Cost-Benefit Analysis in Managerial Decision Making
What is the cost-benefit analysis?
A CBA or a cost-benefit analysis refers to a decision-making tool that enables managers to decide whether the actions they are taking are worthy or not. In other words, it helps to provide (Mishan and Quah, 2020). The quantitative view of the issue is provided based on which a decision can be made either based on opinion, bias or evidence. When the analysis is made, monetary values are assigned to the costs and the advantages of the decision-making. From the benefits, the costs are subtracted so that the net gains can be determined. This helps the managers at estimating the economic benefit of their choice so that they can decide whether it’s a good idea to adopt it or not.
When a CBA shall be used?
Cost-benefit analysis, or CBA, functions best when managers want to decide whether they should pursue a certain course of action. It also assists when the decision entails transparent economic costs and benefits. To determine the feasibility of a project, a CBA can be created (Mishan and Quah, 2020). However, this type of CBA takes time to complete; hence when the managers are faced with a big decision, then only they can take the help of the CBA. For decisions that are not big, the managers can adopt simpler processes such as a decision matrix.
Stated below are some of the examples which suggest when to use a cost-based analysis:
- CBA is used when it comes to developing a new business strategy.
- While allocating resources or decisions related to purchases, a CBA can be used.
- When deciding to purchase a new project, a CBA can be used.
- Comparing new business opportunities requires a cost-based analysis.
- Measuring the desirability ad the impact of the new policies of a company requires a CBA.
- Determining the proposed changes in the processes and the company’s structure calls for a CBA.
How is managerial decision-making affected by cost-based analysis?
To be precise, a cost-based analysis helps managers in decision-making in a wide variety of ways. Firstly, it helps in making informed decisions by comprehending the financial consequences of a decision making (Mishan and Quah, 2020). For instance, if a manager wants to expand the product line, a CBA can help him to determine the cost of marketing, production, and distribution. Hence the managers can decide whether the product line expansion is financially feasible by analysing the potential revenue and the costs. In addition to this, a cost-based analysis helps identify areas where costs can be saved. Managers can also identify where efficiency can be improved, or the additional expenses can be reduced. This leads to increased profitability and an increase in cost savings (Katsaliaki et al. 2021). Thus it is regarded as an important aspect of decision-making. However, it requires a wider knowledge and expertise.
In an elaborate way, The CBA helps managers in their decision-making in the following ways:
- CBA simplifies business decisions that are complex. Organisations embody a variety of expenses in different types of projects. Thus performing a cost-based analysis helps a manager to measure the benefits of the decisions. It comprises financial metrics such as the revenue earned and the saved costs. This helps business managers to compare the various types of projects based on the total benefits.
- It offers a basis for a rational basis, and it is one of the benefits of cost-benefit analysis (Katsaliaki et al. 2021). With a huge amount of investment, managers need help with choosing the best alternatives. Thus the CBA helps in choosing the available options and organises the projects in accordance with their merit to outdo the biases that are required to take the business ahead
- CBA helps in estimating the net benefits of the business. Anticipating benefits is more difficult than anticipating costs (Katsaliaki et al., 2021). Given the wide variety of investment resources, resources are not infinite. For instance, a manager may predict the production cost. However, they cannot anticipate the profit margins of a particular product. Nevertheless, estimating the benefits and costs aids the managers in getting an idea of the lowest revenue that the project requires. Thus the CBA helps to be aware of the next alternative or the opportunity costs.
- CBA helps in developing credibility. This is done by performing a sensitivity analysis (Katsaliaki et al. 2021). The estimated outcome may be changed with the change in situations. In this regard, the sensitivity analysis is instrumental in developing the credibility of the cost-based analysis. When there is ambiguity over the discount rate, cost-based analysis is used. Managers run this analysis with the values to assess the sensitivity of the cost-based analysis model.
How do managers create a cost-benefit analysis?
In the initial stages, the cost-benefit analysis seems daunting, but by following the five mentioned steps below, the cost-benefit analysis can be simplified.
