Cost Benefit Analysis

Cost-benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic approach to estimating the strengths and weaknesses of alternatives that satisfy transactions, activities or functional requirements for a business. 

From the perspective of an economist, it takes both a long-term and a wide view. It is long-term in the sense of examining the effects, implications and repercussions both in the short and long-term. It takes a wide view in the sense of examining the effects of the project on different peoples, industries and regions. It is a broad treatment, and has more in common with economics than with business and commerce. It draws on a range of sub disciplines within economics, such as resource economics and public finance, to create a coherent view of the project.

Cost-benefit analysis has a long history, particularly in France, where the engineer Dupuit published a paper in 1844 on the utility of public works, a groundbreaking contribution to the field of economics.

It provides the best approach for the adoption and practice in terms of benefits in labour, time and cost savings etc. (David, Ngulube and Dube, 2013).

Cost-benefit analysis is primarily an economic analysis. Although market prices are a starting point for the determination of the benefits and the costs, they imperfectly represent the interests of various parties and stakeholders in the project. Market prices may be distorted by political intervention, taxes, subsidies, incentives, lack of competition, price control and other factors. In an economic cost-benefit

analysis, prices are adjusted towards their efficiency prices, those that would be achieved in a perfect market as a result of the best allocation of resources due to supply and demand. This is in contrast with financial or commercial analysis, which considers the flow of cash at market price.

Costs

Category	Details	Cost in First Year
Lease	750 square feet available next door at $18 per square foot	$13,500
Leasehold improvements	Knock out walls and reconfigure office space	$15,000
Hire two more designers	Salary, including benefits Recruitment costs Orientation and training	$75,000 $11,250 $3,000
Two additional workstations	Furniture and hardware Software licenses	$6,000 $1,000
Construction downtime	Two weeks at approximately $7,500 revenue per week	$15,000
Total		$139,750

Benefits

Benefit	Benefit Within 12 Months
50 percent revenue increase	$195,000
Paying in-house designers $15 an hour, versus $50 an hour outsourcing (100 hours per month, on average: savings equals $3,500 a month)	$42,000
10 percent improved productivity per designer ($7,500 + $3,750 = $11,250 revenue per week with a 10 percent increase = $1,125/week)	$58,500
Improved customer service and retention as a result of 100 percent in-house design	$10,000
Total	$305,500

He calculates the payback time as shown below:

$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.

Inevitably, the estimates of the benefit are subjective, and there is a degree of uncertainty associated with the anticipated revenue increase. Despite this, the owner of Custom Graphic Works decides to go ahead with the expansion and hiring, given the extent to which the benefits outweigh the costs within the first year.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows that come in over a number of periods of time, particularly where returns vary from period to period. In these cases, use Net Present Value (NPV) and Internal Rate of Return (IRR) calculations together to evaluate the project, rather than using Cost-Benefit Analysis. (These also have the advantage of bringing "time value of money" into the calculation.)

Also, the revenue that will be generated by a project can be very hard to predict, and the value that people place on intangible benefits can be very subjective. This can often make the assessment of possible revenues unreliable (this is a flaw in many approaches to financial evaluation). So, how realistic and objective are the benefit values used?

Useful link: 

Hanbook of CBA 2006