A cost-benefit analysis (CBA) is a decision-making process that allows a business to compare the forecasted costs and benefits of a possible project and is usually expressed in monetary terms. If the benefits of investing in the project are greater than the costs, then the business will want to invest since it will be a value-maximizing opportunity.
Doing a CBA of each project of interest allows an entrepreneur or business owner to decide about the project’s viability. The process of doing a CBA for a project starts with gathering all the costs and benefits that are associated with it. Then, key financial metrics are used to determine how much value investing in the project will add to the business.
Definition and Example of CBA
A CBA is the process of comparing the costs of a project to the benefits generated from it and determining if a business should invest in the project. While a CBA is usually expressed in monetary terms, intangible costs like time and health risks are sometimes also taken into consideration along with the impact on business income.
- Alternate definition: A CBA is a systematic approach to identify the strengths and weaknesses of a project to determine which to pursue and which to forgo.
- Alternate name: benefit-costs analysis; benefit-cost analysis; risk analysis
An example of CBA from a business perspective is comparing the cost and benefit of adding a new product line to what you already manufacture. Let’s say the cost of adding the product is $500,000. This includes new equipment, more labor, and increased overhead. The benefit of adding the new product line is $300,000, which represents increased sales. As a business owner, you ask yourself whether the cost is worth the benefit. In this example, the costs are $200,000 greater than the benefit. Your decision should be that you are not going to add the product since the cost is greater than the benefit.
How Does a CBA Work?
As a business owner, you want to be able to choose projects that will meet business goals.
A CBA can help you determine, among other things, the financial viability of a project if you need to hire additional staff, and how you want to prioritize investments so you can make an informed decision.
When a business owner does a CBA, they want it to be as accurate as possible. The first example was a simple analysis that did not consider the time value of money. For a CBA to be as accurate as possible, a discounted cash-flow analysis should be used to reflect the figures in today’s dollars. You have to take current interest rates and the time period of the project into account. In a larger company, for example, before a financial manager performs a discounted cash-flow analysis, they often calculate their company’s payback period so they can see how quickly they will make back their investment.
Using the previous example, we know that the initial investment in the project is $500,000. That initial investment is the project’s cost, and it is the only cost during the lifetime of the project.
Let’s say the lifetime of the project is two years. During those two years, a total of $300,000 in cash flow is generated by this project. That is the project’s benefit to the business. During year one, $150,000 in cash flow is generated and the same is generated for year two. We have already established that the time period will be two years, and hypothetically, the current interest rate, or the business’s cost of capital, is 3%.
Calculation of the Payback Period
The payback period is a quick calculation but one that is critical to determine see how long a project takes to return a business’s investment:
For this example, the payback period is: $500,000/$150,000 = 3.33 years
This means that in 3.33 years, the project will have returned its initial investment even though the project will only last two years.
Calculation of the Benefit-Cost Ratio
The benefit-cost ratio (BCR) is another way of calculating whether or not a project should be undertaken. The decision rule is that if the ratio is greater than 1.0, then it is an advantageous project, but if it is less than 1.0, it indicates that the project would not be beneficial. Here is how our previous example is calculated using BCR:
Since the BRC is 0.6, the project should not be undertaken.
Calculating Net Present Value
Net present value (NPV) is a calculation that takes the time value of money into account. You discount cash flow back to the present based on the following formulas, which account for each year of cash flows. They are discounted at the business’s hypothetical 3% cost of capital.
PV(0) = -$500,000 (This is just the capital cost; note that this is a negative number.)
PV(1) = $150,000 ÷ (1.03)1 = $145,631
PV(2) = $150,000 ÷ (1.03)2 = $141,509
NPV = $145,631 + $141,509 - $500,000 = -$212,860 (also a negative number)
The NPV of this project is a negative $212,860. The decision-making rule is to accept a project if the NPV is greater than $0. In this case, it is not, so you would reject this project.
According to all three CBA methods, the business should not undertake the project. However, if one or more methods have conflicting results, a managerial decision-making process may be needed to decide whether to move forward with the project or pass on it.
Types of CBA
While there is essentially one type of CBA, there are a number of financial techniques you can use to do the analysis. You can do a discounted cash-flow analysis like NPV or a non-discounted cash-flow analysis based on the payback period or BCR. Another discounted cash-flow approach you can take is to calculate the project’s internal rate of return, which is best calculated on a financial calculator or a spreadsheet program.
- A CBA is a process of comparing the costs of a project to the benefits for the business.
- Both discounted cash-flow techniques and non-discounted techniques can be used by the business to decide on a project.
- When using discounted cash-flow analysis, the cash flows should be discounted at the business’s cost of capital over the lifetime of the project.
- Unless businesses conduct a CBA of their possible projects, they may have no way of knowing what will be a good investment for their business.