- Creating a framework that outlines the goal of the analysis. The question and an overview of the current situation. Current performance, opportunities, the background of the current situation and the risk of status quo. In addition to this, the scope of CBA should also be included in the framework (Abelson, 2020). This comprises the types of benefits and the costs, and the timeframe over which the potential costs will be estimated.
- Categorising and listing the cost and benefits. To do this, the managers collaborate with the stakeholders so that they can derive benefits from the expertise. The type of costs comprises indirect costs, direct costs, intangible costs and the costs that are related to potential risks (Abelson, 2020). In addition, the benefits comprise direct and indirect benefits. The indirect benefits cannot help in perceiving currency value. On the other hand, the direct benefits help in measuring the currency values, such as the revenue that can be earned from the project.
- To conduct the cost-benefit analysis, managers estimate the value related to the costs and benefits. This aligns well with the tangible categories such as direct costs, indirect costs and direct benefits (Abelson, 2020). However, for the intangible categories, the managers assign KPIs in place of dollar amounts. By tracking customer churn rates, managers can measure customer satisfaction.
- Analysing the cost vs benefits. While doing this, managers shall consider total benefits, total costs, net present value, discount rates, sensitivity analysis, benefit-cost ratio and net costs benefits.
- After completing the cost analysis benefits, managers can make a recommendation. While considering the decision, managers shall consider whether the net cost benefit is positive or negative.
Shortcomings of a Cost-Based Analysis
Managers find cost-based analysis a handy tool for decision-making. Compared to any estimation technique, the Cots-based analysis could be better (Abelson, 2020). Thus while making decisions, managers shall keep in mind the limitations of the cost-based analysis that are listed below as follows:
- Cash flow and revenue are unpredictable due to the dynamics that prevail in the market conditions.
- In some cases, it is noted that benefits or the costs incurred in the decision or the project can be reflected directly by the dollar amounts.
- When managers use KPIs for measuring intangible costs and benefits, the value is regarded as subjective.
- All the potential risks incurred in the projects can be predicted with the help of costs benefit analysis.
- The cost-benefit analysis needs sufficient time commitment to get completed.
Considering the limitations, if the manager is not confident enough to adopt a cost-benefit analysis for a particular situation, he can employ the decision matrix along with the cost-benefit analysis or CBA.
Example of a cost-benefit analysis for a start-up company
Zack is starting his e-commerce business, and he has decided to hire a web designer to promote his brand. The Service cost is around £500, and he can spend about £1000 owing to the increase in web traffic. The formula written below is used by him to calculate:
£1000 – £500 = £500
From the calculation above, it can be inferred that there is a chance of generating £500 profit for his business, and thus, he decides to move ahead with his decision of recruiting a new web designer.
- Mishan, E.J. and Quah, E., 2020. Cost-benefit analysis. Routledge.
- Katsaliaki, K., Galetsi, P. and Kumar, S., 2021. Supply chain disruptions and resilience: A major review and future research agenda. Annals of Operations Research, pp.1-38.
- Abelson, P., 2020. A partial review of seven official guidelines for cost-benefit analysis. Journal of Benefit-Cost Analysis, 11(2), pp.272-293.
Ans: CBA or a cost-benefit analysis refers to an economic evaluation tool which helps in comparing the benefits and costs of an intervention which are expressed in monetary units. This is used by organisations to evaluate any given policy.
Ans: CBA is a data-driven approach that enables a manager to evaluate a decision which is complex. By fragmenting the decision into a cost vs benefits, the CBA helps in reducing the dilemmas that are involved in business decision-making.
Ans: Managers use cost-benefit analysis to determine the economic advantage of a decision. This helps in deciding whether the decision he has taken is worth pursuing or not. To avoid bias in decision-making, this tool has proven to be much useful. Thus the CBA is used by managers to bring about success in their projects.
Ans: The two limitations of cost-benefit analysis are:
Cash flow and revenue become unpredictable due to the changing market conditions.
The potential risk in the project cannot be assessed with the help of a cost-benefit analysis.
Ans: Managers outline a framework which consists of the goal of the cost-benefit analysis, after which they list the cost and benefits by collaborating with the stakeholders. Furthermore, the values related to the costs and benefits are also estimated by the managers.
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