A business conducts a cost benefit analysis when it needs to determine the cost and advantages of a certain business decision or project. This analysis helps in the decision-making process of determining if a certain investment is worth doing, or if a company would be better off trying a different solution. It is an important tool for making good management decisions.
To start a cost benefit analysis, you have to total up all of the costs of the decision you are focusing on as well as its alternatives. Not only are these the total of the direct costs of the project, but also the indirect costs and other factors of the decision that will affect the company in some way. If you need more workers to do a particular project, then you have to calculate in the added expense of an expanded workforce. And that expense may mean more training, HR effort, etc. to get the number of employees to where it needs to be for the project. As a different option, you can compute the cost if that extra work was outsourced.
Once you have determined the costs, then you have to estimate what the benefit to the company is by undertaking the decision. And these benefits are not limited to potential profit, but any other benefit that results such as added safety, social value, competitive advantage, attractiveness to investors, etc.
The goal is to take the information that you have compiled on the costs and the benefits and make the best decision that will have the smallest cost while yielding the biggest benefit. Once again, it is important to not limit the analysis to just the monetary benefits of a decision, but the overall benefits to the firm. While Plan A may realize a bigger profit, Plan B may bring in a slightly smaller figure, but the resulting positive PR that it generates may provide a much bigger benefit in the long-run.
Remember, the short-term and long-term benefits need to be weighed against each other in deciding what is best for the company. A sudden increase in profit at the expense of keeping consistent customers could prove disastrous down the road.
We know the value of money is not fixed. The cost of money changes depending on interest rates, economic conditions, and inflation. These need to be factored in as best as possible when conducting the analysis.
Once you have calculated all of these factors, then each decision needs to be indexed in such a way that you are comparing apples to apples. For this you can calculate the net present value or a payback period. This is done by taking the present value of future cash flow and factoring in the adjustments due to the time value of money. The net present value is cash flow minus the costs. This total is divided by a discount rate. A payback period is the amount of time it takes for the benefits of a decision to surpass the costs. By using either of these methods, it will clearly illustrate how multiple options stack up against each other.