helps you determine the economic benefit of a decision, so you can decide whether it’s worth pursuing. It’s a useful tool when you want to avoid bias in your decision-making process—especially when you’re faced with a big decision that will impact your team or project success. Cost-benefit analyses can seem daunting at first, but don’t fret—we’ve simplified the process into five concrete steps.

Calculating the social benefit of a bridge sounds like a puzzler, but not for Dupuit. He just measured how much people were willing to pay to use it. Then with some fancy calculations, he was able to recommend a toll amount that took into account the costs and benefits of his bridge.

And so, the cost-benefit analysis was born. The process has been refined since Dupuit’s day, and now it’s used less for calculating bridge tolls and more for figuring out if decisions are economically feasible. But the big picture remains the same—when it comes to decision-making, costs and benefits are key. 

What is a cost-benefit analysis? 

A cost-benefit analysis (CBA)—also called a benefit-cost analysis—is a decision-making tool that helps you choose which actions are worth pursuing. It provides a quantitative view of an issue, so you can make decisions based on evidence rather than opinion or bias.

CBA is particularly useful in project planning; it compares the financial feasibility of new projects against their potential returns.

During your analysis process, you assign monetary values to the costs and benefits of a decision—then subtract costs from benefits to determine net gains. The resulting cost-benefit ratio helps you estimate the full economic benefit (or lack thereof) of your choice so you can decide if it’s a good idea to pursue.

When should you use a cost-benefit analysis? 

A cost-benefit analysis works best when you want to decide whether to pursue a specific course of action. It also helps when your decision has clear economic costs and benefits. For example, it’s easier to create a CBA to determine the feasibility of a new project than to evaluate whether a new hire would be a good fit for your team. That’s because it’s hard to assign concrete financial costs and benefits to someone’s experience and work potential. 

This type of economic analysis also takes some time to complete, so it’s best for when you’re faced with a big decision that will impact your team or project success. For smaller or less complex decisions, try using a simpler process like a decision matrix . 

Here are some examples of when to use a cost-benefit analysis: 

Developing a new business strategy

Making resource allocation or purchase decisions

Deciding whether to pursue a new project

Comparing investment opportunities

Measuring the potential impact or desirability of new company policies

Assessing proposed changes to your company structure or processes

How to do a cost-benefit analysis

Creating a cost-benefit analysis may seem daunting at first, but we’ve simplified the methodology into five concrete steps. After you’ve run through this process once, you can tailor these steps to suit your specific project or team needs. 

1. Build a framework

First, create a framework that lays out the goals of your analysis, your current situation, and the scope of what your analysis will include. 

Your framework should include these components: 

The question your analysis will answer

A successful CBA always starts with a good question. It helps to be as specific as possible—for example, it’s easier to answer “Should we improve our mobile app?” than a broader question like “What products should we improve to drive adoption?” 

An overview of your current situation

An overview provides context for your analysis. It gives you a starting point to work from, so everyone understands where you’re coming from and why you’re considering a change. Here’s what to include in your overview: 

Background: A brief description of your current situation. 

Current performance: Quantitative data to demonstrate how things are going in your current situation.  

Opportunities: Any areas of improvement from your current situation. 

Projected future performance with the status quo: Quantitative data to predict how things will be going in the future if nothing changes. 

Risks of the status quo: What might go wrong if you don’t change anything. 

For example, imagine you’re trying to decide whether to overhaul your mobile app. Here’s what your overview might look like: 

Background: We have a mobile app and web app. 

Current performance: Our mobile app has 100k users and our web app has 400k users.

Opportunities: We have 300k users who use the web app but not mobile. 

Projected future performance with status quo: Adoption of our web app has grown 50% YoY. We project this will continue and there will be 600k users one year from now. Meanwhile, adoption of our mobile app has grown 10% YoY. We project this will continue and there will be 110k users one year from now. 

Risks of status quo: Lack of mobile adoption means users have less flexibility. Competitors with better mobile apps could win the category, while our brand may become known for having a poor mobile experience. Without an effective mobile app, we’re missing out on a large number of potential app users. 

When building a cost-benefit analysis framework, it's important to accurately estimate the expected costs associated with your decision, including both direct and indirect expenses.

The scope of your analysis

Finally, your framework should include the scope of your CBA. Like a project scope , this creates boundaries for your analysis and lays out what type of information you’ll consider in your calculations (plus what you won’t consider). Typically, your scope includes: 

The timeframe over which you’ll estimate potential costs and expected benefits. For example, you may decide to limit projections to one year from now. 

The types of costs and benefits you’ll include (or exclude). For example, you could decide to include labor costs and resources, but not opportunity costs. 

How you’ll measure costs and benefits. For example, you may assign dollar values to measure tangible costs like labor and resources, and assign key performance indicators (KPIs) to measure intangible costs or benefits like brand awareness. 

2. List and categorize costs and benefits

Next, it’s time to list all the costs and benefits of your decision. For this step, it’s helpful to collaborate with stakeholders so you can benefit from their specific expertise (for example, your IT team would be able to estimate how much new software would cost). Think of your decision like a project you’ll complete to achieve your proposed course of action. Ask yourself what resources you need (like materials or labor), and what the results of your decision will be (like additional revenue). 

As you list out costs and benefits, sort them into the following categories. Then in the next step, you’ll estimate dollar amounts of each of these items.  

Types of costs

Direct costs: Costs associated with the production of your product, service, or project. This is typically the materials, equipment, or labor you need to follow through on your proposed course of action. For example, these could be the direct cost of revamping your mobile app: product team hours, a contract with a user testing firm, and new development software. 

Indirect costs: Fixed costs that aren’t directly associated with production. These are typically ongoing overhead costs that you need to operate your business—like rent, utilities, or transportation fees. For example, these might be the indirect costs to create a new mobile app: internet for your remote development team, plus subscriptions to new development and collaboration software .

Intangible costs: Costs that you can’t assign a dollar amount to, like impacts to brand perception or customer satisfaction. This might also include opportunity costs, which are lost opportunities when you make one decision instead of another. For example, you could include this intangible cost for your app creation project: decreased satisfaction for prospective desktop users. This is an opportunity cost, since you’re choosing to upgrade your mobile app instead of creating a desktop app. 

Costs of potential risks: Costs associated with unexpected roadblocks. In other words, what you’ll need to spend money on if an unforeseen event knocks your project off track. Think of setbacks you would include in a project risk register —like data security breaches, scheduling delays, or unplanned work. For example, you might list these potential costs for your mobile app project: overtime pay for unplanned work, data security team hours to resolve unforeseen app privacy issues, and rush rates to accommodate for scheduling delays. 

When listing out tangible costs (like direct and indirect costs), follow the same process you would when creating a project budget . Think of all the tasks you need to complete to follow through on your decision, then list out the resources required for each deliverable. For intangible costs, you’ll have to use a bit more creativity. If you’re stuck, try looking at similar projects that have been completed in the past to see what type of impact they had. 

Types of benefits

Direct benefits: Benefits you can measure with a currency value, like the revenue you’ll gain from a project. For example, this could include revenue from new mobile app subscriptions. 

Indirect benefits: Benefits you can perceive but can’t measure with currency values. For example, this could include increased customer satisfaction and improved brand awareness.

3. Estimate values

Now it’s time to estimate the value of each cost and benefit you’ve listed. This is most straightforward for tangible categories you can assign a specific dollar amount to—like direct costs, indirect costs, and direct benefits. For intangible categories like intangible costs and indirect benefits, assign KPIs in lieu of monetary units. For example, you could measure customer satisfaction by tracking customer churn rate (the rate at which customers stop using your service). If you can, use the same KPIs for both costs and benefits so you can easily compare them later. 

We can’t predict the future, so these are ultimately just estimates. To make your calculations as accurate as possible, try comparing costs and benefits from similar projects you’ve completed in the past. Old projects are a gold mine of historical data and lessons learned . They can help you see the real-life economic value of past costs and benefits—plus any items or circumstances you might have overlooked. Using a project management tool can make this step easy—since all of your project information and communications are housed in one place, you can easily look back at past initiatives. 

4. Analyze costs vs. benefits

Now comes the fun part—the actual analysis of your costs and benefits. Before you get started, here are some key terms to keep in mind: 

Total costs: The sum of all costs.

Total benefits: The sum of all benefits.

Net cost-benefit: Total benefits minus total costs. This is also called net benefits. 

Net present value (NPV): The difference between the present value of cash inflows and the present value of cash outflows over a period of time. In simpler terms, net present value is a more dynamic way to measure net cost-benefit, because it includes how your net cost-benefit will change over a period of time. 

Internal rate of return (IRR): Calculates the profitability of an investment by determining the annualized return rate that makes the total value of all cash flows (positive and negative) from the investment balance out to zero. 

Benefit-cost ratio : Represents the overall relationship between costs and benefits over a period of time. It’s essentially the proposed total cash benefit divided by the proposed total cash costs—but to make the calculation more dynamic, you calculate the net present value of your costs and benefits over the proposed lifetime of your project. If your benefit-cost ratio is greater than one, that means benefits outweigh costs. 

Discount rates : Used to estimate how the values of your costs and benefits will change over a long period of time—for example, how they might be influenced by inflation. In other words, discount rates are essentially an interest rate you apply to costs and benefits that will occur in the future, so you can convert them into their present value. That way, you can more accurately estimate what the time values of future  costs and benefits would be worth today. 

Sensitivity analysis : Determines how uncertainty affects your decisions, costs, and profits. For example, you could use a sensitivity analysis to compare the worst- and best-case scenarios for your decision. If the worst-case scenario has more costs than benefits, you can look into strategies to mitigate some of those risks. 

These are a lot of fancy terms, but don’t let that scare you. If you don’t want to include more complex calculations like net present value, benefit-cost ratio, discount rates, and sensitivity analysis, you don’t have to. To keep things simple, you can just calculate your net cost-benefit and leave it at that. 

If you used KPIs to measure intangible costs and benefits, you can compare those separately. To analyze KPIs, there are a couple different approaches: 

If you have the same KPIs for costs and benefits, you can subtract costs from benefits to calculate net gains. For example, if you estimate a 5% increase in churn rate due to your decision not to pursue a desktop app and a 20% decrease in churn rate due to your new mobile app, you would have a net 15% decrease in churn rate. 

If you have different KPIs for costs and benefits, you can compare each one to the status quo. For example, you could compare predicted churn rate to your current churn rate, and predicted adoption rates to current adoption rates. This gives you a better idea of the magnitude of these costs and benefits—but at the end of the day, you’ll need to make a subjective decision about how much you value each different KPI. As such, it’s better to use the same metrics for costs and benefits so you can more accurately compare them. 

5. Make recommendations

Now that you’ve completed your cost-benefit analysis (huzzah!), you can make a recommendation. Here are some factors to consider for your decision: 

If your net cost-benefit is positive, that means the benefits of the project outweigh the costs. However, it’s important to consider the size of your net cost-benefit—if it’s too small, you might not be getting much benefit from all the effort you put in. In that case, you may want to consider an alternative decision. 

If your net cost-benefit is negative, that means your project costs outweigh the benefits. In this case, it’s helpful to consider what the biggest cost inputs are. Is there a different approach you could take that would mitigate some of those extra costs? 

If you used KPIs to measure intangible costs and benefits, you need to consider those in addition to your net cost-benefit. For example, if your net cost-benefit was relatively small but you calculated a large decrease in churn rate, your mobile app project may be worth pursuing after all. 

Cost-benefit analysis examples

Cost-benefit analysis offers valuable insights by quantifying and comparing the pros and cons of different choices. Here are three practical examples demonstrating how cost-benefit analysis can be applied in three different scenarios.

Cost-benefit analysis example 1: Implementing new software in a small business

The decision to upgrade software systems in a small business presents a classic case for cost-benefit analysis.

On one side, there's the initial financial outlay and the training costs for employees.

On the other hand, the benefits include improved efficiency, faster customer service, and long-term savings.

By quantifying these factors, a business can determine whether an investment in new technology will yield a favorable return on investment.

Cost-benefit analysis example 2: Assessing the impact of new environmental regulations

A manufacturing company faces new environmental regulations requiring significant changes in its processes.

The cost-benefit analysis here involves comparing the upfront costs of altering equipment and workflows with the long-term benefits, such as:

Reduced environmental impact

Compliance with legal requirements

Potential improvements in public image

This analysis helps decision-makers understand whether the benefits of adhering to these new regulations outweigh the associated costs.

Cost-benefit analysis example 3: Evaluating an urban public transportation expansion

A thorough cost-benefit analysis is essential when a city is thinking about growing its public transportation system. 

This involves calculating the direct costs of construction and operation expenses against the benefits, including:

Reduced traffic congestion

Lower pollution levels

Improved accessibility for residents

By assessing these factors, the city can decide if the project's long-term benefits justify the significant initial investment.

Pros and cons of cost benefit analysis

Understanding both the advantages of cost analysis and its limitations is important for decision-makers. Let's look at what makes cost-benefit analysis a powerful, but not always simple, tool.

