Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference

Home > Operations Management Checklists > Applying Cost–Benefit Analysis to Project Appraisal

Operations Management Checklists

Applying Cost–Benefit Analysis to Project Appraisal


Checklist Description

This checklist describes the elements of cost–benefit analysis and how to use it to your advantage when evaluating projects.

Back to top

Definition

Cost–benefit analysis is a widely used, straightforward technique for deciding whether to initiate an action or implement changes. Simply put, it involves adding up the value of the benefits of a course of action and subtracting what it will cost to obtain those benefits. Costs are usually either one-off (for example, start-up costs for materials or equipment) or ongoing (such as staff), whereas benefits tend to unfold over a period of time.

When conducting your analysis, you calculate your payback period, which is the length of time it takes for the benefits to repay the costs of implementing them. It is typical to specify a set payback period of, for example, three years, even if the benefits continue to be reaped long after. The end of the payback period is also known as the breakeven point. This can sometimes be more important than any overall benefits delivered by a project, for example because the organization had to borrow funds to purchase expensive plant. Breakeven is easily calculated by plotting costs and income on a graph—it occurs at the point where the two lines cross. Determining the time span of the payback period is not always easy as many benefits don’t have a monetary value or can continue long after the end of payback. The only way to account fully for the effect of time would be to discount all cash flows at the cost of capital.

At its simplest, a cost–benefit analysis assumes that there are only financial costs and financial benefits. For example, a bank needs to train its call centre staff. The analysis would subtract the cost of the training days from the economic benefit that calls will be answered more quickly and efficiently, enabling the bank to handle more calls overall and resolve customer problems more cheaply. Such a simple analysis would not measure the cost of “lost” staff time while they are not on duty, or the benefit of staff having a clearer understanding of standard procedures.

A more sophisticated approach involves trying to work out a monetary value for intangible costs and benefits. This can be highly subjective. For example, when customers praise your call centre staff, how much would it have cost to pay a PR firm to boost the bank’s image of handling customer complaints? Calculating intangibles usually raises many questions that need clear answers.

Where very large sums of money are involved, such as in financial market transactions, project evaluation using cost–benefit analysis can be extremely complex, yet of vital importance to ensure that money is spent as wisely as possible.

Back to top

Advantages

  • The advantage of conducting a cost–benefit analysis is that you can weigh up all the positive and negative impacts of a project using their equivalent financial value to determine whether, on balance, the project is worthwhile.

Back to top

Disadvantages

  • The chief risk in performing a cost–benefit analysis is that the results will only be as accurate as the estimated costs and benefits. Studies have shown that actual costs often turn out to be far higher than estimated, while actual benefits are often lower. This is especially true where intangibles are included in the analysis. It may be safer to perform a straightforward rate-of-return analysis.

Back to top

Action Checklist

  • Work out how much it will cost to make the change, then calculate the benefit you will gain from it.

  • Use mapping tools such as Gantt charts or PERT (program evaluation and review technique) to calculate timescales for implementing a project or introducing a change.

  • A SWOT (strengths, weaknesses, opportunities, threats) analysis can help to keep you focused on what the project should achieve.

  • Calculate the payback period. This is usually the length of the project, but it may be longer if you are aiming for long-term effects resulting from a limited-term project. Remember that you may need to discount the cash flows at the cost of capital if you want to fully take into account the effect of time.

Back to top

Dos and Don’ts

Do

  • Remember that benefits are often intangible, i.e. they have no monetary value.

  • Make a firm decision on whether to include intangible items within the analysis. As you must estimate a value for these, this inevitably brings an element of subjectivity into the process.

Don’t

  • Don’t forget to include a risk analysis as part of your overall planning.

  • Don’t forget to make a cash flow forecast for decisions that will have a purely financial outcome.

Back to top

Further reading

Books:

  • Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 11th ed. New York: McGraw-Hill, 2013.
  • Chakravarty, Sukhamoy. “Cost–benefit analysis.” In Eatwell, John, Murray Milgate, and Peter Newman (eds). The New Palgrave: A Dictionary of Economics. Basingstoke, UK: Palgrave Macmillan, 1987; pp. 687–690. (Dictionary online at: www.dictionaryofeconomics.com/dictionary).
  • Nas, Tevfik F. Cost-Benefit Analysis: Theory and Application. Thousand Oaks, CA: Sage Publications, 1996.

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share