What Is a Cost-Benefit Analysis?
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The business or analyst sums the benefits of a situation or action and then subtracts the costs associated with taking that action. Some consultants or analysts also build models to assign a dollar value on intangible items, such as the benefits and costs associated with living in a certain town. In many models, a cost-benefit analysis will also factor the opportunity cost into the decision-making process.
In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision. Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis. By considering all options and the potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.
A cost-benefit analysis CBA should begin with compiling a comprehensive list of all the costs and benefits associated with the project or decision. An analyst or project manager should apply a monetary measurement to all of the items on the cost-benefit list, taking special care not to underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning a value to both costs and benefits for a cost-benefit analysis.
If so, then the rational decision is to go forward with the project. Otherwise, the company should likely avoid the project. With cost-benefit analysis, there are a number of forecasts built into the process, and if any of the forecasts are inaccurate, the results may be called into question.
For projects that involve small- to mid-level capital expenditures and are short to intermediate in terms of time to completion, an in-depth cost-benefit analysis may be sufficient enough to make a well-informed, rational decision. For very large projects with a long-term time horizon, a cost-benefit analysis might fail to account for important financial concerns such as inflation, interest rates, varying cash flows, and the present value of money.
One of the benefits of using net present value for deciding on a project is that it uses an alternative rate of return that could be earned if the project had never been done. That return is discounted from the results. In other words, the project needs to earn at least more than the rate of return that could be earned elsewhere or the discount rate. However, with any type of model used in performing a cost-benefit analysis, there are a significant amount of forecasts built into the models.
The forecasts used in any CBA might include future revenue or sales, alternative rates of return, expected costs, and expected future cash flows. If one or two of the forecasts are off, the CBA results would likely be thrown into question, thus highlighting the limitations in performing a cost-benefit analysis. Corporate Finance. Fundamental Analysis. Business Essentials. Your Money. Personal Finance. Your Practice. Popular Courses. Login Newsletters.Закладка в тексте
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