Advantages of cost analysis

Streamlining decision-making processes: Cost-benefit analysis aids in simplifying complex decisions by translating them into quantifiable terms. This approach is particularly useful in scenarios where return on investment and cost effectiveness are key considerations.

Revealing overlooked costs and advantages: Some benefits or expenses are not immediately apparent, but a thorough cost-benefit analysis makes them clear and guarantees a thorough evaluation.

Emphasizing a data-centric method: By focusing on quantifiable data, such as estimated costs and forecasted benefits, cost-benefit analysis promotes objectivity, reducing the influence of subjective biases.

Limitations of cost-benefit analysis

Cost-benefit analysis is a handy tool for data-driven decision making . But like any estimation technique, it isn’t perfect. When deciding whether to use a cost-benefit analysis or another decision-making process, keep in mind these limitations: 

Revenue and cash flow can be unpredictable due to changing market conditions.

In some cases, the costs or benefits of a project or decision can’t be directly reflected by dollar amounts. 

Value is subjective when you use KPIs to measure intangible costs and benefits. 

It can be hard to accurately predict all potential risks. 

A cost-benefit analysis requires a significant time commitment to complete. 

Forecasting accuracy diminishes for projects extending over a long period, affecting the reliability of the analysis.

The complexity of accurately predicting every variable, such as future costs and intangible benefits, poses a challenge.

The effectiveness of cost-benefit analysis depends on the accuracy of the data used. Misleading or incorrect data can result in flawed conclusions.

If you decide that a cost-benefit analysis isn’t the right fit for your particular situation, you may want to consider creating a decision matrix or decision tree analysis instead. 

Make decisions count

A cost-benefit analysis helps you use data to make the best possible decision. That means you can say goodbye to coin flips and choose your options with confidence. 

Creating a cost-benefit analysis can seem like a project in its own right, especially if you’re working with multiple stakeholders to get the job done. Before you dive in, consider using a project management tool to coordinate work. Asana lets you create and assign tasks, organize work, and communicate with stakeholders directly where work happens. You can also map out your entire cost-benefit analysis project and save it as a template for future use.

Related resources

How to use a feasibility study in project management

How to track utilization rate and drive team profitability

How to accomplish big things with long-term goals

Smooth product launches are simpler than you think

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Article • 8 min read

Cost-Benefit Analysis

Deciding, quantitatively, whether to go ahead.

By the Mind Tools Content Team

(Also known as CBA and Benefit-Cost Analysis)

Imagine that you've recently taken on a new project, and your people are struggling to keep up with the increased workload.

You are therefore considering whether to hire a new team member. Clearly, the benefits of hiring a new person need to significantly outweigh the associated costs.

This is where Cost-Benefit Analysis is useful.

CBA is a quick and simple technique that you can use for non-critical financial decisions. Where decisions are mission-critical, or large sums of money are involved, other approaches – such as use of Net Present Values and Internal Rates of Return – are often more appropriate.

About the Tool

Jules Dupuit, a French engineer and economist, introduced the concepts behind CBA in the 1840s. It became popular in the 1950s as a simple way of weighing up project costs and benefits, to determine whether to go ahead with a project.

As its name suggests, Cost-Benefit Analysis involves adding up the benefits of a course of action, and then comparing these with the costs associated with it.

The results of the analysis are often expressed as a payback period – this is the time it takes for benefits to repay costs. Many people who use it look for payback in less than a specific period – for example, three years.

You can use the technique in a wide variety of situations. For example, when you are:

• Deciding whether to hire new team members.
• Evaluating a new project or change initiative.
• Determining the feasibility of a capital purchase.

However, bear in mind that it is best for making quick and simple financial decisions. More robust approaches are commonly used for more complex, business-critical or high cost decisions.

How to Use the Tool

Follow these steps to do a Cost-Benefit Analysis.

Step One: Brainstorm Costs and Benefits

First, take time to brainstorm all of the costs associated with the project, and make a list of these. Then, do the same for all of the benefits of the project. Can you think of any unexpected costs? And are there benefits that you may not initially have anticipated?

When you come up with the costs and benefits, think about the lifetime of the project. What are the costs and benefits likely to be over time?

Step Two: Assign a Monetary Value to the Costs

Costs include the costs of physical resources needed, as well as the cost of the human effort involved in all phases of a project. Costs are often relatively easy to estimate (compared with revenues).

It's important that you think about as many related costs as you can. For example, what will any training cost? Will there be a decrease in productivity while people are learning a new system or technology, and how much will this cost?

Remember to think about costs that will continue to be incurred once the project is finished. For example, consider whether you will need additional staff, if your team will need ongoing training, or if you'll have increased overheads.

Step Three: Assign a Monetary Value to the Benefits

This step is less straightforward than step two! Firstly, it's often very difficult to predict revenues accurately, especially for new products. Secondly, along with the financial benefits that you anticipate, there are often intangible, or soft, benefits that are important outcomes of the project.

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

As an example, is preserving an ancient monument worth $500,000, or is it worth $5,000,000 because of its historical importance? Or, what is the value of stress-free travel to work in the morning? Here, it's important to consult with other stakeholders and decide how you'll value these intangible items.

Step Four: Compare Costs and Benefits

Finally, compare the value of your costs to the value of your benefits, and use this analysis to decide your course of action.

To do this, calculate your total costs and your total benefits, and compare the two values to determine whether your benefits outweigh your costs. At this stage it's important to consider the payback time, to find out how long it will take for you to reach the break even point – the point in time at which the benefits have just repaid the costs.

For simple examples, where the same benefits are received each period, you can calculate the payback period by dividing the projected total cost of the project by the projected total revenues:

Total cost / total revenue (or benefits) = length of time (payback period).

Custom Graphic Works has been operating for just over a year, and sales are exceeding targets. Currently, two designers are working full-time, and the owner is considering increasing capacity to meet demand. (This would involve leasing more space and hiring two new designers.)

He decides to complete a Cost-Benefit Analysis to explore his choices.

Assumptions

• Currently, the owner of the company has more work than he can cope with, and he is outsourcing to other design firms at a cost of $50 an hour. The company outsources an average of 100 hours of work each month.
• He estimates that revenue will increase by 50 percent with increased capacity.
• Per-person production will increase by 10 percent with more working space.
• The analysis horizon is one year: that is, he expects benefits to accrue within the year.

He calculates the payback time as shown below:

$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.

Inevitably, the estimates of the benefit are subjective, and there is a degree of uncertainty associated with the anticipated revenue increase. Despite this, the owner of Custom Graphic Works decides to go ahead with the expansion and hiring, given the extent to which the benefits outweigh the costs within the first year.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows that come in over a number of periods of time, particularly where returns vary from period to period. In these cases, use Net Present Value (NPV) and Internal Rate of Return (IRR) calculations together to evaluate the project, rather than using Cost-Benefit Analysis. (These also have the advantage of bringing "time value of money" into the calculation.)

Also, the revenue that will be generated by a project can be very hard to predict, and the value that people place on intangible benefits can be very subjective. This can often make the assessment of possible revenues unreliable (this is a flaw in many approaches to financial evaluation). So, how realistic and objective are the benefit values used?

Cost-benefit analysis is a relatively straightforward tool for deciding whether to pursue a project.

To use the tool, first list all the anticipated costs associated with the project, and then estimate the benefits that you'll receive from it.

Where benefits are received over time, work out the time it will take for the benefits to repay the costs.

You can carry out an analysis using only financial costs and benefits. However, you may decide to include intangible items within the analysis. As you must estimate a value for these items, this inevitably brings more subjectivity into the process.

San Jose State University Department of Economics. (2012). An Introduction to Cost Benefit Analysis. (Available here .) [Accessed 4 September, 2012.]

Griffin, R.C. (1998). 'The Fundamental Principles of Cost-Benefit Analysis,' Water Resources Research, Volume 34, Number 8, August 1998. (Available here) .

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cyndi lynch

I don't understand why the Costs section was repeated 12 times.

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Cost-Benefit Analysis Defined – The Ultimate Guide

In any business, department heads have competing priorities. For example, the chief revenue officer of a B2B software-as-a-service provider wants to establish an indirect channel sales program, while marketing wants to hire a content writer to help organically acquire new leads. Both make good cases — each department is sure they can increase revenue with a few more people and a little more money, after all.

Finance teams acting as mediators should consider a formal cost-benefit analysis exercise. Also sometimes called a benefit-cost analysis, this is a well-established process for guiding leaders to make decisions that are rooted in and informed by data on company goals and priorities and budget realities.

What Is Cost-Benefit Analysis (CBA)?

A cost-benefit analysis involves comparing the explicit and implicit costs of taking an action versus expected benefits. The process of gathering that information may be enlightening because it may require the business to assign monetary value to factors that don’t have explicit costs. The resulting analysis allows decision-makers to weigh all information and make rational choices.

As a pros-and-cons evaluation tool, CBAs are most closely associated with public-sector decision-making. But they’re also used in business when it comes time for project planning around adding employees, purchasing technology or equipment, expanding facilities and more. A CBA can weigh the benefits of taking an action over maintaining the status quo or help a business compare two or more options to see which one makes the most sense.

Key Takeaways

• Cost-benefit analyses help businesses weigh pros and cons in a data-driven way so they can make complex decisions in a systematic manner.
• For a successful CBA, leaders need to identify and project the explicit and implicit costs and benefits of a proposed action or investment.
• It’s also a good idea to assign someone to make the case for the status quo as a way to compare the opportunity cost of doing nothing and investing cash versus proposed actions.
• A cost-benefit analysis is only as good as the data on which it’s based, so companies with more mature financial reporting have a higher likelihood of success.

Cost-Benefit Analysis Explained

Each action a business takes has explicit cost and revenue expectations. But there are also implicit costs, often expressed as the opportunity cost — that is, the money or other benefit lost by pursuing one option over another or of taking no action. Opportunity cost is not an accounting concept, it’s an economic one, but it can be associated with a quantitative value.

A cost-benefit analysis adds up the benefits and costs of a program or purchase, extracts a CBA ratio and then compares that result with both stasis and alternative programs or purchases.

A CBA requires considering both monetary and opportunity costs over a period of time. To compare multiple CBAs, extract a CBA ratio from each. The formula for a cost-benefit analysis ratio can be expressed as:

Projected benefits / projected costs = CBA ratio

For example, the CMO of our fictional SaaS provider wants to hire a content writer to improve the company’s web site content so that it helps deliver more qualified leads to sales. The CRO thinks a channel program can win both new customers and more mindshare. In all cases, the leaders would be asked to approve at least one additional FTE along with some required software and other services.identify and attach dollar values to the explicit and implicit costs of their projects and compare those to the explicit and implicit benefits. The CFO may also run the numbers on “none of the above.”

If that sounds straightforward, it isn’t. An in-depth, precise cost-benefit analysis is a complex undertaking because of the inputs required, the need to set parameters, the fact that not every factor the business needs to measure has an explicit cost or return and the number of indirect or intangible properties that make future outcomes difficult to forecast.

Then there’s the fact that while a project or purchase with a high benefit-to-cost ratio is generally considered the most favorable option, that’s not a given.

Purpose of a Cost-Benefit Analysis

Businesses perform cost-benefit analyses to help leaders remove emotion from assessments and provide an apples-to-apples basis to compare competing priorities. And, when intangible benefits are expressed as a “benefits value,” with dollar amounts assigned, that helps finance calculate a break-even point — the time it takes for a product’s or purchase’s benefits to exceed the cost.

In the future, a CBA can be revisited to evaluate the actual cost and ROI of a project or purchase compared with projections and improve the analysis process.

For example, the CMO’s plan to employ a writer to attract new customers involves recurring investments in both marketing software subscriptions and salary and benefits. Expected returns include increased revenue, a larger customer base and better visibility for the company. Some of these costs and returns are difficult to quantify. In contrast, the CROs ’plan will require the attention of sales leaders to create an entirely new revenue stream that may take a year or two to become profitable. There’s a substantial opportunity lost in pursing more sales through existing channels, but the payoff could be substantial. There’s also the internal dynamic that will surface as the new indirect sales channel takes some of the revenue of the existing sales team.A CBA seeks to select the project with the greatest overall benefit for the incurred costs.

Importance of Cost-Benefit Analysis

Leaders need to make sometimes difficult decisions in a timely manner. Cost-benefit analyses help by providing financial context and data-driven justification for sometimes painful choices that may not be viewed favorably by staff.

A cost-benefit analysis, often paired with the sensitivity or “what if” analyses used in financial modeling , also offsets biases that may sway decisions, like the dreaded HiPPO — highest-paid person’s opinion.

Sensitivity Analysis Template

Below is a sample sensitivity analysis worksheet a CIO might use to evaluate a product purchase alongside a CBA — it’s overly simplified for the sake of space. It combines product attributes, like suitability for the task, with business considerations. Criteria sets may be added and customized.

