With each project we have a desired end point, a definition of success. We spend time, and energy, creating solutions and plans to solve a problem or get to a desired end point; however we may not go ahead with plans because they are not simply financially viable or just too expensive.
Cost Benefit Analysis is a simple and widely used technique for deciding whether to make a change or to go ahead with a project.
As the name suggests, simply add up the value of the benefits of a course of action, and subtract all the costs associated with it. This calculation may be dollar focussed or undertaken on a more qualitative variation.
Costs are either one-off, i.e. a single expense, or may be incurred over a period of time eg weekly monthly etc. or perhaps could be a combination of both.
The Benefits of a course of action are most often received over a period of time.
We build this effect of time into our analysis by calculating a pay-back period. This is the time it takes for the benefits of a project to repay, to the investor or business, the full cost of implementing the project.
In business, companies usually look for pay-back over a specified period of time – e.g. three years being quite normal. This payback period is usually calculated using complicated mathematical and financial formulae, using interest rates and CPI etc and is often described as a percentage return on investment per year.
Simplistically for our purposes let’s say it takes 3 years to pay back the cost of implementation of a project, at zero interest rate, and CPI is also zero. (What a stagnant world that would be) The percentage return per year is therefore 100 divided by 3years equalling 33.33%.
Some businesses have a project hurdle rate of 30%. That means they will not invest in the project unless it returns a better rate then 30%. I.e. The project must pay for itself in less than 3 years.
In its simple form, cost/benefit analysis is carried out using only financial costs and financial benefits.
For example, a simple cost/benefit analysis of a new shopping centre would measure the cost of building the centre, and subtract this from the economic benefit to the developer of increased rental income. It would not measure either the cost of any environmental damage or the benefit to local consumers of convenient and easier travel to the shops.
A more sophisticated approach to cost/benefit analysis is to try to put a financial value on these intangible costs and benefits. This can be highly subjective.
For example; Is an historic building is worth only its material cost if it is in disrepair? Is it worth the value of the land it is sitting on? Or is it worth millions due to the history located with the building, who lived there, what decisions were made, and who was born/died there?
Alternatively what is the $ value of putting fresh plants in an air-conditioned office?
These are questions that managers and business/political leaders have to answer, and be able to justify their answers to others.
The version of cost/benefit analysis we covered here is simple. As noted though, where large sums of money are involved, eg mining projects, oil refineries, and large property developments etc project evaluation is a specialisation on its own.