When making decisions using Cost Benefit analysis, it is critical to adhere to established principles. It is critical to the health of your business and reputation. If you do not follow these rules, your decisions may be flawed.
Let us begin, shall we?
Is this technique appropriate for a small business owner?
Yes. The theory is equally applicable to small businesses as it is to large corporations and government.
Cost Benefit Analysis is a decision-making technique that considers both the positive (benefits) and negative (costs) outcomes of various decision alternatives. The trick is to make it simple for small business owners to implement.
Once you have a working knowledge of the theory and the ability to enter data into a spreadsheet, the rest is relatively straightforward.
Is this all I need to make better choices?
No. Cost Benefit Analysis is a technique that can be used to assist in making more informed financial decisions. It is not a means to an end. However, as part of the Cost Benefit analysis, you must consider all possible outcomes before making a final decision. This is frequently where the majority of people fail in their decision-making endeavours.
Cost Benefit Analysis is also extremely adept at producing a single viability output for each competing option, which simplifies and standardizes comparisons.
What do I include in the Costs and Benefits section?
Costs. All costs directly related to the project must be included. Several of these are detailed below:
– Costs of Assets (both Capital and ongoing)
– Supply costs for purchased items – Additional administrative effort required to manage the project – Delivery costs if paid by you – Future asset replacement costs – Tender preparation costs – Any specialized tooling associated with the project
Revenue. Revenue can be attributed to a project only if it would not have been received had the project not proceeded.
Disposal of Assets and Residual Values Certain assets may be decommissioned prior to the end of their useful lives or salvaged at the project’s conclusion. This amount should be factored into the cash flows (less the costs associated with their sale or disposal).
Savings on costs. All cost savings incurred as a result of the project must be included. Savings on wages and salaries must include overhead and on-costs.
How do I account for non-monetary costs and benefits?
Due to the fact that Cost Benefit models include only cash transactions (both costs and benefits), non-financial costs and benefits are typically described via notes.
If the Benefit Cost Ratio is equal to or greater than 1, no non-monetary costs or benefits are required because the project is already VIABLE. Normally, these non-monetary costs and benefits would be considered when comparing competing options with similar Benefit Cost Ratios.
How can I validate my hypotheses?
You are in the best position to make inferences based on your own experience and judgement. However, you can employ a technique to demonstrate to others the robustness of your assumptions. This is referred to as Sensitivity Analysis.
This technique is critical to comprehend because your analysis contains numerous assumptions. These could have included the amount of new revenue generated, the amount of cost savings realized, or the residual value of the asset at the end of the project’s life. These assumptions underpin your analysis and have influenced your final Benefit Cost Ratio result.
Given the impossibility of accurately forecasting the future, there is a good chance that some of your assumptions will prove incorrect.
By demonstrating how changes in costs and benefits affect the Benefit Cost Ratio, this technique lends conviction and weight to your proposal. Do minor changes render the project unviable?
How can I be certain that the project is viable?
You made your assumptions based on your knowledge and experience with the project. You’ve created a model that demonstrates the project’s viability. If you have followed the established principles, you should be fine. Once the project has been authorized, it is critical to verify that the assumptions are accurate and that the project is actually deliverable.
To ensure this occurs, follow up on the following items: – Any labor savings must be delivered – affected resources must be reallocated – Cost savings due to process changes must be implemented expeditiously – Increased revenue due to price increases must be implemented expeditiously
A year after the project’s implementation, a Post Completion Review will reveal whether all or some of your assumptions were correct. Additionally, it will teach lessons on how to do this more successfully the next time around, rather than repeating the same mistakes.
How can I implement this technique in my organization?
There are several ways to accomplish this:
– Conduct your own cost-benefit analysis in a pilot project – Convince the CEO of the benefits of cost-benefit analysis and leverage that authority – Conduct cost-benefit analysis in a specific business unit
All of these approaches necessitate a thorough understanding of the theory, the rationale for its application, and the anticipated payoffs.
A training programme would need to be implemented to ensure that everyone involved comprehended the technique.
Why is it necessary to include NPV in order to account for the time value of money?
Typically, the asset’s life or the decision being made will have a financial impact that extends beyond one year. This is typically between three and five years (computers, software, and factory machinery), twenty years for some large electrical equipment, and up to one hundred years for underground pipes used in water and sewer reticulation.
Year after year, inflation erodes the purchasing power of the dollar, requiring us to spend more in dollar terms to purchase the same item. As is the case with projects that last longer than a year.
Costs and benefits that occur in years three or four of the project will have a lesser impact than those that occur in year one.
If NPV is not included in the model, the Benefit Cost Ratio and the final determination of VIABILITY may be completely incorrect.
Is its applicability limited in any way?
Not really, as long as financial costs and benefits are considered. It applies to large and small decisions, complex and simple assets, long-lived and short-lived assets, as well as profit, government, and charitable organisations.
There are a few general constraints:
Subjectivity – It is highly improbable that two analysts working independently will arrive at the same Cost Benefit Ratio value. Numerous variables can be treated differently, a few of which are listed below:
– Determination of the asset’s physical and/or economic life – Determination of the costs/benefits of environmental protection
– The ability to select discount rates (the rates illustrated above are indicative of a range which could be applicable)
– The value of benefits varies according to social class (i.e. the poor section of the community values a dollar differently than the affluent class).
Political Decision Making – The necessity of making political judgments about the project’s viability (election timing, regional allegiances) can influence the outcome. Additionally, decision-makers are inconsistent across space and time.
First Round Effects – Normally, we would include only those effects that are directly related to the project moving forward. We would not, for example, include the increased agricultural output in the community as a result of the project’s implementation. This would be justified only if the sector was historically unemployed.
How is this technique going to help me?
There are numerous methods; a few are listed below:
– Increases your confidence by demonstrating that you used a time-tested, dependable method.
– Having considered all possible solutions to the problem, you can present your proposal confident that you have the answers.
– By employing this strategy, you will ensure that you receive recognition and increased opportunities for advancement.
– Once the company recognizes the benefits of this technique, it may wish to have you train other employees or serve as the implementation champion – providing you with additional opportunities.
– This technique will save you time when evaluating projects and ranking competing proposals.