Sensitivity Analysis Table for Product Purchase

Criteria set 1 = Match to needs, reliability, value for price, competitive positioning, roadmap/innovation, integrations

Criteria set 2 = Assists with customer acquisition, adds operational efficiency, staff familiarity, loaded cost

But leaders do need to go beyond the numbers and consider intangibles: Which project or purchase better advances the business’s long- and near-term goals? For example, our fictional CMO makes a strong case, but if the company wants to undertake expansion, whether geographically or selling into a new market segment or industry, the indirect sales channel program championed by the CRO may be the better choice with a bigger eventual payoff, even though accurately comparing the cost of direct versus indirect sales is a complex analysis.

Point is, data needs to play a strong yet balanced role in the decision-making process. By allowing a company to better weigh the implicit costs of taking or not taking an action, where there is no obvious or immediate explicit cost, projects that may not generate a clear profit on the balance sheet may still be moved forward. Think advancing sustainability objectives, diversity and inclusion initiatives and helping employees navigate new workplace realities.

When Should a Business Conduct a Cost-Benefit Analysis?

CBAs are useful anytime there are priorities competing for limited resources. But companies do need to set some ground rules for analyses. For example, all stakeholders should understand the company’s expectation on whether a CBA will address short-, mid or long-term impacts. The further into the future analysis extends, the more difficult it is to accurately forecast costs and benefits.

In general, most companies should do a cost-benefit analysis for major decisions in these five areas:

• Capital investments: Should the business purchase a new delivery vehicle, production machinery, computer hardware or office furniture, or invest in renovating a building? Assign costs with the understanding that the benefit of the investment is derived from the use of the asset, not from its market value. For instance, an investment in new manufacturing equipment should allow me to produce more goods at a lower cost, resulting in more revenue and better margins. I'll retain this benefit even as the value of the equipment declines.
• Business process change: A business process is any defined set of actions that are repeated often and produce a desired result. A company may think that a task that’s high volume, high touch, repetitive and prone to error is a candidate for business process automation . A CBA can help prove the theory. For example, should you purchase software that automatically adds inventory receipts to the inventory ledger and the asset column on the balance sheet versus manual entry? Or, a growing company may run a CBA and find that hiring a third-party to manage the payroll process now makes sense and is a source of savings.

In any cost-benefit analysis, ensure the stakeholder asks: How can we drive inefficiency out of this business function? And how do we attach a dollar value to that?

• Organizational change: This is often related to business process change and refers to human capital. An example is comparing hiring staff versus outsourcing. Adding an indirect sales channel, for example, is a significant organizational change. For a CBA, you’ll need to consider that a productive on-staff sales rep might cost more on a per-sale basis versus indirect, but turnover is high. Commissions may be a wash. Will you need to hire a channel manager (organizational change), set up a portal for functions such as deal registration (a business process change) and/or allocate marketing development funds?
• Adjusting pricing or introducing new product or service: Managers in companies that use cost accounting have pretty granular data on the total costs and revenue attached to a good or service and thus have a head start on cost-benefit analyses. Factors to quantify may include whether the company should introduce a subscription model, or whether it should discontinue a certain product or service because of poor sales before adding a new SKU.
• Entering into a merger, acquisition or divestiture: Decisions around whether to acquire or merge with a company or sell parts of the business are among the most complex analyses, and the most important. A merger that may seem desirable at first glance, upon further consideration, may come with significant process and organizational changes, legal fees, costly layoffs and other factors which may diminish the relative value of the merger.

5 Cost-Benefit Analyses Gotchas to Avoid

• One person’s opinion: Applying a monetary value to intangible risks and benefits requires human judgment and is therefore subjective and prone to bias. The more people who weigh in, the more objective the analysis is likely to be. For important CBAs, assemble a panel with a mix of expertise — HR, engineers and new and longtime employees.
• Dubious data sources: Even line items that should be readily quantifiable may be open to interpretation in the absence of accounting and financial management software. If the quality of data is in question, apply a sensitivity analysis or other valuation method to formalize how the company measures uncertainty for CBA purposes.
• Unrecognized resource constraints: A CBA on hiring a content producer, for example, must recognize the limited number of skilled writers available and the volume of content that one employee can produce. Likewise, lowering the cost of a product may increase consumer demand beyond what the supply chain can bear, thus raising COGS — if an existing supplier can't support increased demand, the manufacturer will either sell out of product or be forced to pay a higher price to purchase raw materials.
• Extended timelines: In general, three years is doable; five years is a stretch. Adjust for extended projections by A: Applying discounted or present value. Select a reasonable interest rate at which future earnings are to be discounted to reduce them to their present value, and use that rate in all analyses. And B: Applying scenario analysis , which provides a rational and structured way to analyze the future and account for externalities.
• Double counting benefits or costs: For example, if an anti-phishing project is predicted to reduce the likelihood of a successful ransomware attack on a SaaS provider, the CIO might be tempted to include both the benefit of increased uptime for the business and higher productivity for employees, yet the cost of downtime probably already includes lost productivity.

What Inputs are Included in a Cost-Benefit Analysis?

In performing a cost-benefit analysis, include:

The costs of taking an action or of doing nothing include:

• Explicit costs: These are accounting costs with explicit monetary value and may include direct costs such as labor, manufacturing and the cost of software or machinery and indirect costs, such as utilities or rent.
• Intangible costs: These are qualitative items, such as lost productivity or reduced customer satisfaction if an existing product is retired because a new SKU is being introduced.
• Implicit costs: These are opportunity costs, both financial and non-financial, like purchasing a capital asset versus investing free cash, or of pulling employees off one project to work on the new initiative.

As with costs, benefits should be categorized:

• Direct benefits: This is the accounting profit from the decision and could include, for instance, cost savings or increased revenue from a new product or service.
• Indirect: These are tangential benefits. For instance, as a result of a new technology implementation, customers may be incentivized to spend more.
• Intangible: These benefits could include, for instance, improved customer satisfaction, employee morale or employee safety.
• Competitive: The business may want to include in its CBA the benefits of gaining a competitive edge in its industry and factor in, for example, increased market share, thought leadership and first-mover advantage.

Pros and Cons of a Cost-Benefit Analysis

A well-conducted cost-benefit analysis provides a level of predictability when undertaking a project. However, leaders need to set parameters and ensure all participants are working with a common set of assumptions.

Advantages of cost-benefit analyses:

• It supports decision-making with data to increase confidence or build support for making a move.
• It provides a way to incorporate qualitative factors into quantitative analysis.
• It can help businesses arrive at the total cost of taking a particular action that eclipses its explicit price tag and contributes to determining the ROI of a project or action.
• By incorporating net present value , businesses may view future investments at current dollar values.

Challenges of cost-benefit analyses:

• It requires assigning explicit monetary value to intangible factors. This can be challenging and introduce ambiguity.
• Gathering accurate data may be challenging, as is forecasting implicit cost and benefits.
• Businesses can become over-reliant on CBAs as a tool for making decisions and as a project-costing and budgeting method.
• Forecasting is inherently difficult. Unless a company regularly performs financial planning & analysis (FP&A) and scenario planning exercises, it should use caution with extended-outlook CBAs.

How to Conduct a Cost-Benefit Analysis

Companies may need to expand the CBA process based on the complexity of the proposals under consideration, but the basic steps are:

• List the projects, investments or actions to evaluate, and identify all stakeholders. Ensure each stakeholder has access to the financial data that will be needed to evaluate the project or investment; understands parameters, such as how far into the future to extend the analysis; and has insights into intangibles, including access to FP&A and scenario planning .
• Determine costs. List all explicit and implicit costs of each action under consideration and assign dollar values to the implicit, or opportunity, costs. For example, if current IT employees are redirected to installing and running new security software, what tasks will no longer be performed?
• Document assumptions. Valuing implicit costs and benefits requires a certain amount of judgement. Any assumptions used to estimate the values should be clearly documented before comparing alternatives.
• Determine benefits. List and assign dollar values to all explicit and implicit benefits of each action under consideration. As with costs, this will be easier for benefits that can be quantified, for example, in terms of saving FTE costs for one or more sales professionals by launching an indirect channel sales program. Others, such as employee productivity or engagement, will be more challenging to quantify. Bring in HR or other experts as needed to check stakeholder assumptions.
• Add perspective. Not everything is a purely dollars-and-cents decision. Senior leaders need to weight options based on company culture, values and goals.
• Compare alternatives. Calculate the cost-benefit analysis ratio for each option under consideration and compare those against one another and against the costs and benefits of doing nothing.

Cost Benefit Analysis Example

Let’s look at a simplified version of the CBA that the head of sales presented for establishing an indirect channel.

Our fictional SaaS provider has a traditional direct sales model, where its asset maintenance scheduling software is sold as service directly to end customers. Customers may also purchase direct from the website, which does not generate a commission.

Goal: The company sells mainly to manufacturers but believes it can expand to serve healthcare groups, which need to perform regular maintenance on expensive medical equipment.

The problem is that the sales team would need to start from scratch to make contacts in this new market. The CMO believes her marketing team can generate sales-qualified leads by hiring a content producer familiar with healthcare, but the chief revenue officer thinks there’s a better way.

Premise: The CRO believes the company can more quickly succeed by establishing an indirect sales channel to complement existing sales capabilities. The program would be open to 10 to 15 value-added resellers and managed service providers that focus on healthcare. The CRO would sign on the partners initially then pass them to a channel salesperson. The company would develop an online portal for partners to register opportunities and execute purchases on behalf of customers.

Note: The numbers below are designed to be illustrative, not a representation of the industry.

Assumptions: The software costs $15000 per year fifty seats – an average sale. The CRO believes that the partner program can bring in 50 new customers in Year 1 and that all will renew. By year three, the partners will bring in 200 new logos per year. Partners earn 20% of sales. Support will take1 $70,000 FTE specialist per 75 logoss. The product for indirect sale is the same as what is sold through the direct sales channel, and pricing will be the same. To avoid channel conflict, direct sales wouldn't be allowed to work deals in certain verticals. And they won't follow up on website leads for for those verticals.

In contrast, the CMO’s proposal would entail gaining those 50 new healthcare customers by spending $100,000 on an FTE plus $250,000 on new marketing tools and ad buys.

Free Cost Benefit Analysis Template

Download this free cost benefit analysis template to help narrow down your options and make complex decisions simpler.

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Manage Your Cost Benefit Analysis with Accounting Software

The most important contributor to an accurate, insightful cost-benefit analysis is accurate data. Modern finance and accounting software combined with integrated planning, budgeting and forecasting tools and enterprise resource planning software suites with HR, supply chain and other insights mean all transactional and forward-looking data is in a central location. This makes it easier for authorized stakeholders to pull accurate, up-to-date information to inform their analyses. Numbers can be automatically exported to Excel or provided in the form of a report to key decision-makers.

Perhaps one of the more challenging parts of a CBA is when a leader selects a project that the numbers say is less profitable than other options. The reason may be a desire to forward long-term goals, or that company culture and values dictate spending more or leaving profit on the table.

And of course, sometimes the right answer will be “do nothing.” At least with a solid cost-benefit analysis, companies can make hard decisions with their eyes wide open.

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Cost Benefit Analysis FAQs

What is meant by the cost-benefit analysis?

A cost-benefit analysis (CBA) is a systemized approach used to assess the advantages (benefits) and disadvantages (costs) associated with a particular decision, project, or policy. The goals is to decide if the benefits outweigh the costs, meaning more informed business decision-making.

What is an example of a cost-benefit analysis?

A company is considering upgrading its software, so it performs a cost-benefit analysis of the new system. The cost includes purchasing the software, training staff, and potential downtime during the transition. The benefits might include increased productivity, reduced operational errors, and enhanced customer satisfaction. A CBA would quantify these factors in monetary terms to determine if the investment in new software is the best decision for the business.

What are the cost-benefit analysis methods?

Various methods are employed in cost-benefit analysis, including:

• Net Present Value (NPV): Calculates the present value of future cash flows minus the initial investment.
• Benefit-Cost Ratio (BCR): Represents the ratio of the benefits to the costs.
• Internal Rate of Return (IRR): The discount rate at which NPV becomes zero.
• Payback Period: Time taken for the benefits to repay the costs.
• Sensitivity analyses are also conducted to account for uncertainties and variables in estimates.

How do you calculate cost analysis?

Cost analysis involves determining all the costs associated with a project or decision. To calculate:

• Identify Direct Costs: These are costs directly attributable to the project, like materials, labor, and equipment.
• Identify Indirect Costs: Overheads or administrative costs that aren't tied to a specific project but are spread over multiple projects.
• Factor in Intangible Costs: Costs not easily quantifiable, like potential brand damage or opportunity costs.
• Sum up: Add all identified costs to derive a total cost.

Historical Cost Principle: How It Works & Why It Matters

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Cost-Benefit Analysis: A Quick Guide with Examples and Templates

When managing a project, many key decisions are required. 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. Before we explain how to do a cost-benefit analysis, let’s briefly define what it is.

