# Cost-Benefit Analysis Explained: Usage, Advantages, and Drawbacks

## What Is a Cost-Benefit Analysis?

Cost-benefit analysis evaluates the feasibility of a project by comparing its expected advantages with its costs, both tangible and intangible. Originating from early economic theories and further refined in the 20th century, this method helps businesses make informed decisions. It involves specific steps to outline project scope, calculate costs and benefits, and ultimately guide strategic planning by weighing each element carefully.

### Key Takeaways

*   A cost-benefit analysis (CBA) is a systematic process used to evaluate whether the benefits of a decision or project outweigh the costs.   
    
*   CBA involves assessing both tangible and intangible factors, assigning monetary values to aid in decision-making.  
    
*   The analysis includes a structured approach usually consisting of defining the scope, determining costs and benefits, computing calculations, and making a recommendation.  
    
*   CBA requires careful forecasting, which can present challenges if estimates are incorrect or if underlying assumptions are not accurate.  
    
*   While insightful, CBA may not be necessary for smaller projects due to the resources and time required to perform a thorough analysis.

![Cost-Benefit Analysis](https://www.investopedia.com/thmb/m3QCoDidXX7xaSHs1TzoMl4eYOk=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Cost-benefitanalysis-3be1b4befc724d8ca1e69760344ece2f.jpg)

*— Michela Buttignol / Investopedia*

## How Cost-Benefit Analysis Works and Why It's Important

Cost-benefit analysis (CBA) estimates and assesses the value of a project's benefits and costs to determine whether or not it's worth pursuing. Originating from the work of Jules Dupuit and Alfred Marshall and developed further by the U.S. Corps of Engineers in the 1930s, CBA involves comparing all current and projected costs and benefits of a project, both monetary and intangible.

Before taking on a new project, prudent managers perform a CBA to evaluate all the potential costs and revenues it might generate. The analysis's outcome determines whether the project is financially viable or whether a company should consider other alternatives.

Many CBA models also factor [opportunity cost](https://www.investopedia.com/terms/o/opportunitycost.asp) into the decision-making process. Opportunity cost represents the potential benefits a business misses out on when choosing one alternative over another. It accounts for the value of the next best option that isn't selected, highlighting the trade-offs involved in any decision. Evaluating opportunity cost can make the decision-making process more comprehensive and effective.

Finally, a manager will compare the total costs and benefits to determine if the benefits outweigh the costs. If they do, the rational decision is to proceed with the project. If not, the business reviews the project to see if adjustments can be made to increase benefits or decrease costs to make it viable. Otherwise, the project should likely be avoided.  

> **Important**
>
> With cost-benefit analysis, a degree of forecasting is built into the process. If any of the forecasts are inaccurate, the results may not be reliable.

## Essential Steps in Conducting a Cost-Benefit Analysis

There is no single, universally accepted method of performing a cost-benefit analysis. However, the process usually has some variation of the following five steps.

### Step 1: Establish the Project's Scope

The first step in a cost-benefit analysis is understanding the current situation, identifying goals, and establishing a framework to define the project scope. Begin by determining the purpose of the cost-benefit analysis. For example, the purpose might be "to decide whether to expand to increase [market share](https://www.investopedia.com/ask/answers/031815/what-strategies-do-companies-employ-increase-market-share.asp)" or "to evaluate the benefits of overhauling the company website."

In this initial stage, the project planning takes place. This includes:

*   Setting a timeline
*   Identifying necessary resources
*   Understanding constraints
*   Determining required personnel
*   Selecting evaluation techniques

> **Fast Fact**
>
> A company must assess whether it's equipped to perform an accurate cost-benefit analysis. If the business doesn't have the technical staff needed for an adequate assessment, it may need to hire outside professionals.

During this phase, the business should identify key stakeholders who will be impacted by the analysis and give them a chance to provide input on the process. For example, if the outcome would be to renovate a company's website, the IT department may be required to hire multiple additional staff or take on extra work. They should be consulted about the impact this will have on their department, workflow, and other projects.

### Step 2: Analyze Project Costs

With the framework behind you, it's time to start looking at numbers. The second step of a cost-benefit analysis is to determine the project costs.

