As an entrepreneur, having all the resources your business needs at once may not always be feasible. There are certainly times when you have limited resources, and you’ll have to decide what to do with them and what project or program should be executed. At this point, you’ll need to use cost-benefit analysis.
In the Nigerian business environment, cost-benefit analysis (CBA) is useful given the challenges businesses face, such as limited resources, competition, and regulatory hurdles. By employing the strategy of CBA, you can ensure that your investments are financially viable and have the potential to deliver positive outcomes.
In this simple guide, we’ll overview the key concepts and steps in conducting a CBA. So, whether you are a business owner, manager, or analyst, this guide will help you understand how to use CBA to make better decisions and improve your business performance.
Table of Contents
What is a Cost-Benefit Analysis?
Cost-benefit analysis evaluates the costs and benefits of a particular project, policy, or program. This is usually done to ascertain whether the project will succeed. Cost-benefit analysis, in general, is totaling up all expenses associated with a project and deducting that sum from the predicted benefits of the project or decision.
You could claim that the initiative was wise if the anticipated advantages outweighs the anticipated expenses. A business may want to reconsider the initiative if, on the other hand, the expenses exceed the advantages.
Why is Cost-Benefit Analysis Important?
Cost-benefit analysis is a tool that comes in handy as it can be beneficial when evaluating decisions that pertain to your business’ success. Here are some reasons why cost-benefit analysis is needed:
It helps you make simpler decisions
As a business owner, you can attest to the fact that making decisions most times is quite a tedious task. With cost-benefit analysis, you can classify your decisions into costs and benefits. Doing so makes making better and simpler decisions easier than just making complex business decisions.
You’ll discover hidden costs and benefits
As stated earlier, making decisions will be a “hard job without cost-benefit analysis.” Another reason why this analysis is needed is that it helps you carefully outline all the costs and benefits you’re expected to incur and gain, respectively. When you do so, you can discover hidden costs that you may not notice if you didn’t use this analysis.
It is a data-driven process
A cost-benefit analysis enables you to examine a proposed project without prejudice. It provides an unbiased and fact-based review of your options as a result, which can assist your company in becoming more data-driven and logical.
Allocation of resources
With the aid of cost-benefit analysis, it’s easier to allocate limited resources efficiently by identifying the projects or decisions with more economic feasibility and potential to yield a higher net present value (NPV).
How Does Cost-Benefit Analysis Work?
Cost-benefit analysis (CBA) is a tool used to evaluate the possible benefits and costs of a particular project or decision. This is to know whether or not the benefits outweigh the costs. Here’s how it works:
Identify the project or decision
The first step when considering cost-benefit analysis is to identify the decision you want to make or the project you intend to start that requires evaluation. Without making a choice, there cannot be a cost-benefit analysis because there won’t be anything to analyze.
Identify those that will be affected by the project
After identifying the project, you should know people who will be affected by the project. The success of the project depends on employees, you have to check whether you need few employee or not.
Identify the costs
Identify the project’s or decision’s associated expenses. Direct expenses (including those for labor, supplies, and equipment) and indirect expenses (such as lost productivity and environmental damage) are included.
Identify the benefits
The next thing to do is to identify the benefits that will be obtained from carrying out the project of the decision. Some benefits you should look for include more revenue and fewer expenses, termed “tangible benefits,” and a reduced risk of operation as an “intangible benefit.”
Give a monetary value to the costs and benefits
You must translate the costs and benefits into monetary terms to compare them. This can be accomplished by calculating the cash amounts associated with the costs and benefits or by applying a common technique for economic analysis, such as present value analysis or net present value analysis.
Tally your net present value (NPV)
When you’ve successfully assigned monetary values to the costs and benefits, you should tally your total net present values. This value is obtained by subtracting your net cost from your net benefits discounted over time. This should give you some insight into the project’s feasibility or decision.
Analyze the results
The next important step in the cost-benefit analysis process is to analyze the results from the previous steps. Here, you consider whether or not the benefits outweigh the costs of running your proposed project. If the net benefits exceed the next set of costs, then it’s go-ahead, and that project is likely economically achievable. If otherwise, you should reconsider the decision or project from the beginning.
Make a decision
Once your evaluation has been ascertained and you have the “green light” to proceed, you should make a move. Business owners may often be limited by their inability to decide to begin. Do not fall into this category. Once you’ve succeeded in all the steps mentioned above, get to work.
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Limitations of Cost-Benefit Analysis
As great as the cost-benefit analysis tool and process are, they have their limitations. The limitations include the following:
Works best for short and midterm projects
Cost-benefit analysis has a greater chance of falling short for projects or commercial decisions with longer durations for a number of reasons. One reason is that it becomes increasingly difficult to make precise forecasts as you move further into the future. Long-term estimates may also fail to adequately consider factors like inflation, which could affect the analysis’s overall accuracy.
All variables cannot be predicted
While a cost-benefit analysis can help you identify the anticipated costs and advantages of a business action, it can be difficult to foresee every factor that could influence the result. Unpredictable changes can occur in market demand, material costs, and the overall business environment, especially over an extended period.
Stakeholders’ influence in valuing costs and benefits
Cost-benefit analysis (CBA) is based on subjective assessments of cost-benefit ratios. Conflicts may arise because stakeholders may hold varying opinions about the significance of particular costs and benefits. Due to the influence of these stakeholders, a cost-benefit analysis may not be feasible.
Possibility of wrong data interfering with results
Since the cost-benefit analysis is a tool and process that relies mainly on an array of data, any form of wrongly inputted data will hamper the results.
Applying cost-benefit analysis in a business has proven to have advantages and limitations. As a business owner, manager, or analyst, this article can help you shape your decisions and identify the best project to execute with the highest return on investment. The limitations can be minimized to the least when you can deal with them appropriately.
Ultimately, your business will be at its best when you can apply the results obtained from the cost-benefit analysis, using them to make very informed decisions.
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