In any business, department heads have competing priorities. For example, the chief revenue officer of a B2B software-as-a-service provider wants to establish an indirect channel sales program, while marketing wants to hire a content writer to help organically acquire new leads. Both make good cases — each department is sure they can increase revenue with a few more people and a little more money, after all.
Finance teams acting as mediators should consider a formal cost-benefit analysis exercise. Also sometimes called a benefit-cost analysis, this is a well-established process for guiding leaders to make decisions that are rooted in and informed by data on company goals and priorities and budget realities.
What Is Cost-Benefit Analysis (CBA)?
A cost-benefit analysis involves comparing the explicit and implicit costs of taking an action versus expected benefits. The process of gathering that information may be enlightening in itself because it may require the business to assign monetary value to factors that don’t have explicit costs. The resulting analysis allows decision-makers to weigh all information and make rational choices.
As a pros-and-cons evaluation tool, CBAs are most closely associated with public-sector decision-making. But they’re also used in business when it comes time for project planning around adding employees, purchasing technology or equipment, expanding facilities and more. A CBA can weigh the benefits of taking an action over maintaining the status quo or help a business compare two or more options to see which one makes the most sense.
- Cost-benefit analyses help businesses weigh pros and cons in a data-driven way so they can make complex decisions in a systematic manner.
- For a successful CBA, leaders need to identify and project the explicit and implicit costs and benefits of a proposed action or investment.
- It’s also a good idea to assign someone to make the case for the status quo as a way to compare the opportunity cost of doing nothing and investing cash versus proposed actions.
- A cost-benefit analysis is only as good as the data on which it’s based, so companies with more mature financial reporting have a higher likelihood of success.
Cost-Benefit Analysis Explained
Each action a business takes has explicit cost and revenue expectations. But there are also implicit costs, often expressed as the opportunity cost — that is, the money or other benefit lost by pursuing one option over another or of taking no action. Opportunity cost is not an accounting concept, it’s an economic one, but it can be associated with a quantitative value.
A cost-benefit analysis adds up the benefits and costs of a program or purchase, extracts a CBA ratio and then compares that result with both stasis and alternative programs or purchases.
A CBA requires considering both monetary and opportunity costs over a period of time. To compare multiple CBAs, extract a CBA ratio from each. The formula for a cost-benefit analysis ratio can be expressed as:
Projected benefits / projected costs = CBA ratio
For example, the CMO of our fictional SaaS provider wants to hire a content writer to improve the company’s web site content so that it helps deliver more qualified leads to sales. The CRO thinks a channel program can win both new customers and more mindshare. In all cases, the leaders would be asked to approve at least one additional FTE along with some required software and other services.identify and attach dollar values to the explicit and implicit costs of their projects and compare those to the explicit and implicit benefits. The CFO may also run the numbers on “none of the above.”
If that sounds straightforward, it isn’t. An in-depth, precise cost-benefit analysis is a complex undertaking because of the inputs required, the need to set parameters, the fact that not every factor the business needs to measure has an explicit cost or return and the number of indirect or intangible properties that make future outcomes difficult to forecast.
Then there’s the fact that while a project or purchase with a high benefit-to-cost ratio is generally considered the most favorable option, that’s not a given.
Purpose of a Cost-Benefit Analysis
Businesses perform cost-benefit analyses to help leaders remove emotion from assessments and provide an apples-to-apples basis to compare competing priorities. And, when intangible benefits are expressed as a “benefits value,” with dollar amounts assigned, that helps finance calculate a break-even point — the time it takes for a product’s or purchase’s benefits to exceed the cost.
In the future, a CBA can be revisited to evaluate the actual cost and ROI of a project or purchase compared with projections and improve the analysis process.
For example, the CMO’s plan to employ a writer to attract new customers involves recurring investments in both marketing software subscriptions and salary and benefits. Expected returns include increased revenue, a larger customer base and better visibility for the company. Some of these costs and returns are difficult to quantify. In contrast, the CROs ’plan will require the attention of sales leaders to create an entirely new revenue stream that may take a year or two to become profitable. There’s a substantial opportunity lost in pursing more sales through existing channels, but the payoff could be substantial. There’s also the internal dynamic that will surface as the new indirect sales channel takes some of the revenue of the existing sales team.A CBA seeks to select the project with the greatest overall benefit for the incurred costs.
Importance of Cost-Benefit Analysis
Leaders need to make sometimes difficult decisions in a timely manner. Cost-benefit analyses help by providing financial context and data-driven justification for sometimes painful choices that may not be viewed favorably by staff.
A cost-benefit analysis, often paired with the sensitivity or “what if” analyses used in financial modeling, also offsets biases that may sway decisions, like the dreaded HiPPO — highest-paid person’s opinion.
Sensitivity Analysis Template
Below is a sample sensitivity analysis worksheet a CIO might use to evaluate a product purchase alongside a CBA — it’s overly simplified for the sake of space. It combines product attributes, like suitability for the task, with business considerations. Criteria sets may be added and customized.
