Cost-Benefit Analysis (CBA)
Cost-Benefit Analysis (CBA) estimates and totals the equivalent money
value of the benefits and costs of the establishment of projects to
the community, to determine whether they are worthwhile. These projects
may be the construction of dams and highways, or training programs and
health systems.
The idea of this economic accounting originated with Jules Dupuit,
a French engineer whose 1848 article is still worth reading. Some formal
concepts that were at the foundations of CBA were formulated by Alfred
Marshall, a British economist. However, the practical development of
CBA came as a result of the impetus provided by the Federal Navigation
Act of 1936. This act required that the U.S. Corps of Engineers carry
out projects for the improvement of the waterway system when the total
benefits of a project, to whomsoever they accrue, exceed the costs of
that project.
Thus, the Corps of Engineers created systematic methods for measuring
such benefits and costs. The engineers of the Corps did this without
much, if any, minimal assistance from the economics profession. It wasn't
until about 20 years later in the 1950's that economists tried to provide
a rigorous, consistent set of methods for measuring benefits and costs,
and deciding whether a project is worthwhile. Some technical issues
of CBA have not been wholly resolved, even now, but the fundamentals
are well established.
How Do You Use CBA?
You may have been intensely creative in generating solutions to a problem,
and rigorous in your selection of the best one available. This solution
may still not be worth implementing, as you may invest a lot of time
and money in solving a problem that is not worthy of this effort.
CBA is a relatively simple and widely-used technique for deciding whether
to make a change. As its name suggests, to use the technique, simply
add up the value of the benefits of a course of action, and subtract
the costs associated with it.
Costs are either one-off, or may be ongoing. Benefits are most often
received over time. We establish this effect of time into our analysis
by calculating a payback period. This is the time it takes for the benefits
of a change to repay its costs. Many companies look for payback over
a specified period of time, e.g., three (3) years.
In its simple form, CBA is carried out using only financial costs and
benefits. For example, a simple cost/benefit analysis of a road scheme
would measure the cost of building the road, and subtracting this from
the economic benefit of improving transport links. It would not measure
either the cost of environmental damage, or the benefit of quicker and
easier travel to work.
A more sophisticated approach to CBA is to try to put a financial value
on these intangible costs and benefits. This can be highly subjective
– that is, for example, a historic water meadow worth $25,000,
or is it worth $500,000 because of its environmental importance? What
is the value of stress-free travel to work in the morning?
These are all questions that people have to answer, and answers that
people have to defend.
The explanation for CBA here is simple. Where large sums of money are
involved (for example, in financial market transactions), project evaluation
can become an extremely complex and sophisticated art. The fundamentals
of this are explained in Principles of Corporate Finance, a “bible”
on the subject, by Richard Brealey and Stewart Myers.
Example
| A sales director is deciding whether to implement a new computer-based
contact management and sales processing system. His department has
only a few computers, and his sales people are not computer literate.
He is aware that computerized sales forces are able to contact more
customers and give a higher quality of reliability and service to
those customers. They are better able to meet commitments, and can
work more efficiently. |
His financial cost/benefit analysis is shown here:
Costs
New computer equipment:
| No. of Units |
Equipment |
Cost per Unit |
Total |
| 10 |
Network-ready PCs with supporting software |
$1,225.00 |
$12,250.00 |
| 1 |
Server |
$1,750.00 |
$1,750.00 |
| 3 |
Printers |
$600.00 |
$1,800.00 |
| |
Cabling and Installation |
$2,300.00 |
$2,300.00 |
| |
Sales Support Software |
$7,500.00 |
$7,500.00 |
| GRAND TOTAL
|
$25,600.00 |
Training costs:
| Topic |
No. of People |
Cost per Head |
Total |
| Computer introduction |
8 |
$200.00 |
$1,600.00 |
| Keyboard skills |
8 |
$200.00 |
$1,600.00 |
| Sales support system |
8 |
$350.00 |
$2,800.00 |
| GRAND TOTAL |
$6,000.00 |
Other costs:
| Lost Resources |
Unit |
Cost |
Total |
| Time |
40 man days |
$100.00/day |
$4,000.00 |
| Sales through disruption |
|
$10,000.00
(estimate) |
$10,000.00 |
| Sales through inefficiency during first months |
|
$10,000.00
(estimate) |
$10,000.00 |
GRAND TOTAL |
$24,000.00 |
Total cost:
| Expenses |
Cost |
| Equipment |
$25,600.00 |
| Training Costs |
$6,000.00 |
| Other resources |
$24,000.00 |
| TOTAL |
$55,600.00 |
Benefits
| |
Cost |
| Tripe mail shot capacity (estimate) |
$20,000.00/year |
| Ability to sustain tele-sales campaigns (estimate) |
$10,000.00/year |
| Improved efficiency and reliability of follow-up (estimate) |
$25,000.00/year |
| Improved customer service and retention (estimate) |
$15,000.00/year |
| Improved accuracy of customer information (estimate) |
$5,000.00/year |
| Better management of sales |
$15,000.00/year |
TOTAL |
$90,000.00 |
Payback time: $55,600.00/$90,000.00 = 0.62
of a year (approximately 8 months)
Inevitably, the estimates of the benefit given by the new system are
quite subjective. Despite this, the Sales Director is very likely to
introduce it, given the short payback time.
Key Points
CBA is a powerful, widely-used and relatively easy-to-use tool for
deciding whether to make a change.
To use the tool, work out how much the change will cost to make, first.
Then, calculate the benefit you will gain from it.
Where costs or benefits are paid or received over time, work out the
time it will take for the benefits to repay the costs.
CBA can be carried out using only financial costs and financial benefits.
You may, however, decide to include intangible items within the analysis.
As you must estimate a value for these, this inevitably brings an element
of subjectivity into the process.
Source:
http://www.mindtools.com/pages/article/newTED_08.htm
http://www2.sjsu.edu/faculty/watkins/cba.htm
