Understanding & Using Cost-Benefit Analysis

Instructor: Sandra Judge

Sandra is a CPA, CA with a graduate diploma in public accounting.

This lesson will introduce the concepts, advantages, and disadvantages of cost-benefit analysis. Although the cost-benefit analysis is an excellent tool, we shall see that not all costs and benefits can easily be assigned monetary values.

Cost-Benefit Analysis

Meet Jim! Jim has a shoe company and is considering buying new equipment for his factory. To decide on the best options, Jim will perform a cost-benefit analysis, a useful decision-making tool to determine if benefits outweigh costs over the long-term of a project.

Advantages

  • It's a simple tool. Add all the cash inflows and outflows; then find the present value of the cash flows, or the current value of all the cash inflows and outflows over the life of the project.

  • It aids in budgeting. When the new project is undertaken, management will have an idea of what the costs and benefits should be. If there is a significant variance in costs and benefits, management will be able to make adjustments to get back on track.

  • It provides an objective basis for comparing different projects. Since the costs and benefits are assigned a dollar value, different projects can be evaluated on a common basis.

Disadvantages

  • Cost-benefit analysis is based on estimates. So, small errors in estimation can lead to the wrong decision.

  • Not all factors can be assigned a monetary value. Because a dollar value can't be assigned, less weight may be assigned to non-monetary factors.

  • The final decision is based on the present value of future cash flows. To compare future dollars with today's dollars, we must find the present value. By calculating the present value, more emphasis is placed on the current year's cash flows, and less on future year's cash flows; this can cause problems if there are losses in the future that are minimized (due to applying the present value formula, which we will review momentarily).

How to Perform Cost-Benefit Analysis

First, let's help Jim tackle his investment decision by performing a cost-benefit analysis. The cost-benefit analysis can be broken down into five steps.

Step 1: Identify Options

Jim can either continue using his old equipment or invest in a new machine.

Step 2: Identify Stakeholders

We need to consider all the people who will be affected by this decision. Jim will want to maximize his profits. We also need to consider Jim's employees. For example, if there any costs to layoff or retrain the employees, these costs should be included in the analysis. We must also consider the customers. Does the new machine result in a higher-quality product? Also consider the company's reputation and environmental impact. Notice that some of these are non-monetary considerations. You may assign a dollar value to non-monetary considerations or consider them as qualitative factors in the final decision.

Step 3: Identify and Assign Dollar Values to All Costs and Benefits

The new machine is $100,000 and will last 5 years. It will produce less pollution and use less energy. It will also decrease operating costs by $25,000 per year and increase profits by $2,000 per year. In its current condition, the old machine can be sold for $10,000. Jim has paid an engineer $2,000 to come up with these numbers. If Jim does not buy the new machine he would gain $1,000 per year in investment income.

Costs to Consider

  • Relevant costs: These are costs affected by your decision. They can be identified because they will be different between two courses of action. Relevant costs are always included in the analysis. In our example, these include the cost of the new machine, proceeds from selling the old machine, decreases in operating costs, and increased revenues.

  • Opportunity costs: Costs (or benefits) that will be lost by selecting one course of action over another; these costs should be included in your analysis. Opportunity costs in our example are the investment income that Jim will forego if he buys the new machine.

  • Sunk costs: These are costs that have already occurred and cannot be recovered. These are not included in our analysis. A sunk cost in our example is $2,000 paid to the engineer to perform the analysis.

  • Non-monetary costs and benefits: Social and environmental impact and the company's reputation are qualitative factors that go into the final decision. The new machine being more environmentally friendly is a non-monetary factor.

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