What Is a Cost-Benefit Analysis?

A cost-benefit analysis (CBA) is a process that’s used to estimate the costs and benefits of projects or investments to determine their profitability for an organization. A CBA is a versatile method that’s often used for business administration, project management 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

These project costs and benefits are then assigned a monetary value and used to determine the cost-benefit ratio. However, a cost-benefit analysis might also involve other calculations such as return on investment (ROI), internal rate of return (IRR), net present value (NPV) and the payback period (PBP).

The Purpose of Cost-Benefit Analysis

The purpose of cost-benefit analysis is to have a systemic approach to figure out the pluses and minuses of various business or project proposals. The cost-benefit analysis gives you options and offers the best project budgeting approach to achieve your goal while saving on investment costs.

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Cost Benefit Analysis Template

Use this free Cost Benefit Analysis Template for Excel to manage your projects better.

When to Do a Cost-Benefit Analysis

Cost-benefit analysis is a technique that helps decision-makers choose the best investment opportunities in different scenarios. Here are some of the most common applications for a cost-benefit analysis in project management.

Cost Benefit Analysis & Feasibility Studies

A feasibility study determines whether a project or business initiative is feasible by determining whether it meets technical, economic, legal and market criteria.

Cost Benefit Analysis & Business Requirements Documents

A cost-benefit analysis should be included in a business requirements document , a document that explains what a project entails and what it requires for its successful completion.

Cost Benefit Analysis & Government Projects

Government projects also require conducting a cost-benefit analysis. However, in these types of projects, decision-makers must not only focus on financial gain, but rather think about the impact projects have on the communities and external stakeholders who might benefit from them.

Keeping track of project costs is 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 makes a successful project. Get started for free today.

How to Do a Cost-Benefit Analysis

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 basic cost-benefit analysis using the cost-benefit ratio and present value formulas:

1. What Are the Project Goals and Objectives?

Create a business case for your project and state its goals and objectives.

2. Review Historical Data

Before you can know if a project proposal might be valuable, you need to compare it to similar past projects to see which is the best path forward. 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. What Are the Project Costs and Benefits?

Estimate the future value of your project costs and benefits and think about all the non-financial benefits that a project proposal might bring

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. Define a Project Timeframe

Look over the costs and benefits of the project, assign them a monetary value and map them over a relevant time period. It’s important to understand that the cost-benefit ratio formula factors in the number of periods in which the project is expected to generate benefits.

6. What Is the Rate of Return?

As explained above, the rate of return is used to calculate the present values of your project’s costs and benefits, which are needed to find the cost-benefit ratio.

Free Cost-Benefit Analysis Template

Use this Excel template to put what you’ve learned into practice. This free cost-benefit analysis template helps you identify quanitative costs and benefits, as well as qualitative costs and benefits, so you can appreciate the full impact of your project. Download yours today.

What Is the Cost-Benefit Ratio?

The cost-benefit ratio, or benefit-cost ratio, is the mathematical relation between the costs and financial benefits of a project. The cost-benefit ratio compares the present value of the estimated costs and benefits of a project or investment.

Cost-Benefit Ratio Formula

This is a simplified version of the cost-benefit ratio formula.

Cost-Benefit Ratio= Sum of Present Value Benefits / Sum of Present Value Costs

Here’s how you should interpret the result of the cost-benefit ratio formula.

• If the result is less than 1: The benefit-cost ratio is negative, therefore the project isn’t a good investment as its expected costs exceed the benefits.
• If the result is greater than 1: The cost-benefit ratio is positive, which means the project will generate financial benefits for the organization and it’s a good investment. The larger the number, the most benefits it’ll generate.

Present Value Formula

The present value of a project’s benefits and costs is calculated with the present value formula (PV).

PV = FV/(1+r)^n

• FV: Future value
• r= Rate of return
• n= Number of periods

We’ll apply these formulas in the cost-benefit analysis example below. Our free cost-benefit analysis template can help you gather the information you need for the cost-benefit ratio analysis.

Cost-Benefit Analysis Example

Now let’s put the formulas reviewed above into practice. For our cost-benefit analysis example, we’ll think about a residential construction project, the renovation of an apartment complex. After using project cost estimation methods and evaluating past-project data, the apartment management company concludes that:

• The project costs are $65,000. They’re paid upfront, so it’s not necessary to calculate their present value
• The project is expected to generate $100,000 in profit for the next 3 years
• The rate of return based on inflation data is 2%

Next, we’ll need to calculate the present value of the benefits expected to be earned in the future using the present value formula:

PV= ($100,000 / (1 + 0.02)^1) + ($100,000 / (1 + 0.02)^2) + ($100,000 / (1 + 0.02)^3)=$288,000

Now we need to use this cost value to find the cost-benefit ratio. Here’s how it would be calculated in this case:

Cost-Benefit Ratio: 288,000/65,000= 4.43

Since we obtained a positive benefit-cost ratio, we can conclude that the project will be profitable for this company. This result implies that the project will generate about $4,43 dollars per each $1 spent to cover expenses .

This is a simple cost-benefit analysis that relies on the cost-benefit ratio to establish the profitability of this project. In other scenarios, you might also need to calculate the return on investment (ROI), internal rate of return (IRR), net present value (NPV) and the payback period (PBP). In addition, it’s advisable to conduct a sensitivity analysis to evaluate different scenarios and how those affect your cost-benefit analysis.

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 and customized tags you can assign team members to own each item. Our online tool automatically tracks the percentage complete for each item in real time. All the data you collect in our list view is visible throughout the tool. Regardless of the view, they all update live and they’re ready for you to utilize.

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
• Improperly using 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

Cost-Benefit Analysis Limitations

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 Template

One of the steps when executing a cost-benefit analysis includes identifying project stakeholders. 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 Template

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, office equipment, admin and insurance. A thorough budget makes for a more accurate cost analysis.

Project Risk Register Template

You have your stakeholders identified and your budget outlined, but there’s always the unknown to consider. You can’t leave that up to chance: you must manage risk, which is why our free project risk register is so essential. Use it to outline inherent project risks. There are places to list the description of the risk, its impact, the level of risk and who’s responsible for it. By maintaining a risk register, you can control the project variables 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 award-winning project management software with the tools you need to realize the potential of your project. First, you need an airtight plan.

Planning on Gantt Charts

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 Tools

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 online 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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Cost-Benefit Analysis

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Benefit-cost analysis ; CBA

CBA is a framework employed to assess both the social and private costs and benefits of a project (program, scheme, intervention, or policy) with the aim to determine whether the project is desirable from the social welfare perspective. In order to assess the welfare change attributable to the project (i.e., the project’s net benefit to society as a whole), all costs and benefits resulting from the project must be quantified and transformed into monetary values . CBA is used in ex ante evaluation as a tool for policy makers to select alternative projects or to decide whether a specific scheme is worthwhile for society. It can be also employed ex post to quantify the net social worth of a fully implemented specific program.

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CBA is a normative procedure involving making value judgments for policy interventions. Accordingly, CBA has its roots in welfare economics , a branch of economics that deals with ethical propositions in order...

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Stiglitz, J. E. (1994). The rate of discount for benefit-cost analysis and the theory of the second best. In R. Layard & S. Glaister (Eds.), Cost-benefit analysis (2nd ed., pp. 116–159). Cambridge, UK: Cambridge University Press.

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Ortega, B. (2021). Cost-Benefit Analysis. In: Maggino, F. (eds) Encyclopedia of Quality of Life and Well-Being Research. Springer, Cham. https://doi.org/10.1007/978-3-319-69909-7_600-2

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What Is Cost Analysis?

Discover how cost analysis aids in determining whether the benefits of a business endeavor outweigh its costs.

While it’s natural to harbor uncertainties about the best course of action when facing critical decisions in business, you can use cost analysis to help you choose the most lucrative path forward. Whether you're evaluating the feasibility of a proposed project or contemplating a shift in sales strategy, cost analysis serves as a guiding compass, offering insights into a business decision's potential benefits and drawbacks. Essentially, you can implement this tool to determine how much a project will cost and then compare that to how much the project can produce. 

Read on to understand the nuances of cost analysis, including effective comprehensive analysis strategies. 

Why is cost analysis important?

Cost analysis, or cost-benefit analysis (CBA), is a systematic approach that helps you evaluate an endeavor or project's financial implications and benefits. Essentially, a CBA quantitatively compares the estimated costs and benefits. The outcome provides a numerical indicator (total benefits minus total costs) that helps you assess whether a proposed project is economically sound. 

For instance, consider the launch of a new product line. Performing a cost analysis would help you discern the preliminary expenditure, potential revenue (tangible benefit), and the overall financial viability of this endeavor. Armed with this information, stakeholders within your firm can make well-informed financial decisions, thereby contributing to the success of the new product line.

What are the direct outcomes of conducting a cost analysis?

If you conduct a cost analysis, strategic budgeting is one of the direct outcomes. Stakeholders, including investors, need relevant data for budgeting decisions. When you provide transparent cost analysis, you foster collaboration, ensuring stakeholders contribute meaningfully to budgeting. 

Read more: What Is a Pricing Analyst?

Steps involved in cost analysis

A universally agreed-upon method for conducting a cost-benefit analysis doesn’t exist; however, most techniques have the following steps in common:

1. Define project goals and scope.

Setting explicit objectives can help enhance the accuracy of your cost-benefit analysis. For example, you might want to conduct a CBA to assess the cost and benefits of adopting a remote work policy within your organization.  

After outlining your project scope, choose a metric for comparing the associated benefits and costs. You can choose to use job hours, actual currency, or customer satisfaction index as a metric, depending on the nature of your project. If you use a specific currency as a metric, ensure that costs and benefits are expressed in the same currency for an accurate comparison. 

2. Record estimated costs and benefits.

Create two lists to document the estimated costs and benefits associated with your project. Costs can be direct (labor, inventory, raw materials, and manufacturing expenses), indirect (utilities and rent), opportunity (missing a chance to do something cheaper, an example being hiring additional employees when you don't need them), or intangible (advertising expenses, branding costs, market research, and legal fees). 

Like costs, benefits can be direct (increased revenue from a new product line), indirect (strengthened customer loyalty and positive word-of-mouth), competitive (establishing market leadership by introducing unique features or services), or intangible (elevated company reputation, stronger brand image, and improved employee morale). 

3. Set a value for every cost and benefit.

After compiling all costs and benefits, assign a value, such as a dollar amount, to each for comparison. Note that quantifying intangible and indirect costs/benefits may not be straightforward. Nevertheless, you can utilize analytical tools to determine probable values.

4. Compare total costs with total benefits.

You can sum the costs, and then you can deduct that result from the total benefits. If total benefits exceed total costs, proceed with your business goal(s). If total costs surpass total benefits, you may want to reevaluate your set target(s) because you could lose money if you move forward with the project. 

Example : A small café is contemplating the introduction of a new specialty coffee blend to attract more customers. Emily, the café owner, conducted a cost analysis to check for feasibility. 

The direct costs for the new blend include coffee beans and packaging materials, totaling $300. Indirect costs, covering utilities and additional staff, amount to $150. Intangible costs, like potential disruptions and research, are capped at $50. 

The total costs sum up to:

$300 (direct) + $150 (indirect) + $50 (intangible) = $500.

As a next step, Emily enlists a financial analyst to gauge probable benefits. If the new blend sells well, the analyst forecasts an additional $700 in revenue for the café. 

Finally, to complete the cost-benefit analysis, the financial analyst subtracts the onset cost from the expected revenue:

$700 (benefit) - $500 (cost) = $200

The analysis reveals a potential profit of $200 , coupled with the competitive advantage of offering a unique specialty coffee blend. Encouraged by the positive outcome, Emily proceeds to make the required investment. 

When should you conduct a cost analysis?

The gains resulting from a cost-benefit analysis extend beyond launching a new product, service, or policy because you can also use it for employee training and expanding your business. The following scenarios demonstrate the analysis’ versatility in guiding your decisions across different aspects of a business:

1. Implementing employee training programs

Scenario : Investing in digital training platforms for staff development

Rationale for CBA : Evaluating the costs of training against anticipated improvements in employee skills, productivity, and organizational performance

2.  Adopting sustainability 

Scenario : Incorporating eco-friendly packaging to limit carbon footprint

Rationale for CBA : Assessing the costs of adopting sustainable practices against long-term benefits such as improved brand image and potential cost savings

3. Introducing customer loyalty programs

Scenario: Establishing a customer loyalty program to enhance customer retention

Rationale for CBA : Determining the costs of the program against projected gains in customer loyalty, repeat business, and overall customer satisfaction

4. Expanding geographic presence

Scenario : Considering expansion into a new city or country

Rationale for CBA : Analyzing expansion costs versus potential market growth and profitability 

Pros and cons of cost analysis

If you own a firm or are in charge of the finances of a business, conducting a CBA can help you with the following: 

Present fact-based data or evidence to support new project ideas.

