Meaning, Purpose and Problems of Cost Benefit Analysis Meaning

MEANING, PURPOSE AND PROBLEMS OF COST BENEFIT ANALYSIS
Meaning:
A cost benefit analysis is done to determine how well, or how poorly, a planned action
will turn out. Although a cost benefit analysis can be used for almost anything, it is most
commonly done on financial questions. Since the cost benefit analysis relies on the addition of
positive factors and the subtraction of negative one to determine a net result, it is also known as
running the numbers.
Cost Benefit Analysis: Definition:

A cost benefit analysis finds, quantifies and adds all the positive factors. These are the
benefits. It then identifies, quantifies and subtracts all the negatives, the costs. The difference
between the two indicates whether the planned action is advisable. The real trick to doing a cost
benefit analysis well is making sure you include all the costs and all the benefits and properly
quantify them.
What Is a Cost-Benefit Analysis?

A cost-benefit analysis is a systematic process that businesses use to analyze
which decisions to make and which to forgo. The cost benefit analyst sums the potential rewards
expected from a situation or action and then subtracts the total costs associated with taking that
action. Some consultants or analysts also build models to assign a dollar value on intangible
items, such as the benefits and costs associated with living in a certain town.
Understanding Cost-Benefit Analysis

Before building a new plant or taking on a new project, prudent managers conduct a cost-
benefit analysis to evaluate all the potential costs and revenues that a company might generate
from the project. The outcome of the analysis will determine whether the project is financially
feasible or if the company should pursue another project.
In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-
making process. Opportunity costs are alternative benefits that could have been realized when
choosing one alternative over another. In other words, the opportunity cost is the forgone or
missed opportunity as a result of a choice or decision. Factoring in opportunity costs allows
project managers to weigh the benefits from alternative courses of action and not merely the
current path or choice being considered in the cost-benefit analysis.
By considering all options and the potential missed opportunities, the cost-benefit analysis is
more thorough and allows for better decision-making.
Example: Cost Benefit Analysis

As the Production Manager, Harry is proposing the purchase of a Rs. 1 Million stamping
machine to increase output. Before he can present the proposal to the Vice President, he needs
some facts to support his suggestion, so he decides to run the numbers and do a cost benefit
analysis.
He itemizes the benefits. With the new machine, he can produce 100 more units per hour.
The three workers currently doing the stamping by hand can be replaced. The units will be
higher quality because they will be more uniform. He is convinced these outweigh the costs.
There is a cost to purchase the machine and it will consume some electricity. Any other
costs would be insignificant.
He calculates the selling price of the 100 additional units per hour multiplied by the
number of production hours per month. Add to that two percent for the units that aren't rejected
because of the quality of the machine output. He also adds the monthly salaries of the three
workers. That is a pretty good total benefit.
Then he calculates the monthly cost of the machine, by dividing the purchase price by 12
months per year and divides that by the 10 years the machine should last. The manufacturer's
specs tell him what the power consumption of the machine is and he can get power cost numbers
from accounting so you figure the cost of electricity to run the machine and add the purchase
cost to get a total cost figure.
He subtracts his total cost figure from his total benefit value and his analysis shows a
healthy profit. All he has to do now is present it to the VP, right? Wrong. He has got the right
idea, but he left out a lot of detail.
Purpose of Cost –Benefit Analysis:

The Cost-Benefit Analysis Process
A cost-benefit analysis (CBA) should begin with compiling a comprehensive list of all the costs
and benefits associated with the project or decision.
The costs involved in a CBA might include the following:
 Direct costs would be direct labor involved in manufacturing, inventory, raw materials,
manufacturing expenses.
 Indirect costs might include electricity, overhead costs from management, rent, utilities.
 Intangible costs of a decision, such as the impact on customers, employees, or delivery
times.
 Opportunity costs such as alternative investments, or buying a plant versus building one.
 Cost of potential risks such as regulatory risks, competition, and environmental impacts.
Benefits might include the following:
 Revenue and sales increases from increased production or new product.

