Imagine you're a sports shoe company. You're thinking about launching a new range of running shoes and there are two alternatives on the table, the "Bling Warrior" model for the teenager who likes Swarovski crystals on her footwear and the waterproof "Oak Leaf" model for the keen gardener. Both products could bring tremendous success for the company, but management and marketing are in disagreement about which product to choose. What to do?
One option is to run a cost-benefit analysis comparing the expected benefits from each product relative to its cost. Although this method is a simple and convenient way to figure out the returns of a project, there are a number of arguments against using a cost-benefit analysis as a decision-making tool.
What Is a Cost-Benefit Analysis?
Cost-benefit analysis is a simple tool for evaluating the costs of a project versus the benefits. It begins (as most things do) with a list of every single project expense, including the direct and indirect costs such as overhead. You'll also need a second list of the benefits the business will receive after successfully executing the project.
Some of these benefits will be monetary, for example, increased product sales. Others may be less quantifiable and for these, you're going to have to allocate a numerical value to the benefit. If you were considering an initiative to allow home working, for instance, you would have to allocate a dollar amount to such benefits as increased productivity, fewer absences and reduced staff turnover. Whenever possible, costs and benefits should be expressed in numerical terms so you can calculate the project's return on investment.
The difference between the cost and the benefits will indicate whether the project is worth pursuing. If you're choosing between two projects, it will tell you which one is likely to return the greatest benefit relative to its cost over an agreed-upon time frame.
Advantages of Cost-Benefit Analysis
The main advantage of a cost-benefit analysis is you're putting numerical values on all the costs and benefits of a project, even the intangible ones. So, it's a systematic way to figure out the pros and cons of a project, task or investment. It's also extremely versatile, with businesses performing cost-benefit analyses to:
- Figure out whether a project is sound and justifiable by analyzing whether its benefits outweigh the costs.
- Make decisions transparently and on an equal footing, so that every team member can replicate the analysis across the various projects they're assessing.
- Take a broad spectrum of costs and benefits, many of which are intangible, and convert them to the same "currency" so you can make an apples-to-apples comparison.
- Get a baseline for comparing projects so you can see which is the best path forward.
The cost-benefit analysis is suitable for all sorts of projects, from evaluating new product development to weighing investment opportunities, assessing change initiatives and deciding whether to hire new staff.
Disadvantages of Cost-Benefit Analysis
Despite these advantages, there are some limitations of the cost-benefit analysis. These mostly relate to the accuracy of the data you put into the analysis and the problems associated with human agendas, such as fudging the numbers to get the exact result you want.
It's Hard To Get Accurate Data
As with any type of analysis, the quality of what you get out depends on the quality of what you put in. The more accurate your numbers, the more accurate your results.
The problem here is that a lot of your benefits will be hard to quantify. Attempts to measure items that are generally unmeasurable – things like staff motivation or customer loyalty – will always be approximations, and you have no way of knowing whether your estimate is anywhere close to the true value. Most companies put safeguards in place to stop their estimations from being a wild stab in the dark. But even then, you can get inaccuracies. What do you think happens to the analysis if:
- You rely too heavily on data collected from past projects, but the market has moved since the data was collected and the old project had a different size, scope and objective to the current one?
- You rely on subjective evaluations to quantify an intangible?
- You're attached to a particular project so you use only data that backs up what you want to find?
As you can see, it's pretty easy to game the system, which will throw the whole analysis out of whack.
You Operate in an Imperfect Market
Cost-benefit analysis works really well for short-term projects where the market is not going to shift much between the time you run the analysis and the time you put your project into action (like getting your running shoes on store shelves). For projects with a longer-term horizon, you're going to struggle in the face of ever-changing market conditions.
What happens, for instance, if mortgage and credit card interest rates go up so consumers have less cash in their pockets at the end of the month? What about inflation? What if you preferred supplier goes bust halfway through production and you have to switch to a more expensive supplier at short notice? What if teens suddenly ditch blingy running shoes in favor of iridescent sandals?
Projects that go on for a long time can be problematic for the cost-benefit analysis because there are too many outside factors that impact the accuracy of the analysis.
The Costs Turn Into a Budget
Another criticism of cost-benefit analysis is it turns a list of potential costs into a budget for the project. When you put together the analysis and present it to senior leaders, there's a risk that decision-makers will treat the expected costs as actual rather than an estimation. This can throw the budget off, cause the misallocation of funds and defeat attempts to control costs further down the line.
Present Value Errors
To make a decision with a cost-benefit analysis, you have to compare the net present value (NPV) of the project's costs with the net present value of its benefits. This means you have to calculate the value of all future cash flows over the lifetime of the project (for instance all projected running shoe sales over the next 10 years) and reduce them by the value of those benefits if they were incurred today.
The issue here is that, to calculate the NPV, you have to choose an appropriate discount rate for the project, and that normally correlates with the usual returns for the business. For instance, if the running shoe company normally gets returns of 10 percent per year on the sale of its running shoes, that's the discounting factor you'd plug into the NPV calculation.
However, no one can accurately calculate the NPV, because t_here's no guarantee that the discount rate you've used is realistic_. Who knows if "Bling Warrior" will make the same profits as the rest of your product range? And a miscalculation of just one percent per year could push an otherwise profitable project into the red. This makes it essential to run a sensitivity analysis of various scenarios, testing the robustness of the cost-benefit analysis against changes in some of the key numbers to see if the project still works from a financial point of view.