Every company that is serious about its finances and the financial implications of its decisions will take cost-benefit analysis very seriously. For those who don’t know what CBA is, it’s simply a qualitative approach designed to determine the value of a course of action by evaluating the benefits of the action and then comparing those benefits to the said action.
It is important to understand that cost-benefit analysis is a crucial financial technique that companies heavily rely upon when it comes to making business or investment decisions.
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Key Elements of Cost-Benefit Analysis
- A general description of the project. This part explains the environment under which the cost-benefit analysis is done such as the assumptions, the objectives, the lifespan of the decision, and so on.
- A list of the alternative scenarios. This part lists the options on hand for the cost-benefit analysis. In order to determine which is the best option during the analysis, the decision-makers have to take the costs and the benefits of every option on the table into account.
- Identification of benefits and costs. This part lists the exact benefits as well as costs to be incurred with every alternative scenario.
- A schedule of benefits and costs. Here, the analyst identifies the value of each benefit as well as the cost for each year over the life cycle of the decision starting from Year 0( the start of the decision’s life) for each of the alternatives mentioned in step 2. The costs and benefits are worked out, converted to a common unit of measurement, and compared to the competing alternatives. That is accomplished by discounting future dollar values, transforming future benefits and costs to their current values.
- Comparison of alternatives. In this part, the technique compares alternative solutions, illustrating values with graphs and tables, thereby facilitating decision making.
- A sensitivity analysis. Here, the technique helps the analyst define how sensitive the results are to changes in the benefits and costs.
Purpose of Cost-Benefit Analysis
- To help with comparing projects with regards to terms of total expected benefits and costs of each CBA alternative, determining if the benefits outweigh the costs or vice versa.
- To determine whether the proposed business decision is feasible, sound as well as justified or not.
Cost-Benefit Analysis (FAQs)
CBA is a qualitative approach designed to determine the value of a course of action by evaluating the benefits of the action and then comparing those benefits to the said action.
CBA comprises five key components i.e.;
• A general description of the project
• A list of the alternative scenarios
• Identification of benefits and costs
• A schedule of benefits and costs
• A sensitivity analysis
CBA helps businesses compare projects with respect to total expected benefits and costs of each alternative during a decision-making process, determining if the benefits outweigh the costs or vice versa. Apart from that, it determines whether the proposed business decision is feasible, sound as well as justified or not.
There are mainly two types of cost-benefit analysis; economic cost-benefit analysis and social cost-benefit analysis. ECBA is designed to determine the economic value of a course of action, whereas SCBA is designed to determine the social value of a course of action.