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Applying CostBenefit Analysis to Project Appraisal

Checklist

This checklist describes the elements of costbenefit analysis and how to use it to your advantage whenevaluating projects.

Definition

Costbenefit analysis is a widely used, straightforward technique for deciding whether to initiate an actionor implement changes. Simply put, it involves adding up the value of the benefits of a course of action andsubtracting what it will cost to obtain those benefits. Costs are usually either one-off (for example, start-upcosts for materials or equipment) or ongoing (such as staff), whereas benefits tend to unfold over a period oftime.

When conducting your analysis, you calculate your payback period, which is the length of time it takes forthe benefits to repay the costs of implementing them. It is typical to specify a set payback period of, forexample, three years, even if the benefits continue to be reaped long after. The end of the payback periodis also known as the breakeven point. This can sometimes be more important than any overall benefitsdelivered by a project, for example because the organization had to borrow funds to purchase expensiveplant. Breakeven is easily calculated by plotting costs and income on a graphit occurs at the point wherethe two lines cross. Determining the time span of the payback period is not always easy as many benefitsdont have a monetary value or can continue long after the end of payback. The only way to account fully forthe effect of time would be to discount all cash flows at the cost of capital.

At its simplest, a costbenefit analysis assumes that there are only financial costs and financial benefits.For example, a bank needs to train its call centre staff. The analysis would subtract the cost of the trainingdays from the economic benefit that calls will be answered more quickly and efficiently, enabling the bank

to handle more calls overall and resolve customer problems more cheaply. Such a simple analysis wouldnot measure the cost of lost staff time while they are not on duty, or the benefit of staff having a clearerunderstanding of standard procedures.

A more sophisticated approach involves trying to work out a monetary value for intangible costs and benefits.This can be highly subjective. For example, when customers praise your call centre staff, how much wouldit have cost to pay a PR firm to boost the banks image of handling customer complaints? Calculatingintangibles usually raises many questions that need clear answers.

Where very large sums of money are involved, such as in financial market transactions, project evaluationusing costbenefit analysis can be extremely complex, yet of vital importance to ensure that money is spentas wisely as possible.

Advantages

The advantage of conducting a costbenefit analysis is that you can weigh up all the positive andnegative impacts of a project using their equivalent financial value to determine whether, on balance,the project is worthwhile.

Disadvantages

The chief risk in performing a costbenefit analysis is that the results will only be as accurate as theestimated costs and benefits. Studies have shown that actual costs often turn out to be far higher thanestimated, while actual benefits are often lower. This is especially true where intangibles are included

in the analysis. It may be safer to perform a straightforward rate-of-return analysis.

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Action Checklist

Work out how much it will cost to make the change, then calculate the benefit you will gain from it. Use mapping tools such as Gantt charts or PERT (program evaluation and review technique) to

calculate timescales for implementing a project or introducing a change.

A SWOT (strengths, weaknesses, opportunities, threats) analysis can help to keep you focused onwhat the project should achieve.

Calculate the payback period. This is usually the length of the project, but it may be longer if you areaiming for long-term effects resulting from a limited-term project. Remember that you may need todiscount the cash flows at the cost of capital if you want to fully take into account the effect of time.

Dos and Donts

Do

Remember that benefits are often intangible, i.e. they have no monetary value.

Make a firm decision on whether to include intangible items within the analysis. As you must estimate avalue for these, this inevitably brings an element of subjectivity into the process.

Dont

Dont forget to include a risk analysis as part of your overall planning. Dont forget to make a cash flow forecast for decisions that will have a purely financial outcome.

More Info

Books:

Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 9th ed.McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate. Boston, MA: McGraw-Hill/Irwin, 2008.

Chakravarty, Sukhamoy. Cost-benefit analysis. In Eatwell, John, Murray Milgate, and Peter Newman(eds). The New Palgrave: A Dictionary of Economics. Basingstoke, UK: Palgrave Macmillan, 1987, pp.687690. (Dictionary online at: www.dictionaryofeconomics.com/dictionary)

Nas, Tevfik F. Cost-Benefit Analysis: Theory and Application. Thousand Oaks, CA: Sage Publications,1996.

See Also

Best Practice

Comparing Net Present Value and Internal Rate of Return Project Planning Techniques for Small and Medium Enterprises Using Decision Analysis to Value R&D Projects

Checklists

Appraising Investment Opportunities Costing a New Project

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