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Monday, May 12, 2014

Pro's and Con's of a Cost / Benefit Analysis

Before making important business decisions, many business owners conduct a cost-benefit analysis to help in their decision process. Transactions that may require a cost-benefit analysis include (but not limited to): acquiring additional capital, selling equity to a new potential business partner, hiring a manager with above average rates, relocating the business, etc.

There are many ways individuals attempt a cost-benefit analysis. If the results are accurate then it could improve the business’s cash flow, avoid financial hardship, and present new opportunities that didn't previously exist. However, business owners should be cautious of the validity of the information used in the analysis. If the information is not accurate the consequences could be dire.

For those who are not familiar with cost-benefit analysis, the process of generating such an analysis is as follows:

It is a process of comparing the investment costs, today and ongoing, whether it is additional labor hours, capital, or reallocation of existing resources in today’s dollars versus the total benefit. Often this exercise is done when a company must decide between several options to implement a desired, and often required, output (i.e. new equipment to replace the pre-existing damaged or obsolete equipment, developing a new product line, hiring or replace staff, etc.); as well it occurs when a business is presented with an opportunity that requires additional analysis.

The calculations involved are financial equations including net present value as well as various management accounting ratios to assess the capability of business owner today to determine the feasibility of the transaction in question. The calculation process may be considered advanced for the average individual, but it is important to note the complexity of the process before starting.

The following is a list of pros for performing a cost-benefit analysis:
1) Generates a calculated “best guess” to determine feasibility:

A cost-benefit analysis is really an estimate; however, it is important to be prepared. Costs would be easier to assess than the benefits forecasted; therefore, it is a merely an educated guess. The results from a cost-benefit analysis should give business owners, if every variable is entered correctly, enough data to make a decision with confidence.

2) Determines affordability today:

Depending on the business’s cash flow the demands from additional costs could derail the company’s cash position. Upon reviewing the costs required from the new venture being analysed, business owners can determine their ability to reallocate resources or conclude if they are capable of securing financing with their current financial situation. The ability to afford the costs ongoing especially if the benefits is scheduled to occur in the future instead of instantly.

3) Potentially discovers unknown variables:

When collecting the relevant data to facilitate a cost-benefit analysis additional variables may materialize in the review process. Unknown variables could aid the calculation to be more favourable or it could take away from it. Examples of unknown variables could include additional financing costs, sources of revenues, cost savings from price breaks, etc.

The following is a list of cons for performing a cost-benefit analysis:
1) It may not factor indirect benefits:

It is difficult to assess indirect benefits and attach a corresponding cost or benefit towards it. Indirect benefits may include producing an output for social profit; however, it may be difficult to monetize the benefits from social profits. Other benefits may include cost savings in other areas of the business’s operations that cannot easily be assessed today. Finally, there may be opportunities that are known but are not factored into the cost-benefit analysis, such as: increase in workplace safety, employee morale and retention, and overall knowledge.

2) Variables might be biased:

Conducting a cost-benefit analysis could be ineffective if the variables are biased. It is possible for benefits to be overestimated from ambitious decision makers; however, if the bar is set too high the decision to move forward could be costly to the business. As well, assuming discounts will be offered from selected suppliers could be dangerous. Business owners must be honest with the information they decided to choose to create a cost-benefit analysis.

3) Unknown variables might significantly add to costs or lower benefits:

It is possible that variables are not considered or overlooked for the analysis. Realistically most cost-benefit analysis will not have the exact cost and benefit figures; however, there is a significant risk if certain variables are overlooked. Spend time to get as much information as possible and consider as many external factors as possible that could affect the costs and/or benefits.

Be prepared when performing a cost-benefit analysis. If the end result is not favourable then it is the business’s best interest to not pursue. Otherwise, if there were positive results then it would be wise to consider additional research to support the analysis.

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