Performing a Cost-Benefit Analysis
Whether you know it as a cost-benefit analysis or a benefit-cost analysis, performing one is critical to any project. When you perform a cost-benefit analysis, you make a comparative assessment of all the benefits you anticipate from your project and all the costs to introduce the project, perform it, and support the changes resulting from it.
Cost-benefit analyses help you to
Decide whether to undertake a project or decide which of several projects to undertake.
Frame appropriate project objectives.
Develop appropriate before and after measures of project success.
Prepare estimates of the resources required to perform the project work.
Everything gets a dollar value in a cost-benefit analysis
You can express some anticipated benefits in monetary equivalents (such as reduced operating costs or increased revenue). For other benefits, numerical measures can approximate some, but not all, aspects. If your project is to improve staff morale, for example, you may consider associated benefits to include reduced turnover, increased productivity, fewer absences, and fewer formal grievances. Whenever possible, express benefits and costs in monetary terms to facilitate the assessment of a project’s net value.
Consider costs for all phases of the project. Such costs may be nonrecurring (such as labor, capital investment, and certain operations and services) or recurring (such as changes in personnel, supplies, and materials or maintenance and repair). In addition, consider the following:
Potential costs of not doing the project
Potential costs if the project fails
Opportunity costs (in other words, the potential benefits if you had spent your funds successfully performing a different project)
Cost-benefit analysis: Weighing future values today
The farther into the future you look when performing your analysis, the more important it is to convert your estimates of benefits over costs into today’s dollars. Unfortunately, the farther you look, the less confident you can be of your estimates. For example, you may expect to reap benefits for years from a new computer system, but changing technology may make your new system obsolete after only one year.
Thus, the following two key factors influence the results of a cost-benefit analysis:
How far into the future you look to identify benefits
On which assumptions you base your analysis
Although you may not want to go out and design a cost-benefit analysis by yourself, you definitely want to see whether your project already has one and, if it does, what the specific results of that analysis were.
The net present value (NPV) is based on the following two premises:
Inflation: The purchasing power of a dollar will be less one year from now than it is today. If the rate of inflation is 3 percent for the next 12 months, $1 today will be worth 97 cents just 12 months from today. In other words, 12 months from now, you’ll pay $1 to buy what you paid 97 cents for today.
Lost return on investment: If you spend money to perform the project being considered, you’ll forego the future income you could earn by investing it conservatively today. For example, if you put $1 in a bank and receive simple interest at the rate of 3 percent compounded annually, 12 months from today you’ll have $1.03 (assuming zero-percent inflation).
To address these considerations when determining the NPV, you specify the following numbers:
Discount rate: The factor that reflects the future value of $1 in today’s dollars, considering the effects of both inflation and lost return on investment
Allowable payback period: The length of time for anticipated benefits and estimated costs
In addition to determining the NPV for different discount rates and payback periods, figure the project’s internal rate of return for each payback period.