Identify and track not-so-obvious or hidden costs, such as intangible costs.

Mitigate the impact of subjective biases like personal opinion or judgment that may inadvertently influence decision-making.

While CBA has its perks, it’s important to note that it’s not without limitations. Here are a few notable ones:

It requires a substantial amount of data. Analysis based on insufficient data can lead to faulty conclusions.

Completing a cost-benefit analysis requires a considerable time investment.

CBA is less effective for long-term projects, with factors like inflation compromising forecast accuracy.

A common misconception in cost analysis

It may be natural take the most economical solution, but cheaper is not always better when it comes to cost analysis. While cost analysis can accurately measure profitability, it cannot ascertain whether the least expensive option is the best overall.

For example, consider a technology company evaluating software solutions based on licensing costs alone. While a conventional cost analysis might emphasize the economic benefits of a particular software package, it may neglect vital non-financial aspects like compatibility with current systems, user-friendliness, and the potential for future upgrades.

Cost analysis vs. return on investment

Return on investment (ROI) helps measure tangible gains against the costs of implementing your proposed project or solution. In contrast, cost-benefit analysis (CBA), which is more complex, aids in measuring both tangible and intangible costs and benefits. Since ROI is slightly more simplistic, you can show it to executives as evidence that your proposal is sound. Typically, an ROI needs to be greater than zero for executives and investors to support your project.

ROI = (net benefits/total cost)*100

Net benefits = total benefits - total costs

Get started with Coursera. 

Learn the fundamentals of product and service costing with the Cost Accounting Specialization , on Coursera. Offered by the Technical University of Munich (TUM), this Specialization includes quizzes and interactive learning options to help you identify relevant costs, track overhead rates, assess profitability, and more.  Upon completion, gain a shareable Professional Certificate to include in your resume, CV, or LinkedIn profile.

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The Official Journal of the Pan-Pacific Association of Input-Output Studies (PAPAIOS)

• Open access
• Published: 07 July 2021

Impact and cost–benefit analysis: a unifying approach

• Pasquale Lucio Scandizzo   ORCID: orcid.org/0000-0002-8824-3589 1  

Journal of Economic Structures volume  10 , Article number:  10 ( 2021 ) Cite this article

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Metrics details

This paper presents a methodology to integrate cost–benefit analysis and SAM-CGE-based impact evaluation. While the two types of analysis have developed in parallel and without a clear connection, there is growing consensus that the two approaches should be integrated for complex investment projects, since their economic evaluation cannot rely solely on the partial equilibrium assumptions of cost–benefit (CB) analysis. Unlike CB analysis, impact evaluation looks at the economy as a complete system of interdependent components (industries, households, investors, government, importers, exporters). By integrating project accounting into a SAM-CGE framework, the methodology developed presents several properties that make it fit to the purpose of providing a reliable assessment of project contribution to the economy.

1 Background

A social accounting matrix (SAM) is an analytical construct that brings together the material input output matrix originally conceived by Leontief, with a consistent framework of transactions across production sectors, factors of production and various classes of economic agents. In the form that has become more popular and was developed first by Stone’s research team in Cambridge, the SAM is the basis of modern national accounting and records transactions across activities, production factors, and the main institutional agents that constitute a modern market economy, namely households, enterprises, government, the financial and the international trade sector. As for the input–output, but in more integrated and value-based fashion, a SAM collects data on inflows and outflows of services by recording receipts and payments using the double accounting principle in a mutually consistent form. By convention, each column of a SAM thus records payments from that account to each other account, while each row records receipts to a specific account from each other account, with total receipts being equal to total expenditures. For this reason, the columns reporting production activities outlays can be interpreted as production processes, whose costs, including factor payments, equal in aggregate the value of production. At the same time, the corresponding rows can be interpreted as the revenues of each activity from all other activities. The SAM records value added formation by accounting for payments from activities to primary production factors (capital and labor) and to the government in the form of indirect taxation. The SAM also accounts for income formation by recording payments from factors of production (value added) to households, government and other institutions, including the financial and the foreign sector, and by accounting for other transactions, including direct taxes, subsidies, interest payments and various types of transfers across institutions. The SAM concept and practice is at the base of the UN national account system (SNA), and in more recent years it has been extended to include environmental flows, such as carbon emissions and ecosystem services of various sort (Burthoo-Barah et al. 2019 ; Scandizzo and Cufari 2019 ; Scandizzo and Ferrarese 2015 ).

While the SAM has been often utilized to evaluate the indirect effects of capital expenditures from investment projects as a demand shock (Scandizzo and Ferrarese 2015 ; Debowicz et al. 2013 ), its use to assess the impact of the investment beyond the activation effects of the construction period, has been limited. The theory and practice of project evaluation has also typically neglected the fact that, while in the construction period a project may be considered as part of the capital formation account, after the construction period, the project is generally a production activity, which is linked to sectors, factors and institutions by a series of transactions that can be accounted for, using the same principles, industrial classification and balancing of all other activities represented in the SAM. For example, the increased demand generated by public investment in a new road during the construction period can be measured as a vector of purchases of capital goods, in analogy and as an implicit part of the investment (capital formation) vector in the SAM. Once completed, however, the road becomes a service producing activity that not only generates increased demand for inputs, but also contributes to revenue formation, increase consumer surpluses and spill over the economy thereby increasing economic activity in the rest of the economy. An investment project, in particular, is characterized by a cash flow, for each year or project life, that can be split into a series of costs and a series of revenues and, as such, conveniently represented in a specific column and row of a SAM. This representation not only provides a convenient way to represent a project in a SAM, but also suggests that SAM production activities can be seen as sets of investment projects at various stages of implementation and are thus subject to variations over time due to the overlapping of projects of different generations. In turn, this twofold consideration on the role of projects as activities and of the activities as overlapping ongoing projects, indicates that a proper SAM accounting should not only aim at accounting for direct responses to final demand changes, but also for the variation of the patterns of transactions (i.e., changes in the SAM coefficients) due to new projects and technologies.

Following Stone’s original interpretation (Stone 1952 ), SAM accounts and coefficients can be considered special cases, respectively, of a transaction and a response matrix for an economy. The response matrix can be more or less complex and may coincide with a linear approximation of a full-fledged computable general equilibrium model (Perali and Scandizzo 2018 ). In the case of an investment project, therefore, while the project cash flow can be directly incorporated in a transaction SAM, its translation into a column and row vector of coefficients require a series of assumptions on the technology and the behavior of the economic agents involved. In the simplest case, the response matrix is a matrix of input output coefficients for the production activities, and of expenditure shares for the behavior of the institutions (households, government, etc.). In the case of a CGE model, the project transaction column contains, for each period of project life, the project payments to the factors of production (including the project net revenues to capital), as well as to activities and institutions. The response (coefficient) column instead in the simplest case embeds the hypothesis that project outlays are fixed proportions of its total cost. Similarly, the project transaction row contains the revenues and possibly the external effects paid to the project by production activities, institutions and the financial sector. For these stakeholders the payments made to project represent costs for goods or services provided by the project, so that in the response matrix, they are converted into coefficients, which in the simplest case are fixed proportions of total costs of their own production. As required for all SAM accounts, project rows and columns of the transaction matrix balance, since the project outlays, which include the net project revenues paid to capital, equal the project inflows or gross revenues with any financial gap filled by the capital formation (i.e., the financing) sector. For example, in the construction period, the outlays will consist of the construction costs, while the balancing inflows will be provided by payments from the capital formation accounts.

More generally, the rows and columns of the SAM as a transaction matrix can be reinterpreted as the twin entries of the cash flow account of an economy for a given period of time. For the production sectors, this means that revenues from product sales are recorded in the row entries and costs in the column entries. The difference between revenues and intermediate costs is value added. This can be considered a result of the production activity (the larger the better, ceteris paribus) and is the basis to compute all welfare measures including GDP. In turn, value added is recorded as a row entry in the accounts of factors of production. Here row entries represent incomes from employment while column entries document payments to factor owners, which in a market economy are households, firms and the government. For institutions, finally, row entries represent incomes from factor ownership, interests and dividends, or transfers of various kind, while column entries are expenditures for goods and services and savings (as purchases of financial assets). Rather than value added, however, the return to capital in the form of gross margins of production are recorded as the difference between sector revenues and sector costs (including cost of intermediates and cost of labor) and are credited to the account of capital as a factor of production.

In sum, while the general practice in input output and SAM-based model has been to consider an investment project as a vector of expenditure shocks, the proper way to analyze it is as a special form of an activity, with its own input output parameters that evolve over time. This type of activity is characterized by a series of cash flows that change over time. At any point in time an investment project can thus be represented in the SAM as a column of cash outflows, including all capital and maintenance costs from intermediates and resulting value added, and as a row of cash inflows, including financing from the government and private savings during the construction phase, and revenues from increased production of goods and services during the operational phase. Since costs and revenues have to balance, financing from the capital formation sector, or directly from the government or other project sponsors must be recorded as one or more row entries in the years where cash outflows are larger than cash inflows (the “construction” period). Vice versa, once the project is operational and inflows become larger than outflows, returns can be credited to capital (as gross business margins) or institutions (government or households).

The benefits from the project, however, are not limited to the remuneration of capital, since other social benefits and costs may also be considered in the economic analysis.

2.1 A SAM-based model for project evaluation

Consider the social accounting matrix equation for a generic scenario:

where X is an n ,1 vector of activity levels for productive sectors, and incomes for factors and institutions and \(Q = I - A\) , the SAM coefficient matrix.

We can consider an investment project as an additional activity and augment the size of the SAM by adding a column and a row of transactions corresponding, respectively, to the outlays and the receipts of the project cash flow. In order for the inflows and outflows to balance, this entails, in particular, accounting, among the receipts, for any financing flow and, among the expenditures, any profits distributed to factors of production and other stakeholders. We can then write two new equilibrium conditions for the situation “without” and “with project” SAM as:

In (2a) and (2b), \(A_{s}\) and \(A_{c}\) are n  + 1, n  + 1, SAM matrices augmented of one column and one row to represent, respectively, the situation without and with the project. The matrix without the project \(A_{s}\) , in particular, can either contain an additional column and row of zeros, for the case of full project additionality, or the data of the cash flow of an alternative project as a counterfactual.

Subtracting Eq. ( 1 ) from Eqs. ( 2a ) and ( 2b ), we obtain, after some manipulation:

As noted in the literature on structural decomposition (e.g., Rose and Casler 1996 ), the two expressions ( 3a ) and ( 3b ) signal an index number problem. In the remainder of this paper, we will assume that the differences between (3a) and (3b) are small enough that they can be ignored or otherwise solved by appropriately averaging the results obtained by separately applying the two equations (Koppany 2017 , p. 619).

Both the \(A_{s}\) and the \(A_{c}\) matrix are singular, but we can decompose them into a non-singular square submatrix of coefficients of endogenous variables and rectangular submatrices of coefficients of exogenous variables:

In (4) \(X_{{ei}}\) and \(X_{{xi}}\) are vectors, respectively, of endogenous and exogenous activity levels and \(A_{{ee,i}} ,~A_{{ex,i,~~~}} A_{{xe,i,~~~}} A_{{xx,i}}\) corresponding submatrices from partitioning of \(A_{i} .~~\) Developing the expression, we can re-write (2) and (3) as follows:

This expression identifies one part of the system ( \(A_{{ex,i}} X_{{xi}} )~\) as a vector of exogenous demand levels and one part (( \(I - A_{{ee,i}} )X_{{ei}} )\) as a corresponding vector of endogenous supply levels necessary to satisfy the direct and indirect demand generated by the exogenous demand levels.

Subtracting the endogenous vector without the project from the one with the project, we obtain:

More synthetically, expression ( 6 ) can be re-written in difference notations as:

Solving for the endogenous variables, we obtain:

Expression ( 8 ) indicates that the variation of the endogenous variables of the model may be the consequence of three different shocks, all filtered through the matrix of multipliers of the endogenous sectors: (i) the autonomous variation of the exogenous variables (capital formation, exports or a specific vector of project expenditures); (ii) the variation of the SAM coefficient submatrix of the transactions within the endogenous accounts, and (iii) the variation of the SAM submatrix of the transactions between the endogenous and the exogenous accounts. Intuitively, the exogenous activities increases aggregate demand through the value chains quantified in the SAM, but may also introduce technological change, and induce a new pattern of transactions, boost or reduce existing connections and create new ones.

If one of the exogenous accounts is a specific investment project, in particular, consider the exogenous variation measured by the project cash flow over a time horizon \(t = 0,1, \ldots ..T\) and the changes in the SAM coefficients due to the changes of the project cash flow every year.

