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Allocating Resources: Cost/Benefit Analysis

Instructor: Shawn Grimsley
In a perfect world we can have our cake and eat it too, but the world is not perfect and we often must choose one thing over another. In this lesson, you'll learn about how we can use cost-benefit analysis to make such decisions.

Cost-Benefit Analysis Defined

Brittany is a real estate developer who has just sold an office building she built. Now Brittany needs to decide what her company should pursue next with the profits and other resources of the company, such as its labor and capital equipment. She's looking at making an investment involving a condo conversion in a part of town currently undergoing a period of urban renewal. In order to determine whether to green light the investment, she'll utilize a cost-benefit analysis. A cost-benefit analysis is a means of decision-making where the costs and benefits of a proposed activity or project is assessed and oftentimes compared against alternative choices. Let's take a look at the process by seeing Brittany utilize it.

Process

In order to perform a cost-benefit analysis, all the costs and benefits must be given a common value, which is almost always monetary. It can be difficult to accurately evaluate the cost of more abstract factors such as improved public image or health. For example, how much monetary value would you place on your life when considering the cost of a life-saving surgery? Fortunately for Brittany, the costs and benefits of the proposed real estate development can pretty easily be measured in dollars. Let's take a look at what the typical costs and benefits may be for Brittany if she pursues the project.

Developing real estate includes many different types of costs. Brittany will have to buy the land and the materials to construct the buildings and supporting infrastructure. She'll also have to pay for the labor involved, interest for any loans she takes out to finance the project, and property taxes on the dirt. Other expenses may include marketing costs, architectural fees, building permits, surveying expenses, lending fees, legal fees, and accounting fees. She also needs to consider her costs if the project fails.

Brittany must also tally up the benefits that she expects to reap from the proposed development. The biggest and most concrete benefit is simply the return on her investment - the profit that should be realized after deducting all costs of the project. She may also consider other benefits as well, such as the value of an increase in market share or her company's brand and its goodwill.

Rome wasn't built in a day and neither will Brittany's development if she decides to green light it. For projects that may take a significant time to complete, you are well served to take into account the cost of inflation, which is the rate of increase of prices overtime. In most instances, a dollar today is worth more than a dollar is tomorrow. Consequently, it's a good idea to discount the expected profit on a project to present day dollars. For example, a $1,000 profit in three years may only be worth $900 in today's dollars.

How does all this help Brittany make a decision? If the benefits of the project outweigh the costs, then the project is economically viable. Of course, this assumes that there's only one choice: either to proceed with the project or doing nothing, but the real world rarely works that way.

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