"Costs" can be financial, such as expenses recorded on an income statement, or non-financial, such as negative repercussions on the community. These costs can be categorized as follows:

*   **Direct costs**: Created by the project, such as labor, inventory, [raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp), and manufacturing expenses
*   **Indirect costs**: Associated or partially associated with the project, such as electricity, overhead costs from management, rent, and utilities
*   [**Intangible costs**](https://www.investopedia.com/terms/i/intangiblecost.asp): Impact that can't be measured directly, such as the impact on customers, employees, or delivery times
*   **Opportunity costs**: Potential benefits lost from choosing this alternative instead of another
*   **Cost of potential risks**: Regulatory risks, competition, and environmental impacts

When determining costs, consider if they're recurring or one-time expenses. Additionally, evaluate whether costs are variable or fixed. For fixed costs, consider step costs and relevant ranges that could impact those expenses.  

> **Tip**
>
> Using net present value (NPV) in project decisions offers the benefit of considering an alternative rate of return that could be earned if the project weren't undertaken. A positive NPV indicates that the projected earnings exceed the anticipated costs, making the project a worthwhile investment, while a negative NPV suggests the opposite.

### Step 3: Evaluate Project Benefits

Every project will have different underlying principles, and the benefits might be tangible or intangible. These could include:

*   Higher [revenue](https://www.investopedia.com/terms/r/revenue.asp) and sales from increased production or new products
*   Improved employee safety and morale
*   Greater customer satisfaction
*   Increased customer retention
*   [Competitive advantage](https://www.investopedia.com/terms/c/competitive_advantage.asp)
*   Expanded market share  
    

In this stage, the project manager or analyst performing the cost-benefit analysis will need to determine both explicit and implicit benefits. Explicit benefits require future assumptions about market conditions, sales volumes, customer demand, and product expectations. Implicit benefits, such as the impact of increased employee satisfaction, may be difficult to quantify as there's no straightforward formula to calculate the financial effect of happier workers.

For the analysis to work, each type of benefit will need a monetary value assigned to it.  

> **Tip**
>
> Be careful not to underestimate costs or overestimate benefits. A conservative approach that avoids subjective tendencies when calculating estimates is best for assigning value to both costs and benefits.

### Step 4: Perform Cost-Benefit Calculations

With the cost and benefit figures in hand, it's time to perform the analysis. This involves concisely summarizing the costs, benefits, net impact, and how the findings support the original purpose of the analysis.

However, some cost-benefit analyses require more detailed examination. This may include:

*   Applying [discount rates](https://www.investopedia.com/terms/d/discountrate.asp) to determine the net present value of cash flows
*   Running the analysis with different discount rates
*   Conducting cost-benefit analysis for multiple options, each with different costs and benefits
*   Comparing different options by calculating a cost-benefit ratio
*   Performing sensitivity analysis to understand how slight changes in estimates may impact outcomes  
    

### Step 5: Develop Recommendations and Implement Results

If a cost-benefit analysis is positive, the project offers more benefits than costs. However, a company must consider its limited resources, which may force it to make mutually exclusive decisions. For example, a company with limited capital might find positive cost-benefit analyses for upgrading its warehouse, website, and equipment, but it may not have enough funds to pursue all three projects at the same time.

> **Fast Fact**
>
> Not all cost-benefit analyses that result in net benefit should be accepted. For example, a company must consider the project's risk, alignment with its company image, and capital limitations.

## Benefits of Using Cost-Benefit Analysis in Decision-Making

There are several reasons to conduct a cost-benefit analysis. It uses data to make decisions and provides recommendations based on measurable information. It focuses on one problem, preventing decisions from being too complex by considering too many factors.

Conducting a cost-benefit analysis requires thorough research on all costs, even the unpredictable ones. This extensive research strengthens the findings and supports [strategic planning](https://www.investopedia.com/financial-edge/0612/the-importance-of-strategic-planning.aspx) efforts.

A cost-benefit analysis also requires quantifying non-financial metrics, such as the financial benefit of increased employee satisfaction. Although challenging to assess, this process forces the analyst to consider aspects of the project that are harder to measure. The ultimate goal is to deliver a straightforward report that simplifies decision-making.  