Indicating with the t subscript the time, the term \(A_{{ex,c,t}} \Delta X_{{x,t}} = A_{{ex,c,t}} \left( {X_{{xc,t}} - X_{{xs,t}} } \right)\) is the increase in project expenditure in the t th year, while ( \(\Delta A_{{ex}}^{t} )X_{{xs}}^{t}\) , is the change induced by the project into the counterfactual SAM matrix of the same period without the project. With no competing alternative ( \(X_{{xs,t}} = 0)\) , we have: \(~A_{{ex,c,t}} \Delta X_{{x,t}} = A_{{ex,c,t}} X_{{xc,t}}\) , i.e., the project cash flow. This includes, as all columns of the SAM, the demand increases (with respect to the situation without the project) generated by the expenditures of the project with respect to all sectors. These expenditures include both costs and net benefits of the project such as the payments made to project stakeholders as for example the net margins paid to capital and the other net benefits, accounted in gross terms in a corresponding row of the SAM. The term \(\left( {\Delta A_{{ext}} } \right)X_{{xt}} = (A_{{ext + 1}} - A_{{ext}} )X_{{xs}}^{t}\) represents the structural impact of the technology embodied in the project. This impact may be due to different project requirements in terms of use of intermediate inputs and value added in comparison to existing technologies. Project impact is thus evaluated as the sum of two components, one depending on the change in the scale of the cash flow, and one depending on the change of the weights of the different items of the project transaction vector in a new SAM updated to account for the transactions introduced by each phase of the project.

The present value at rate of discount r of project impact can be directly derived from Eq. ( 8 ):

However, \(A_{{ee,t + 1}}\) will approximately remain constant if the project is small enough, and \(\Delta A_{{eet}} \cong 0\) , so that expression ( 9 ) can be approximated on the basis of the initial SAM for the endogenous accounts:

Expression ( 10 ) allows to estimate the present value of project impact using a single SAM and its variations as the direct and indirect effects of the present values of the project cash flows. In turn these are defined as the sum of two components: (i) the yearly project outlays for a given structure of the interdependencies between the project and the rest of the economy, and (ii) the yearly increases in the same outlays due to the variation of these interdependencies brought about by the changes of project outlays over time.

3.1 Building a project SAM

In the theory of cost–benefit analysis, actual transactions in the form of revenues and expenditures at market prices are associated with the so-called “financial analysis”, which has the purpose to evaluate projects from the point of view of a private subject. In the “economic analysis”, instead, the basis to compute benefits and costs are no longer actual transactions at market prices, but virtual transactions that reflect what consumers or producers gain from market exchanges and other project effects, but not necessarily pay for them. Two typical concepts used to quantify these values are the well-known constructs of consumer and producer surplus.

While definitions can be made more precise by a better specified theoretical context, both consumers and producers surplus have a long history in economics as their definition and initial use is due to Marshall ( 1890 ), one of the founding fathers of microeconomic theory. Consumer surplus can be defined as the excess of willingness to pay for a good or service, compared to what consumers actually pay, while producer surplus can be similarly defined as the excess of the price received compared to producers’ willingness to accept. In both cases, therefore, a measure of the difference between a virtual transaction and an actual one is used as a monetary measure of a real gain. While an increase in household income is matched by an increase in consumer expenditure and/or savings, an increase in consumer surplus does not apparently result in an increase in transactions. However, as shown by Weitzman ( 1988 ), real income, calculated with an appropriate price deflator (a Laspeyres index in case of homothetic preferences), is essentially equivalent to consumer surplus. This implies that any increase in consumer surplus is equivalent to the sum of the increase in income at baseline prices plus a term (of a second order of magnitude) reflecting the fact that real income is also larger because of as concomitant favorable change in relative prices. For example, suppose that the project determines an increase in market supply of a particular good and this determines a corresponding increase in consumer expenditure. This larger expenditure in turn can be decomposed in a consumption saving (i.e., a gain in income) for the quantity consumed without the project (i.e., for those who already consume the good) plus an increase in expenditure due to the fall in price.

In addition to consumer and producers surplus, cost–benefit analysis also takes into account a number of other benefits and costs that are not translated into market transactions, either because they are not the result of market exchanges or because market exchanges do not reflect “true” social values. In other words, these two classes of project effects reflect the so-called “shadow prices”, which differ from market prices of an amount reflecting the components of social values that for various reasons are not internalized by existing markets. Since the important work of Ronald Coase ( 1937 ), these externalities have been recognized as themselves corresponding to virtual (or potential) transactions.

Table 1 shows how benefits and costs of a project can be incorporated in the project row (project receipts) and columns (project outlays). The economic components of project receipts are: (i) revenues from project intermediates; (ii) revenues from consumer purchases; (iii) government subsidies; (iv) debt or equity financing, and (v) exports. The corresponding project costs are: (i) capital and operational costs; (ii) net margins (credited to capital); (iii) consumer incomes, credited to households; (iv) taxes; (v) interests and dividends, and (vi) imports. The project row and column at market prices balance since net margins, i.e., the difference between revenues and costs are included in the project SAM column as a cost for capital. In this way the two sums, respectively, of the column and the row entries for market transactions (the so-called “financial analysis” of the project) equal the project gross revenues, i.e., all receipts. In order to go from financial to economic analysis all the above variables must valued at shadow prices and conform, as indicated in Weitzman ( 1976 ), Eisner ( 1988 ) and Hartwick ( 1990 ) to the notion of Net National Product (NNP), i.e., to an ideal flow measurement of national wealth of a dynamic economy. They can thus also incorporate social welfare effects, externalities and natural capital (last three rows and columns in the matrix) for which market prices are not available (as in Banerjee et al. 2016 ).

3.2 Economic analysis

Tables 2 and 3 show an example of a social accounting matrix incorporating a project cash flow, respectively, in the construction period ( t  = 0), and in the operational period ( t  = 1), with the project cash flow being accounted for as an extra activity and/or institution in the SAM. The cash flow data in the construction period include only capital expenditure (capital goods produced by activities) in the account column and financing from capital formation in the account row. In the operational period, the project account column includes all project costs (capital replacement and operational costs), while the row account contains all project receipts. The value added account is credited in the project column of the payments to labor and capital, including the returns paid as net business margins to project sponsors. These payments amount to the sum of the inflows reported in the row minus all the costs (other than value added) reported in the column. As a consequence, the sum of the column and the sum of the row both amount to the gross revenue component of the project cash flow. In a more detailed account, with value added split between various types of production factors and a capital account, wages would be paid to different types of labor and the net margins from the project would be explicitly credited to capital. On the other hand, while net benefits depend on the return to capital, they also include the indirect effects on the economy which are credited to households, government or other accounts.

As Table 2 shows, in the construction period, the project is assumed to produce no revenues, while its costs are assumed to be 100 monetary units, with payments to activities, production factors (value added), and rest of the world (ROW). These costs are entirely financed from capital formation and give rise, to the extent that they mobilize unemployed resources, to value added increases through indirect effects. Revenues, on the other hand, are collected by the project as listed in the project row in Table 3 . These revenues are collected from various stakeholders who purchase the goods or services provided by the project, including households and government. With no indirect effects, project net (financial) benefits would thus simply be the portion of value added credited to capital net of any charges due to user costs for maintenance.

Project financing is then repaid in the operational period with interests (120 monetary units versus the 100 units borrowed for construction). In this period (Table 3 ), the project is assumed to collect revenues equal to 365 units from all sectors and institutions, with intermediate costs of 20 units from domestic activities and 25 units from imports. The difference between project receipts of 365 and project intermediate costs of 45 is credited for 120 units to the capital formation account and for 200 units to the value added account and add to total project outlays, including loan repayment with interests accrued to capital formation. As a consequence, the value added account in the operation period is the sum of the project direct payments to production factors and indirect taxes to meet operational costs and of the returns to capital obtained from project revenues after paying for intermediate goods and capital formation. The capital formation expenditures include loan repayments, interests, capital depreciation (assumed to be 5% per year) and any expenditure for replacement of capital goods.

The two transaction matrices in Tables 2 and 3 correspond to two coefficient matrices, whose difference is reported in Table 4 .

Assuming as exogenous accounts, in addition to the project, capital formation and the rest of the world, we can now compute the project impact in both periods according to expressions ( 8 ) and ( 9 ).

Table 5 reports the values of the main SAM accounts affected by the project, while Table 6 compares outcome variables with project costs. Multiplier estimates from value added and, considering depreciation charges, for Net National Product (NNP) are around 1 for the construction period and around 1.5 for the operational period, where not only costs but also net revenues from the project are taken into account.

4 Discussion

In this paper, I have presented a methodology to integrate cost–benefit analysis in the impact evaluation performed on the basis of social accounting principles (SAM or SAM-based models). The integration requires simply a recasting of the economic and/or financial data used in the discounted cash flow analysis in the format used in the SAM accounts and involves a simple reclassification of costs and revenues according to the statistical system used in the SAM (Eisner 1988 ). The methodology generalizes the use of multipliers to evaluate the short-term impact of investment projects, which is typically used alongside cost–benefit analysis, but without a clear relation with both its theoretical principles and practical applications. Unlike the simple multiplier method, by integrating project accounting in the SAM, it allows an exhaustive analysis of impact on revenues, costs and financing, thus providing a clear picture of the project contribution to both demand and supply both in the project construction and operational periods. By integrating in a consistent accounting framework value added formation and economic benefits and costs, this method also allows making full use of the information provided by the sector and the distributional details of investment cash flows through the entire project life.

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Scandizzo, P.L. Impact and cost–benefit analysis: a unifying approach. Economic Structures 10 , 10 (2021). https://doi.org/10.1186/s40008-021-00240-w

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Cost-Benefit Analysis

What is cost-benefit analysis?

Cost-benefit analysis is a way to compare the costs and benefits of an intervention, where both are expressed in monetary units.

Both CBA and cost-effectiveness analysis (CEA) include health outcomes. However, CBA places a monetary value on health outcomes so that both costs and benefits are in monetary units (such as dollars).

What inputs are included?

• Costs including those of implementing an intervention.
• Benefits including those resulting from an intervention, such as medical costs averted, productivity gains, and the monetized value of health improvements.

What output does a cost-benefit analysis provide?

CBA provides the net benefits (benefits minus costs) of an intervention.

Cost-Benefit Analysis Example:

The example provides the results from a CBA of an intervention to reduce trans fats in the food supply.

1-Monetary Valuation. The analysis estimates that the following benefits are worth $40 billion: Direct medical costs averted. Valuation of quality of life gained due to non-fatal heart attacks averted. Valuation of life years gained due to fatal heart attacks averted. Next, the analysis estimates that costs to the industry and consumers are $6 billion. 2- Calculation of Net Benefits – $140 billion in benefits minus $6 billion in costs equals $134 billion in net benefits. Therefore, benefits minus costs equals net benefits.

The table demonstrates that the intervention could generate $134 billion in net economic benefits.

For additional information, please see the examples used in the CDC Introduction to Economic Evaluation in Public Health online training.

How can decision makers use this information?

CBA’s estimated net benefit offers a sense of the economic value provided to society by an intervention.

Decision makers can also use CBA to compare health and non-health interventions because both costs and benefits are expressed in monetary units. For example, CBA could be used to compare health and environmental interventions.

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Course providing a broad overview of economic evaluation methods with illustrative examples from public health

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Research Article

Cost–benefit model for multi-generational high-technology products to compare sequential innovation strategy with quality strategy

Roles Conceptualization, Formal analysis, Methodology, Writing – original draft

Current address: NICE, Yeoeuido-dong, Seoul, Republic of Korea

Affiliation Department of Industrial Engineering, Yonsei University, Seoul, Republic of Korea

Roles Conceptualization, Methodology, Writing – original draft, Writing – review & editing

* E-mail: [email protected] (SJJ); [email protected] (SYS)

Current address: Institute for New Economic Thinking at the Oxford Martin School, University of Oxford, Oxford, United Kingdom

Roles Conceptualization, Funding acquisition, Methodology, Supervision, Writing – review & editing

• Hyoung Jun Kim, 
• Su Jung Jee, 
• So Young Sohn

• Published: April 7, 2021
• https://doi.org/10.1371/journal.pone.0249124
• Reader Comments

In the rapidly changing high-tech industry, firms that produce multi-generational products struggle to consistently introduce new products that are superior in innovativeness. However, developing innovative products in a short time sequence period is likely to cause quality problems. Therefore, considering time and resource constraints, two kinds of strategies are commonly employed: sequential innovation strategy , sequentially introducing a new generation of technology product at every launch interval, ensuring timely innovativeness but with relatively uncertain quality, or quality strategy , intermittently introducing a new generation of products, together with a derivative model between generations to enhance the quality. In this study, we propose a framework for a cost–benefit analysis that compares these two strategies by considering competition between firms within a generation as well as that within a firm across multiple generations (i.e., cannibalization) throughout the launch cycle of high-tech products. We apply our proposed framework to the smartphone market and conduct a sensitivity analysis. The results are expected to contribute to strategic decision-making related to the introduction of multi-generational technology products.

