Cost-benefit Analysis: How To Make Your Choices Count

A cost-benefit analysis (CBA) is a data-driven approach to estimate the strengths and weaknesses of alternatives. It is used to determine options that achieve the most benefits with the least investment. Small costs, big revenues. Cost-benefit analyses can be employed to compare potential courses of action to estimate the value against the cost of a decision, project, or policy. They help individuals and organizations make better choices. Commonly used in business, policy, commerce, and project management.

The crux of a CBA is to determine whether an investment is sound. By definition, this means the benefits have to outweigh the costs. CBAs act as a basis for comparing decisions. Benefits and costs typically refer to money, but other elements can and should also be evaluated. Assuming a CBA is used correctly, it offers an informed estimate of the best possible alternative. Of course, a perfect appraisal of all present and future costs and benefits is impossible. Generally, a CBA will provide a relative measure of the positive and negative consequences of a given action.

It is vital to decision-making because it measures it’s tangible and intangible feasibility and helps you avoid losses. If the analysis clearly shows the losses outweigh the benefits, you just don’t take that course of action. Simple. Otherwise, the project is profitable and it is viable to proceed. Same goes for budgeting, resource allocation, risk management, communication, and policy. A CBA tells you whether you have allocated a big enough budget, whether the return on investment outweighs the resources invested, and whether the potential risks are worth it for the benefits. CBAs reveal lucrative opportunities.

Everything goes in CBAs. Assess every cost relevant to you. This can be the direct costs—labor, materials, supply, salary. They might also include the indirect costs—office rent, utilities—and intangibles—decreases in productivity, loss of goodwill, employee morale. After identifying the costs, we reckon with the benefits. The beautiful ducklings. Tangibles like revenue growth, cost savings, and increased efficiency. Intangibles including reputation, employee satisfaction, and customer loyalty. The key to make a CBA effective is to consider both the short- and long-term consequences. Hiring temporary staff might get faster delivery on a project but increase immediate payroll expenses. Weigh things.

CBAs, much like SWOT analyses, can be used pretty much universally. Use them to rank projects or decisions based on their net benefit. Concentrate on high-return initiatives—where benefits trump costs. Apply CBAs when weighing significant options like entering a new market, launching a product, or investing in new tech. Governments and organizations find use in CBAs when evaluating the gain of public policies or social programs. From startups deciding whether to invest in automation to speed up their workforce, to cities deciding whether to build new public transit systems to reduce traffic, pollution, and commute times, CBAs are broadband tools. Perhaps not the sharpest, but sharp tools nonetheless.

Real life implications of CBAs:

• Business: implementing a new software costs 100,000 dollars initially, 10,000 in training and 5,000 for the downtime incurred during implementation, but the benefits are an increase of productivity and reduced error rate tallying up to 60,000 dollars per year. If the software is to be used for at least two years, proceed;

• Infrastructure: building a new highway costs 1 billion for construction and 50 million per year for maintenance, but the time savings for commuters tally 2 billion and reduced fuel costs exceed 500 million dollars. Benefits exceed costs, approve the project;

• Healthcare: approving a new drug costs 500 million for the research and development and an additional 50 for managing side-effects, but patient outcomes bring an estimated benefit of 1 billion dollars. Given the drug delivers societal benefits that justify the cost, go with approval;

• Policy: reducing carbon emissions by virtue of transition to renewable energy costs 10 billion dollars, but the reduced health costs and mitigated climate impacts accumulate to over 60 billion dollars in gain. Enact the policy.

How you might use CBAs as a thinking tool: (1) define the scope, clearly stating the decision, policy, investment, project, or purchase under review; (2) determine the time horizon for this to get done; (3) list out the costs and benefits, short-term and long-term, indirect and direct, tangible and intangible; (4) quantify them, assigning monetary or measurable values to each factor where possible; (5) discount future values, adjusting future costs and benefits to those of today, as “a dollar tomorrow is worth more than a dollar today.”; (6) see how sensitive the values are to variables, like how less of a particular gain (e.g. revenue from marketing) affects the cost (e.g. ad spend); (7) make the decision, yes if the benefits exceed the costs, no if they do not.

Thought-provoking insights. “You can’t make an omelet without breaking eggs.” shows how every decision includes trade-offs and opportunity costs. “Measure twice, cut once.” highlights careful evaluation to preserve optionality and avoid costly mistakes. “Look before you leap.” is a classic phrase to evaluate costs and benefits before taking action. CBAs, at first glance, are unbeatable: structured comparisons, versatility, and translation of complex ambiguity into measurable terms. But they aren’t if you let your subjective desires skew the results or fail to account for long-term and short-term consequences. Use them. With care. Else they’ll prove costly.