But leaders do need to go beyond the numbers and consider intangibles: Which project or purchase better advances the business’s long- and near-term goals? For example, our fictional CMO makes a strong case, but if the company wants to undertake expansion, whether geographically or selling into a new market segment or industry, the indirect sales channel program championed by the CRO may be the better choice with a bigger eventual payoff, even though accurately comparing the cost of direct versus indirect sales is a complex analysis.
Point is, data needs to play a strong yet balanced role in the decision-making process. By allowing a company to better weigh the implicit costs of taking or not taking an action, where there is no obvious or immediate explicit cost, projects that may not generate a clear profit on the balance sheet may still be moved forward. Think advancing sustainability objectives, diversity and inclusion initiatives and helping employees navigate new workplace realities.
When Should a Business Conduct a Cost-Benefit Analysis?
CBAs are useful anytime there are priorities competing for limited resources. But companies do need to set some ground rules for analyses. For example, all stakeholders should understand the company’s expectation on whether a CBA will address short-, mid or long-term impacts. The further into the future analysis extends, the more difficult it is to accurately forecast costs and benefits.
In general, most companies should do a cost-benefit analysis for major decisions in these five areas:
Capital investments: Should the business purchase a new delivery vehicle, production machinery, computer hardware or office furniture, or invest in renovating a building? Assign costs with the understanding that the benefit of the investment is derived from the use of the asset, not from its market value. For instance, an investment in new manufacturing equipment should allow me to produce more goods at a lower cost, resulting in more revenue and better margins. I'll retain this benefit even as the value of the equipment declines.
Business process change: A business process is any defined set of actions that are repeated often and produce a desired result. A company may think that a task that’s high volume, high touch, repetitive and prone to error is a candidate for business process automation. A CBA can help prove the theory. For example, should you purchase software that automatically adds inventory receipts to the inventory ledger and the asset column on the balance sheet versus manual entry? Or, a growing company may run a CBA and find that hiring a third-party to manage the payroll process now makes sense and is a source of savings.
In any cost-benefit analysis, ensure the stakeholder asks: How can we drive inefficiency out of this business function? And how do we attach a dollar value to that?
Organizational change: This is often related to business process change and refers to human capital. An example is comparing hiring staff versus outsourcing. Adding an indirect sales channel, for example, is a significant organizational change. For a CBA, you’ll need to consider that a productive on-staff sales rep might cost more on a per-sale basis versus indirect, but turnover is high. Commissions may be a wash. Will you need to hire a channel manager (organizational change), set up a portal for functions such as deal registration (a business process change) and/or allocate marketing development funds?
Adjusting pricing or introducing new product or service: Managers in companies that use cost accounting have pretty granular data on the total costs and revenue attached to a good or service and thus have a head start on cost-benefit analyses. Factors to quantify may include whether the company should introduce a subscription model, or whether it should discontinue a certain product or service because of poor sales before adding a new SKU.
Entering into a merger, acquisition or divestiture: Decisions around whether to acquire or merge with a company or sell parts of the business are among the most complex analyses, and the most important. A merger that may seem desirable at first glance, upon further consideration, may come with significant process and organizational changes, legal fees, costly layoffs and other factors which may diminish the relative value of the merger.
What Inputs are Included in a Cost-Benefit Analysis?
In performing a cost-benefit analysis, include:
The costs of taking an action or of doing nothing include:
Explicit costs: These are accounting costs with explicit monetary value and may include direct costs such as labor, manufacturing and the cost of software or machinery and indirect costs, such as utilities or rent.
Intangible costs: These are qualitative items, such as lost productivity or reduced customer satisfaction if an existing product is retired because a new SKU is being introduced.
Implicit costs: These are opportunity costs, both financial and non-financial, like purchasing a capital asset versus investing free cash, or of pulling employees off one project to work on the new initiative.
As with costs, benefits should be categorized:
Direct benefits: This is the accounting profit from the decision and could include, for instance, cost savings or increased revenue from a new product or service.
Indirect: These are tangential benefits. For instance, as a result of a new technology implementation, customers may be incentivized to spend more.
Intangible: These benefits could include, for instance, improved customer satisfaction, employee morale or employee safety.
Competitive: The business may want to include in its CBA the benefits of gaining a competitive edge in its industry and factor in, for example, increased market share, thought leadership and first-mover advantage.
Pros and Cons of a Cost-Benefit Analysis
A well-conducted cost-benefit analysis provides a level of predictability when undertaking a project. However, leaders need to set parameters and ensure all participants are working with a common set of assumptions.
Advantages of cost-benefit analyses:
- It supports decision-making with data to increase confidence or build support for making a move.
- It provides a way to incorporate qualitative factors into quantitative analysis.
- It can help businesses arrive at the total cost of taking a particular action that eclipses its explicit price tag and contributes to determining the ROI of a project or action.
- By incorporating net present value, businesses may view future investments at current dollar values.
Challenges of cost-benefit analyses:
- It requires assigning explicit monetary value to intangible factors. This can be challenging and introduce ambiguity.