Citation: Kim HJ, Jee SJ, Sohn SY (2021) Cost–benefit model for multi-generational high-technology products to compare sequential innovation strategy with quality strategy. PLoS ONE 16(4): e0249124. https://doi.org/10.1371/journal.pone.0249124

Editor: Wonjoon Kim, KAIST, REPUBLIC OF KOREA

Received: August 17, 2020; Accepted: March 11, 2021; Published: April 7, 2021

Copyright: © 2021 Kim et al. This is an open access article distributed under the terms of the Creative Commons Attribution License , which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.

Data Availability: Source of data underlying the results ( https://benchmarking.ihsmarkit.com/344608/teardown-analysis-apple-iphone-4s-16gb-mobile-handset ) ( https://support.apple.com/kb/sp655?locale=ko_KR ) ( https://support.apple.com/kb/sp655?locale=ko_KR ) ( http://www.arg.co.kr/news/articleView.html?idxno=71717 ) ( http://news.mt.co.kr/newsEmail.html?no=2016051711075293157&type=1&gubn=undefined ) ( https://benchmarking.ihsmarkit.com/344608/teardown-analysis-apple-iphone-4s-16gb-mobile-handset ) ( https://www.consumerinsight.co.kr/voc_view.aspx?no=2734&id=ins02_list&PageNo=1&schFlag=1 ).

Funding: This work was supported by the National Research Foundation of Korea (NRF) grant funded by the Korea government (MSIT) (2020R1A2C2005026).

Competing interests: No authors have competing interests.

1. Introduction

The shortened product lifecycle in the competitive high-tech industry has made participating firms struggle to introduce new innovative products within a short timeframe [ 1 , 2 ]. However, such high-tech products have often resulted in serious and unexpected quality problems after they are launched, due to the difficulties in achieving both innovativeness and superior quality in a short development period. Therefore, firms that regularly introduce new high-tech products usually face challenges in optimizing allocation of their efforts between innovativeness and quality [ 3 ]. Such decision-making concerning time management when developing and introducing new products in the market are important managerial issues for high-tech firms [ 4 ].

Firms involved in today’s high-tech industry usually adopt a strategy of multiple-generation product lines (MGPL) [ 5 , 6 ] that introduces a line of products instead of a single product to efficiently utilize technology and resources in the long term [ 7 ]. While applying the MGPL approach, each firm chooses a different strategy reflecting its own priority with regard to innovativeness over shorter period unit or innovativeness over longer period unit. By focusing on the improvement of technological innovativeness over a short time period, firms can benefit from attracting customers through continuous technological advancement [ 8 , 9 ]. However, as commonly known, high-tech products that are upgraded within a short development window are likely to have more quality problems [ 10 – 12 ]. Meanwhile, firms pursuing a strategy that focuses more on superior quality rather than a series of innovativeness may risk losing opportunities to attract customers that expect consistent innovativeness (due to the long interval between launches of new-generation products) [ 13 ]. Therefore, both strategies have their own advantages and disadvantages. With the increased complexity and development costs of new products, it is essential to estimate and compare the costs and benefits of both strategies [ 14 ].

In this study, we propose a cost-benefit model based on the concept of total cost of ownership (TCO), which reflects all costs and benefits associated with the adoption, use, and disposition of a product or a service during its lifecycle [ 15 ], to compare the economic value of these two strategies. Specifically, our model is based on the revised form of Norton and Bass’s diffusion model [ 16 ] that considers competition both within a generation (i.e., cannibalization) and between generations (i.e., competition between competing firms) since firms that adopt the MGPL strategy may not only compete with rival firms but also cannibalize their older-generation products [ 7 ]. We apply the proposed framework to the case of smartphones, with two competing firms pursuing above strategies. We expect that this framework will assist firms’ decision-making to efficiently allocate limited resources when developing and introducing high-tech products under the MGPL strategy.

The rest of this paper is organized as follows. In Section 2 we review related literature on diffusion and TCO models. In Section 3, we explain the two strategies, propose a revised form of diffusion model for sales forecasting by considering the competition between generations and within a generation, and suggest our framework. In Section 4, we discuss the results of our case analysis applied to the Korean smartphone market, along with the results of a sensitivity analysis. Lastly, in Section 5, we conclude with our findings and suggest directions for future study.

2. Literature review

2.1 total cost of ownership.

2.2 Diffusion model

Diffusion models have been frequently used to forecast products’ life cycles and sales amount [ 24 – 26 ]. Based on the Bass model [ 27 ], Norton and Bass [ 16 ] added the cannibalization effect between generations of multi-generational products, and the model has been widely used for forecasting the sales of various multi-generational products [ 28 , 29 ]. Meanwhile, some scholars have proposed competitive Bass models [ 30 – 32 ] that added to the original Bass model factors reflecting competition among firms within a generation. To a similar end, the Lotka-Volterra equation (originally developed to show the interaction between two competing species in a given ecosystem) has been adopted by several other diffusion models to consider competition among firms within a generation [ 33 – 35 ]. However, to our knowledge, few efforts have been made to incorporate both competition between generations and competition within a generation into the diffusion model. Therefore, to estimate the benefits of two different strategies considered in our cost-benefit model, we suggest a revised form of diffusion model reflecting both types of competition (see Section 3.2).

3. Methodology

A quantitative cost–benefit analysis can justify and easily trace evaluators’ process of decision-making [ 36 ]. We elaborate the two different strategies for introducing multi-generational products into the high-tech market and then propose a cost-benefit analysis framework based on the cost factors and expected benefits from the revised diffusion model to compare the two strategies. Fig 1 shows the structure of our model.

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https://doi.org/10.1371/journal.pone.0249124.g001

3.1. Two strategies

High-tech firms with an MGPL strategy face difficulty in determining the appropriate strategy for introducing new products. They need to consider the benefits and risks of focusing either on maintaining constant innovativeness or guaranteeing high quality of products while spending longer time to develop the product’s next generation. There is evidence that a negative relationship between innovativeness and quality in new products exists [ 11 ], implying a trade-off between these two elements. In light of this, we define the following two strategies: sequential innovation strategy and quality strategy .

Specifically, the sequential innovation strategy sequentially introduces a new generation of products annually (or at launch interval). The new generation contains advanced technologies and new designs. This strategy penetrates the market by consistently and frequently displaying improved technical performance. However, this strategy simultaneously has a relatively high probability of jeopardizing the firm’s reputation due to unexpected quality failure. Meanwhile, the quality strategy introduces a new generation of products every other year (or launch interval), together with a derivative model between generations to retain its customer base. The derivative model has specifications similar to its earlier model, but with some slightly upgraded technical components. This strategy requires a longer development period than the sequential innovation strategy to guarantee improvements and superior quality. However, due to the longer period between generations, firms pursuing this strategy have to endure the risk of losing opportunities to attract customers who favorably respond to consistent and frequent innovativeness of high-tech products.

The two strategies have been often employed in industries where high-technology firms adopt MGPL. For example, Samsung Electronics strategically has launched its flagship smartphone, the Galaxy S series, by every year. The flagship models Galaxy S5, S6, and S7 were annually launched at Feb 2014, March 2015, and Feb 2016, respectively. Moreover, in 2015, the company strategically brought forward the launch of Galaxy S7, which was the company’s new flagship smartphone, to defend its sales ahead of a launch by Apple’s flagship model [ 37 , 38 ]. By contrast, Apple has introduced its flagship models, the iPhone series, by every other year, and has introduced a derivative model between the launches of the flagship models. For example, the flagship models iPhone 6 and 7 were launched at September 2014 and September 2016, respectively, while the derivative version of the iPhone 6, called iPhone 6s, was launched between them, at September 2015.

3.2. Revised diffusion model

3.3. Cost-benefit model

In this section, we propose a cost-benefit model based on the concept of TCO to estimate the total cost incurred when multigenerational products are produced and sold. Based on previous studies, we consider the variables Development Cost , Manufacturing Cost , Quality Cost , and Warranty Cost .

3.3.1. Development cost.

3.3.2. Manufacturing cost.

3.3.3. Quality cost and warranty cost.

To compare the quality strategy and sequential innovation strategy , we set two firms in the Korean smartphone market, A and B. Because the sales performance of a product’s former generations indirectly affects that of later generations, several generations must be considered to thoroughly observe the complex dynamics among generations [ 4 ]. Moreover, as two firms have different generation lengths for their flagship models, the total net present value along an infinite timeline must be considered. As shown in Fig 2 , we take two years as one cycle after the year of introduction to calculate the net profit infinitely. We assume that the increased maximum potential number of users is the same on the infinite timeline.

https://doi.org/10.1371/journal.pone.0249124.g002

4. Application in the Korean smartphone market

In this section, we apply our proposed framework to the South Korean smartphone market to illustrate how to assess the expected net profit of the two different strategies. Smartphones are usually introduced over multiple generations [ 6 ], and there are few competitors in the market. We assume that there are two leading firms, A and B, in the smartphone market and the two firms apply the quality strategy and sequential innovation strategy , respectively. We take into account each firm’s flagship models. Each model is assumed to be sold for two years because Korean mobile firms usually suggest two years for the compulsory usage of a smartphone. In each firm, products are introduced at time 0 (the first model), 12 (the second model), and 24 (the third model). The first generation of the quality strategy is named A1, while the subsequent derivative model is named A1s. The first- and second-generation models for the sequential innovation strategy are named B1 and B2, respectively. Subsequent models are likewise named sequentially.

4.1. Innovativeness degree

A smartphone is usually composed of 12 main components ( https://support.apple.com/kb/sp655?locale=ko_KR ). Pun [ 46 ] claimed that the components of a product influence how customers perceive and evaluate the product. As noted above, Innovativeness Degree of a new product is indicated by the number of components that are improved over those of a previous model. Thus, we set the Innovativeness Degree to range from 0 to 12. As the earlier generation of a product is replaced by the subsequently more advanced generation, the Innovativeness Degree is always greater than 0 [ 44 ]. For example, Table 1 shows the actual main components of three iPhone models, which follow the quality strategy . The highlighted components are the upgraded parts compared to the previous generation’s product components. The derivative version of the 4 th generation (i.e., the iPhone 4s) changed six components from the original 4 th generation model. Meanwhile, the 5 th generation (iPhone 5) had eight improved components. Specifications described in Table 1 show the clear difference in the Innovativeness Degree between the new generation model and derivative model.

https://doi.org/10.1371/journal.pone.0249124.t001

With reference to actual smartphone specifications, we set the Innovativeness Degree in our case example as follows. Basically, firm A, which implements the quality strategy , invests two years to introduce a new-generation product and introduces a derivative model between generations, while firm B, which implements the sequential innovation strategy , invests a year and present new generations every year. Therefore, we specify that, first, d A ,1 (the Innovativeness Degree of firm A’s first-generation model) has a slightly larger value than d B ,1 (the Innovativeness Degree of firm B’s first-generation model). Second, d A ,1 s (the Innovativeness Degree of the derivative model of firm A’s first-generation model) has a relatively smaller value than d B ,2 (the Innovativeness Degree of firm B’s second-generation model). Based on such specifications, we set six scenarios by changing the Innovativeness Degree of firm A’s and B’s product models as shown in Fig 3 . Such scenarios allow us to see whether and how net profits vary depending on the Innovativeness Degree . In addition, assuming that the two firms’ resources are identical, the sum of the Innovativeness Degree for the three models in each strategy are set to be identical. First, throughout the scenarios from 1 to 6, we gradually increase the total innovativeness degree of products launched within a cycle (please see Fig 3 ). By doing so, we can investigate at which innovativeness degree each firm can gain maximum net profits. Second, by comparing the net profit of firm A ( quality strategy ) to that of firm B ( sequential innovation strategy ) on each scenario, we expect to find the innovativeness degree that can provide firm A with its advantage of more innovative flagship model regardless of slower introduction than firm B.

https://doi.org/10.1371/journal.pone.0249124.g003

4.2. Maximum potential users at a unit time period

Annual smartphone sales in South Korea increased from 10 to 20 million in 2016 (Atlas Research & Consulting; http://www.arg.co.kr/news/articleView.html?idxno=71717 ). Based on this information, we set the increment of potential users as m k = 0.01 (in billions), where 0.1 (in billions) is divided by 12 to yield monthly added potential users.

Parameters of Pr i , k ( t ), which are α 0 and α 1 , at 2.5 and 8, respectively, are set to higher prices for products with higher Innovativeness Degree and more rapid price declines for products with lower Innovativeness Degree . These parameters are applied to show the effect of Innovativeness Degree on price and time elapsed following a product’s introduction. We set the initial retail price as $1,000, which is an approximate price for actual smartphones. The speed of price decline accelerates when the Innovativeness Degree is low, as explained in Section 3.2.

According to recent news concerning Korean electronics firms ( http://news.mt.co.kr/newsEmail.html?no=2016051711075293157&type=1&gubn=undefined ), the Development Cost typically accounts for approximately 8% of the previous year’s sales when Innovativeness Degree is moderate. Therefore, in order to set the Development Cost as accounting for approximately 8% of the previous year’s sales when the Innovativeness Degree is 7 or moderate, the parameters in DC i , k , ρ 0 , ρ 1 , σ 0 and σ 1, are set to be 0.215, 0.016, 5, and 0.1 (see Eq 7 ), respectively. DC i , k increases monotonically along with the Innovativeness Degree .

