Cost-benefit analysis (CBA) is a process that weighs the advantages of a course of business action against potential costs. Performing a cost-benefit assessment gives businesses a framework to evaluate choices, guiding them to proceed with the most profitable actions and avoid costly ones.
Often used by government agencies to demonstrate fiscal responsibility, cost-benefit analysis is also an important tool for businesses. Companies can use CBA to evaluate the consequences of major decisions, manage risk and drive effective decision-making. During economically volatile periods, smart businesses factor CBA into their overall financial strategy.
The Key Components Of Cost-Benefit Analysis
According to a CFO in the Paro expert network, cost-benefit analysis helps break down the potential cost and risk of every action into concrete terms and categories, allowing for flexible, realistic budgets. Consider an expanding business trying to choose between renting additional manufacturing capability or acquiring their own facility. CBA helps the company analyze the following:
- Direct costs: Direct costs include initial fees such as land purchase, construction costs and staffing expenses, as well as known operating costs.
- Indirect costs: These are fixed costs like utility charges for the new facility, which may not be fully known until after completion but can be estimated with reasonable accuracy.
- Intangible costs: These are qualitative costs that may include impact on employee productivity and morale or potential boost to brand image. Intangible costs also include opportunity costs—the lost value of actions not undertaken because the analyzed action absorbs the resources instead.
A full CBA also assesses the action’s potential benefits by similar metrics:
- Direct benefits: Increased production and revenue provided by the new facility.
- Indirect benefits: A more efficient distribution chain going forward.
- Intangible benefits: Increased customer satisfaction, improved brand image, being the first to market, etc.
Conducting an Effective Cost-Benefit Analysis
Cost-benefit analysis is generally reserved for larger decisions, as the process takes time and skill. There is more to each major choice than just the upfront price; CBA assigns a dollar value to every pro and con, and the calculations can become complex. But CBA is available to businesses at all stages, whether just starting up or firmly established.
One Paro expert and fractional CFO successfully used cost-benefit analysis to secure funding for the implementation of a new feature in a company’s product, illustrating the method’s practical impact. The assessment clearly demonstrated that the new feature would drive significant revenue. Investors agreed and released additional funding, resulting in more signed deals and increased market share.
Communicating CBA Results to Stakeholders
Effectively communicating the results of a cost-benefit analysis is essential for gaining stakeholder buy-in. By examining all direct, indirect and intangible costs and benefits, companies can tailor their communication to meet the needs of various audiences, from investors to employees to customers.
When companies have a thorough understanding of their cost-benefit analysis, they can articulate the advantages of each cost clearly. This ensures stakeholders grasp the rationale behind decisions and feel confident in the company’s strategic direction.
One CFO we spoke to used membership fees as an example. Companies that charge membership fees, like Costco, can use numbers and data derived directly from their CBA to explain to customers how much money a membership will save them. They can also detail to the Board how much membership fees will add to the bottom line.
Common Cost-Benefit Assessment Pitfalls To Avoid
As with any economic assessment, CBA has limitations. A primary example is overreliance on initial assumptions. The cost-benefit ratio can change over time, and what the costs or benefits may appear to be before initialization often change as the action and its consequences unfold.
Another common mistake is underestimating or neglecting indirect and intangible costs and benefits. Cost-benefit analysis requires a comprehensive perspective. Companies must consider alternative scenarios for every action they undertake and be prepared to pivot if necessary.
In one strong cost-benefit analysis example, one Paro network CFO had a client who assumed from the numbers that increased marketing spend was key to acquiring new clients. When market conditions changed, and expected returns did not materialize. The CFO helped redefine the client’s focus by completing a cost-benefit assessment for a new marketing strategy.
The company was reluctant to take on another expenditure, but the CBA demonstrated that as few as two new clients would generate a positive return on investment (ROI). With the CBA demonstrating evidence of long-term benefits, the company became more adaptable and willing to invest, leading them on the road to future success.
The Strategic Value of Cost-Benefit Analysis
Mastering cost-benefit analysis offers significant strategic value for ongoing business growth. It helps companies prioritize major actions, mitigate risk and optimize resource allocation. In addition to ensuring steady cash flow, CBA also improves the ability to communicate with stakeholders and increases access to capital.
Given the complexities involved, many growing companies may find it challenging to conduct the precise and detailed work of cost-benefit assessments. Instead, businesses can leverage expert financial guidance for assistance with CBA to facilitate informed decision-making. Paro offers fractional CFO advisory services, delivered by experienced professionals. Discover how our expert network can help your company make the most profitable decisions.