- Gathering accurate data may be challenging, as is forecasting implicit cost and benefits.
- Businesses can become over-reliant on CBAs as a tool for making decisions and as a project-costing and budgeting method.
- Forecasting is inherently difficult. Unless a company regularly performs financial planning & analysis (FP&A) and scenario planning exercises, it should use caution with extended-outlook CBAs.
How to Conduct a Cost-Benefit Analysis
Companies may need to expand the CBA process based on the complexity of the proposals under consideration, but the basic steps are:
- List the projects, investments or actions to evaluate, and identify all stakeholders. Ensure each stakeholder has access to the financial data that will be needed to evaluate the project or investment; understands parameters, such as how far into the future to extend the analysis; and has insights into intangibles, including access to FP&A and scenario planning.
- Determine costs. List all explicit and implicit costs of each action under consideration and assign dollar values to the implicit, or opportunity, costs. For example, if current IT employees are redirected to installing and running new security software, what tasks will no longer be performed?
- Document assumptions. Valuing implicit costs and benefits requires a certain amount of judgement. Any assumptions used to estimate the values should be clearly documented before comparing alternatives.
- Determine benefits. List and assign dollar values to all explicit and implicit benefits of each action under consideration. As with costs, this will be easier for benefits that can be quantified, for example, in terms of saving FTE costs for one or more sales professionals by launching an indirect channel sales program. Others, such as employee productivity or engagement, will be more challenging to quantify. Bring in HR or other experts as needed to check stakeholder assumptions.
- Add perspective. Not everything is a purely dollars-and-cents decision. Senior leaders need to weight options based on company culture, values and goals.
- Compare alternatives. Calculate the cost-benefit analysis ratio for each option under consideration and compare those against one another and against the costs and benefits of doing nothing.
Cost Benefit Analysis Example
Let’s look at a simplified version of the CBA that the head of sales presented for establishing an indirect channel.
Our fictional SaaS provider has a traditional direct sales model, where its asset maintenance scheduling software is sold as service directly to end customers. Customers may also purchase direct from the website, which does not generate a commission.
Goal: The company sells mainly to manufacturers but believes it can expand to serve healthcare groups, which need to perform regular maintenance on expensive medical equipment.
The problem is that the sales team would need to start from scratch to make contacts in this new market. The CMO believes her marketing team can generate sales-qualified leads by hiring a content producer familiar with healthcare, but the chief revenue officer thinks there’s a better way.
Premise: The CRO believes the company can more quickly succeed by establishing an indirect sales channel to complement existing sales capabilities. The program would be open to 10 to 15 value-added resellers and managed service providers that focus on healthcare. The CRO would sign on the partners initially then pass them to a channel salesperson. The company would develop an online portal for partners to register opportunities and execute purchases on behalf of customers.
Note: The numbers below are designed to be illustrative, not a representation of the industry.
Assumptions: The software costs $15000 per year fifty seats – an average sale. The CRO believes that the partner program can bring in 50 new customers in Year 1 and that all will renew. By year three, the partners will bring in 200 new logos per year. Partners earn 20% of sales. Support will take1 $70,000 FTE specialist per 75 logoss. The product for indirect sale is the same as what is sold through the direct sales channel, and pricing will be the same. To avoid channel conflict, direct sales wouldn't be allowed to work deals in certain verticals. And they won't follow up on website leads for for those verticals.
In contrast, the CMO’s proposal would entail gaining those 50 new healthcare customers by spending $100,000 on an FTE plus $250,000 on new marketing tools and ad buys.
History of Cost Benefit Analysis
Engineer turned economist Jules Dupuit is considered the founder of cost-benefit analysis theory. Dupuit put forth the idea in 1844, but use of cost-benefit analyses didn’t gain popularity as a determining factor in public policy decisions until much later, in the 1980s.
Federal agencies are now required by law to conduct cost-benefit analyses to study the implications of policy across a broad range of areas — transportation, public health, criminal justice, defense, education and the environment. These agencies are often called upon to apply dollar values to intangibles, such as the value of clean air or safer highways.
Companies that work with public-sector customers may be more familiar with the CBA process, but all businesses can benefit.
Manage Your Cost Benefit Analysis with Accounting Software
The most important contributor to an accurate, insightful cost-benefit analysis is accurate data. Modern finance and accounting software combined with integrated planning, budgeting and forecasting tools and enterprise resource planning software suites with HR, supply chain and other insights mean all transactional and forward-looking data is in a central location. This makes it easier for authorized stakeholders to pull accurate, up-to-date information to inform their analyses. Numbers can be automatically exported to Excel or provided in the form of a report to key decision-makers.
Perhaps one of the more challenging parts of a CBA is when a leader selects a project that the numbers say is less profitable than other options. The reason may be a desire to forward long-term goals, or that company culture and values dictate spending more or leaving profit on the table.
And of course, sometimes the right answer will be “do nothing.” At least with a solid cost-benefit analysis, companies can make hard decisions with their eyes wide open.