As reported by IHS iSuppli ( https://benchmarking.ihsmarkit.com/344608/teardown-analysis-apple-iphone-4s-16gb-mobile-handset ), one of the world’s largest market research firms, in an article titled “Estimate for the Major Subsystems in the iPhone 4s in October 2011,” the raw cost for the most innovative smartphone in the market at that time was approximately US $250. Based on this report, in order to meet the Manufacturing Cost as approximately US $200 when the Innovativeness Degree is 7 or moderate, we set the parameters of MC i , k , ω 0 and ω 1 as 0.001 and 0.2 (see Eq 8 ) respectively, setting the Manufacturing Cost to equal US $200 when the Innovativeness Degree is 7 or moderate. MC i , k increases logarithmically according to the Innovativeness Degree .

Fig 4 shows the QFP i , k (0) of the two strategies according to the Innovativeness Degree . The probability when t = 0 indicates the situation wherein a product is recalled due to catastrophic quality failure. Multiplying QFP i , k (0) by the number of produced smartphones results in the expected number of smartphones that must be disposed of due to a major quality problem. After a disastrous failure, these products are disposed of, and the firm takes over the Quality Cost for phones that were produced. We can observe that the slope of the sequential innovation strategy is much steeper than that of the quality strategy . The Quality Failure Probability at t>0 for each strategy shows similar patterns of monotonically increasing. This probability is related to the expected Warranty Cost after the product is sold. The expected monthly Warranty Cost is estimated for a year and summed up as Warranty Cost per unit device.

https://doi.org/10.1371/journal.pone.0249124.g004

5.1. Total profits

Fig 5 shows the profit that each firm can make (in million $) in six scenarios. It is notable that the highest profits for both strategies can be achieved in scenario 4. That is to say, an optimal scenario clearly exists that balances the benefits from innovativeness and the costs from quality failures. After reaching the optimal level of innovativeness, the net profits decrease due to the costs associated with excessive innovativeness. Excessively incorporating new technological features may lead high quality costs for the firms employing either strategy.

https://doi.org/10.1371/journal.pone.0249124.g005

In addition, it is apparent that in scenarios 1 and 2, the profits of the quality strategy (firm A) and the sequential innovation strategy (firm B) do not vary significantly. The difference between the two strategies becomes notable in scenario 3, showing that profits from the sequential innovation strategy is clearly higher than that of quality strategy . This shows a circumstance that introducing the less innovative derivative model ultimately leads to a huge cost due to the missed opportunities to attract new customers in highly competitive environment. In addition, we can expect that a firm seeking sequential innovation strategy may struggle with high quality costs if innovativeness degrees of introduced products are too high. In line with this expectation, scenario 6 shows that the profit in the quality strategy exceeds that of the sequential innovation strategy (firm B). The results show that relative advantages of sequential innovation strategy decrease while those of quality strategy increase when an innovativeness degree of high-tech products is higher.

5.2. Sensitivity analysis

In this section, we test the impact of a key parameter β 1 in the innovation coefficient, p ( d i , k ). A larger β 1 implies that the models for both companies penetrate the market more quickly. This kind of sensitivity analysis can provide more generalized results of the cost–benefit analysis [ 47 ]. For β 1, we consider three values 0.1, 0.03, and 0.001. We then investigate the given scenarios to understand the impact of this parameter on the total profit. Fig 6 shows the changing patterns in profits of firms A and B following the changes in β 1 .

https://doi.org/10.1371/journal.pone.0249124.g006

In scenarios 1 and 2, there are no clear differences between the total profits of two strategies, even with the extended range value of β 1 . In scenario 3, for all of the three different values of β 1 , the total profit of sequential innovation strategy (firm B) clearly outruns that of quality strategy (firm A). However in scenario 4, where the innovativeness degree of derivative model in the quality strategy is higher than that of scenario 3, the total profit of sequential innovation strategy is overtaken by that of quality strategy when β 1 is 0.1 or 0.03. The results imply that, if the innovativeness degree of derivative meets a certain level, advantages coming from sequential innovation strategy is more likely to be overtaken by those of quality strategy when the speed of initial market penetration is higher (i.e., the higher β 1 ). In other words, it connotes that when there are more customers called ‘innovators’ who quickly adopt innovative products without hesitation (i.e., the higher β 1 ), quality strategy can outperform sequential innovation strategy by trying to maintaining a certain degree of innovativeness in its derivative model. Similarly, in scenario 5 and 6, we can observe that the benefit from quality strategy outruns that of sequential innovation strategy if the former makes a more innovative derivative model (i.e., scenario 6), even regardless of different values of β 1 in this case.

6. Conclusion

In this study, we suggested a cost–benefit analysis framework for comparing two different strategies, namely, the sequential innovation strategy and the quality strategy , for developing and introducing multi-generational high-technology products. We rely on the concept of TCO by reflecting the lifetime cost factors related to the two strategies along with the diffusion model to take into consideration the competition within a generation and between generations. Previous studies have been limited in suggesting frameworks that reflect two possible layers of competition. Our approach has integrated competition both within and between generations and thus, has contributed to filling the gap in this area. Our framework has intuitive components that make it easy to use. It is applicable in initial market situations that lack sufficient data to design a product introduction strategy. If historical data exists, the framework can be easily adjusted to the corresponding market situation.

We applied the proposed cost–benefit analysis framework to two virtual firms in the Korean smartphone market and showed net profits under a competitive market situation reflecting various scenarios. For this, we set the parameters by referring to actual smartphone models and smartphone market conditions in Korea. Through this analysis, other than observing the behavior of each firm’s profits across different scenarios, we also found that there exists an optimal Innovativeness Degree that maximizes profits for each strategy. Furthermore, sensitivity analysis showed how the results can vary according to the parameter related to innovation coefficient. Applying such analysis could provide guidelines for firms in designing and introducing products with the appropriate level of innovativeness, while taking into consideration market competition and limited resources.

Firms in the real world do not have a consistent product lineup strategy, but instead modify their approach based on the market situation. Apple, for instance, introduced the iPhone 5C that is a downgraded version of the 5 th generation iPhone. Moreover, in 2017 the firm launched two generations of iPhone, the iPhone 8 and the iPhone X. Likewise, the generation gap between flagship models, which was once thought to be fixed, keeps changing to adapt to developments in the competitive high-tech market. Therefore, we believe that this study provides insights that will be useful for many firms working to build a strategy for developing and introducing new products. In particular, our framework can be used effectively when a firm employs a cost–benefit analysis of various market scenarios and products with different innovativeness.

However, this study has limitations that present opportunities for future studies. First, we conduct our study under the premise that the customers prefer innovative and high quality products. However, customer preferences sometimes are beyond product quality and instead are merely based on other factors such as specific brands and designs [ 46 ]. Second, our framework requires many parameters that are assumed to be known. In our case, the parameters were set by referring to actual market conditions. If the parameters can be set more accurately by taking historical data into account, the cost–benefit analysis framework can be more useful and meaningful. For example, if the Innovativeness Degree can be expressed according to each component’s technological depth, the results would be more reliable. Furthermore, our study expresses competition within the same generation through price effects. Other terms such as performance effects could be added to consider the within-generation competition. Lastly, this study assumed that innovativeness is linked to various type of costs including quality cost, development cost, and manufacturing cost. We chose innovativeness as a key variable because achieving a certain level of innovativeness within a given time period usually requires corresponding costs, which increase as the level of planned innovativeness is higher [ 1 , 2 ]. Despite our reasoning, future efforts to decrease those assumptions are needed to further develop our approach. These are suggested as areas for future research.

Supporting information

S1 file. source of data underlying the results..

https://doi.org/10.1371/journal.pone.0249124.s001

Acknowledgments

An earlier version of this article was presented as a poster at the Asian Network for Quality (ANQ) in 2018.

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Cost and Benefits of Market Research

What are the benefits of market research for professional services firms? Is it worth the cost? And does it really matter?

These are some of the questions we get from our clients when we recommend  researching their current clients and target markets . While on some level we all know that market research is a good thing, these are legitimate questions. What exactly are the costs and benefits of market research?

Why Market Research?

Let’s start with why your professional services firm should consider using market research in the first place. There are a number of occasions where market research is appropriate. Here are some of the most typical situations where you’d use it:

• When your firm is launching a new service
• When you’re looking to select verticals to concentrate on and specialize in
• When you’re developing your organizational strategy
• When your firm is seeing a diminishing market share
• When your industry environment is changing
• When your firm needs to accelerate growth

The Benefits of Market Research

While there are many intangible benefits of market research on your current and prospective clients, such as better targeting and a more accurate understanding of how your firm is viewed, there is a much more tangible and direct measure of benefits. In a  study of high growth professional services firms , we found that professional services firms that do systematic, structured research on their target client groups are more profitable and grow faster.

This relationship is documented in the figure below.

This figure shows that professional services firms that do frequent research (at least quarterly) grow more and are more profitable that firms that do occasional or no research on their target industry or client group.

Because of the specificity of these findings we are in a position to project the true economic benefits of  market research for services firms . But first let’s consider the cost side of the equation.

Download the Professional Services Guide to Research

The Cost of Market Research

The cost of a specific market research program is determined by the  research method  used (face-to-face interviews are more expensive than phone interviews, for example) and the sample size needed. Larger firms will typically require a larger sample. Taking these variations into account, we have estimated the typical market research costs for both occasional research (once per year) and a program of frequent research (quarterly).

Below are estimated costs for a single round of research for three sizes of firms:

• Small ($5M revenue): $20,000
• Medium ($20M revenue): $40,000
• Large ($200M revenue): $60,000

For a program of frequent research (quarterly) you can simply quadruple these estimates. And keep in mind that the average duration of a market research project ranges from about 2 to 8 weeks.

See also: Top 6 B2B Marketing Benefits of Doing a Brand Study

The Return on Investment of Market Research

With estimates for the costs and economic benefits, we can now calculate the return on an investment in a program of market research for a professional services firm. For each of the three firm sizes, we’ll subtract the total research cost from the economic gain. This shows the net increase to top line revenue and bottom-line profitability over a one-year period.

Two things are immediately apparent from this analysis. First, the net return on invested research dollars is very sizable. If your firm realizes even a small fraction of the documented benefits of market research, you are well advised to make the investment.

The second observation is that the larger the firm, the greater the return on invested dollars. This is a very straightforward relationship arising from the observation that the expense of market research does not rise in lockstep with firm size. Put another way, market research is a relative bargain for larger firms.

Putting Research to Work in Your Firm

Sadly, market research is not magic. To enjoy the generous benefits it can provide, you need to take it seriously and systematically use it to adjust strategy and shape staff behavior. As it turns out, well-conducted and well-presented market research is often a powerful catalyst for change. 

Historically, professional services marketing has been driven by hunches and habits. But most professionals are pretty logical, and fact based in their work. Consequently, they are often refreshingly open to new data on their clients’ behavior and perceptions. Perhaps that is why it works so well. This is where a research organization such as The Hinge Research Institute can help.  The Hinge Research Institute believes that research can not only help you make more informed planning and strategy decisions—as premium content, it can also educate your target audiences, thereby increasing visibility, trust, sales leads, and engagement.

There are two viable ways to use research as premium content: customized research and licensed research . The advantage of customized research is that it allows you to get specific responses to specific questions from specific audiences. The downside to some is that customized research takes months to produce and can be perceived as expensive. This is where licensed research may be more appealing. Some research organizations offer licensed research on reports they publish. This type of research is typically available immediately, for 12 months, to be used in part or entirety. The advantages of licensed research are that it costs less than customized research and it is available almost immediately. The downside to some is that you are limited to existing or available topics so you give up some control. However, whether you use customized or licensed research, you should get a level of visibility, trust, and sales leads that you have never experienced before.

Another tip when looking for a research organization. Choose one that can help you launch your published research so that you can use it as premium content to generate more visibility, leads, and revenue for your firm. A research firm that can support your rollout with webinars, blogs, articles, videos, and more will ensure you get a higher level of prospect engagement through trust and credibility. 

Free Resource

The Professional Services Guide to Research

How Hinge Can Help

Need help conducting market research? Research gets to the core of what will resonate with those audiences—and is an integral part of what Hinge does for clients. Learn more about our research services or contact us to learn whether research makes sense for your professional services firm.

Additional Resources

• Our  Research As Content guide  gives you the tools and knowledge you need to use research to make better decisions AND educate and persuade your target audiences.
• Understand your buyers. Win more business. Download our research study  Inside the Buyer’s Brain  and read the latest findings from the biggest study of professional services buyers to date.
• If more of a hands-on approach is for you, register for one of our courses through Hinge University and become the next  Visible Firm ® .

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