 Intangible benefits, such as improved employee safety and morale, as well as customer
satisfaction due to enhanced product offerings or faster delivery.
 Competitive advantage or market share gained as a result of the decision.
An analyst or project manager should apply a monetary measurement to all of the items on
the cost-benefit list, taking special care not to underestimate costs or overestimate benefits. A
conservative approach with a conscious effort to avoid any subjective tendencies when
calculating estimates is best suited when assigning a value to both costs and benefits for a cost-
benefit analysis.
Finally, the results of the aggregate costs and benefits should be compared quantitatively to
determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with
the project. If not, the business should review the project to see if it can make adjustments to
either increase benefits or decrease costs to make the project viable. Otherwise, the company
should likely avoid the project.

The principles of cost-benefit analysis (CBA) are simple:
One of the problems of CBA is that the computation of many components of benefits and
costs is intuitively obvious but that there are others for which intuition fails to suggest methods
of measurement. Therefore some basic principles are needed as a guide.
1. Appraisal of a project: It is an economic technique for project appraisal, widely used in

business as well as government spending projects (for example should a business invest in a new
information system)
2. Incorporates externalities into the equation: It can, if required, include wider
social/environmental impacts as well as ‘private’ economic costs and benefits so that
externalities are incorporated into the decision process. In this way, COBA can be used to
estimate the social welfare effects of an investment.
3. Time matters: COBA can take account of the economics of time – known as discounting.
This is important when looking at environmental impacts of a project in the years ahead
The Main Stages in the Cost Benefit Analysis Approach
At the heart of any investment appraisal decision is this basic question – does a planned
project lead to a net increase in social welfare?
o Stage 1(a) Calculation of social costs & social benefits. This would include calculation of:
 Tangible Benefits and Costs (i.e. direct costs and benefits)
 Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)
This process is very important – it involves trying to identify all of the significant costs &
benefits.
o Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important question -
If you estimate that a possible benefit (or cost) is £x million, how likely is that outcome? If you
are reasonably sure that a benefit or cost will ‘occur’ – what is the scale of uncertainty about the
actual values of the costs and benefits?
o Stage 2: - Discounting the future value of benefits – costs and benefits accrue over time.
Individuals normally prefer to enjoy the benefits now rather than later – so the value of future
benefits has to be discounted
o Stage 3: - Comparing the costs and benefits to determine the net social rate of return
o Stage 4: - Comparing net rate of return from different projects – the government may have
limited funds at its disposal and therefore faces a choice about which projects should be given
the go-ahead.
History of Cost-Benefit Analysis
CBA has its origins in the water development projects of the U.S. Army Corps of Engineers. The
Corps of Engineers had its origins in the French engineers hired by George Washington in the
American Revolution. For years the only school of engineering in the United States was the
Military Academy at West Point, New York.
In 1879, Congress created the Mississippi River Commission to "prevent destructive floods."
The Commission included civilians but the president had to be an Army engineer and the Corps
of Engineers always had veto power over any decision by the Commission.
In 1936 Congress passed the Flood Control Act which contained the wording, "the Federal
Government should improve or participate in the improvement of navigable waters or their
tributaries, including watersheds thereof, for flood-control purposes if the benefits to
whomsoever they may accrue are in excess of the estimated costs." The phrase if the benefits to
whomsoever they may accrue are in excess of the estimated costs established cost-benefit
analysis. Initially the Corps of Engineers developed ad hoc methods for estimating benefits and
costs. It wasn't until the 1950s that academic economists discovered that the Corps had
developed a system for the economic analysis of public investments. Economists have influenced
and improved the Corps' methods since then and cost-benefit analysis has been adapted to most
areas of public decision-making.

Meaning, Purpose and Problems of Cost Benefit Analysis Meaning

Uploaded by

Copyright:

Available Formats

Meaning, Purpose and Problems of Cost Benefit Analysis Meaning

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Meaning, Purpose and Problems of Cost Benefit Analysis Meaning

Uploaded by

Copyright:

Available Formats

MEANING, PURPOSE AND PROBLEMS OF COST BENEFIT ANALYSIS

Cost Benefit Analysis: Definition:

What Is a Cost-Benefit Analysis?

Understanding Cost-Benefit Analysis

Example: Cost Benefit Analysis

Purpose of Cost –Benefit Analysis:

The costs involved in a CBA might include the following:

Benefits might include the following:

 Revenue and sales increases from increased production or new product.

1. Appraisal of a project: It is an economic technique for project appraisal, widely used in

The Main Stages in the Cost Benefit Analysis Approach

History of Cost-Benefit Analysis

You might also like