## Challenges and Limitations of Cost-Benefit Analysis

A detailed cost-benefit analysis needs resources like time and personnel, which may not be cost-effective for smaller projects.

Cost-benefit analysis relies on estimates and forecasts. Accurate predictions may work for mid-level expenses over short to medium terms. However, for large projects with a long-term time horizon, a cost-benefit analysis might overlook critical factors, such as inflation, interest rates, varying cash flows, and the [present value](https://www.investopedia.com/terms/p/presentvalue.asp) of money.

Overestimating or underestimating these factors can make the analysis unreliable.

### Cost-Benefit Analysis

Pros

*   Data-driven analysis
    
*   Avoids considering too many options at once
    
*   Deeper, potentially more reliable findings
    
*   Insights to financial and non-financial outcomes  
    

Cons

*   May be unnecessary for smaller projects
    
*   Requires capital and resources
    
*   Relies heavily on forecasted figures
    
*   Over or underestimating can make findings inaccurate
    

## What Are the Five Steps of Cost-Benefit Analysis?

The broad process of a cost-benefit analysis is to set the analysis plan, determine your costs, determine your benefits, perform an analysis of both costs and benefits, and make a final recommendation. These steps may vary from one project to another.

## What Is the Main Goal of Using a Cost-Benefit Analysis?

The main goal of cost-benefit analysis is to determine whether it is worth undertaking a project or task. This decision is made by gathering information on the costs and benefits of that project. Management leverages the findings of a cost-benefit analysis to decide whether it is in the best interest of a company to pursue a new project or to find an alternative.

## How Do You Weigh Costs vs. Benefits?

Cost-benefit analysis is a systematic method for quantifying and then comparing the total costs to the total expected rewards of undertaking a project or making an investment. Each cost and benefit, whether tangible or intangible, is assigned a numerical cost. This can require estimating and forecasting, which should be done as accurately as possible. If the benefits greatly outweigh the costs, the decision should go ahead; otherwise, it should probably not. A cost-benefit analysis should also include the opportunity costs of missed or skipped projects.

## What Are Some Tools or Methods Used in Cost-Benefit Analysis?

Depending on the specific investment or project being evaluated, a cost-benefit analysis may require discounting the time value of cash flows using net present value calculations. A [benefit-cost ratio (BCR)](https://www.investopedia.com/terms/b/bcr.asp) may also be computed to summarize the overall relationship between the relative costs and benefits of a proposed project. Other tools may include [regression](https://www.investopedia.com/terms/r/regression.asp) modeling, valuation, and [forecasting](https://www.investopedia.com/terms/f/forecasting.asp) techniques.

## What Are the Costs and Benefits of Doing a Cost-Benefit Analysis?

The process of doing a cost-benefit analysis itself has its own inherent costs and benefits. The costs involve the time needed to carefully understand and estimate all of the potential rewards and costs. This may also involve money paid to an analyst or consultant to carry out the work. One other potential downside is that various estimates and forecasts are required to build the cost-benefit analysis, and these assumptions may prove to be wrong or even biased.

The benefits of a cost-benefit analysis, if done correctly and with accurate assumptions, are to provide a good guide for decision-making that can be standardized and quantified.

## The Bottom Line

Cost-benefit analysis is an effective tool for evaluating complex decisions like projects or expansions when financial outcomes aren't immediately apparent. By assessing both monetary and intangible elements, businesses can streamline decision-making through structured evaluations. However, the reliability of cost-benefit analysis hinges on precise forecasts and assumptions. Misestimations can lead to flawed conclusions, underlining the importance of thorough research and analysis. When executed with care and accuracy, cost-benefit analysis offers strategic insights for resource allocation and informs confident decision-making.

> **Article Sources**
>
> 1.  San Jose State University. "[An Introduction to Cost Benefit Analysis](https://www.sjsu.edu/faculty/watkins/cba.htm)."
>     
> 2.  Mercatus Center at George Mason University. "[Accounting for the Opportunity Cost of Capital in Cost-Benefit Analysis: Public Interest Comment on the Marginal Excess Tax Burden as a Potential Cost under Executive Order 13771](https://www.mercatus.org/research/public-interest-comments/accounting-opportunity-cost-capital-cost-benefit-analysis-public)."