Cost-Benefit Analysis Notes.docx

**Cost-Benefit Analysis** Even though it is necessary to take risks as an entrepreneur, successful people take **calculated risks.** This means that the potential costs and benefits are carefully considered before starting a business. One method used to determine a calculated risk is called a **cos...

**Cost-Benefit Analysis** Even though it is necessary to take risks as an entrepreneur, successful people take **calculated risks.** This means that the potential costs and benefits are carefully considered before starting a business. One method used to determine a calculated risk is called a **cost-benefit analysis** or **CBA**. It is the process of adding up all the expected benefits of an opportunity and subtracting all the expected costs. If the benefits outweigh the costs, then the opportunity may be worthwhile. Costs can be one-time payments or ongoing costs (such as rent). Benefits are most often received over a period of time. For example, let's say you want to buy a computer, but you don't have the money to pay for it. The purchase price could be a one-time cost if you save up and pay cash for it in six months. But, if you use a credit card to buy the computer today, you should calculate how much extra cost you will have to pay in interest charges over the next few months. If buying the computer NOW enables you to earn more money than the total interest, the benefit may outweigh the cost. A difficult part of doing a cost/benefit analysis is assigning a monetary value to **intangible** (non-material) things. For example, what is the value of your time? In what ways can you use your time most profitably? Obviously, some costs and benefits have to be based on personal values and priorities. What is important to you may not be the same as for someone else. **Background:** 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: - - - 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. **Step 1: Brainstorm Costs and Benefits** Take time to brainstorm all 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 2: Assign a Monetary Value to the Costs** Costs include the costs of physical resources needed, as well as the cost of the human effort (labor) 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 3: Assign Monetary Value to the Benefits** This step is less straightforward than step two! First, it\'s often very difficult to predict revenues accurately, especially for new products. Second, 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 4: 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). **Example as shown on Canvas:** 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** - - - -