Cost Benefit Analysis

One of the most important tools for any supply chain or business folks to know is the Cost Benefit Analysis (acronym CBA). This tool will help how to reach a rational decision based on given criteria. In this article we are going to discuss the theory behind this analysis and the term of opportunity cost and how it can help to make a coherent decision.

Cost benefit analysis is a systematical methodology to find the benefits and costs of multiple potential alternatives to make an ending judgment for what is suitable for a business. The benefits are listed for every option in terms of qualifying criteria. Then these criteria are converted to a money value to measure its final cost. The option with highest benefits and lower cost will be the rational one to choose.

The application of Cost benefit analysis is confined in determining if the decision’s benefits are outweigh its cost and to provide assessment basis between expected costs and benefits. CBA is often used by companies to evaluate the attractiveness of a given strategy.

Common cost benefit analysis procedure is consisted mainly of the following steps,

·         Goals Definition: To define objectives of the analysis and the desired outcome of the comparison.

·         Alternatives Listing: Citation of available alternatives that will lead to the predefined goals.

·         Measurements selection: choosing of measurement tools that will assist in comparison of alternatives. These gears will assist in define the possible outcomes of each alternative.

·         Outcomes prediction: Identify expected benefits and costs for each one of the alternatives. Benefits and costs can be either a qualitative or quantitative.

·         Monetizing costs and benefits: after outcomes detection, it will be shown in monetary terms to make a standard base for comparison; transfer qualitative outcomes to quantitative outcomes.

·         Sensitivity analysis: this will measure the aptitude for every alternative to be changed due some factors and how this will affect its predicted benefits and costs.

·         Adoption: final selection of the best alternative that achieve the highest benefits and lowest cost.

After outlining the costs and benefits for all alternatives, Benefits Cost ratio needs to be calculated for every alternative. That is what we call cost benefit analysis formula. This ratio for a single alternative is computed as the sum of present value of future benefits divided by the sum of the future costs. The target will be choosing alternative that will give the highest ratio.

One of the factors needs to be considered in this analysis is the Opportunity Cost which can be defined as “the cost incurred from not choosing the benefits of the next best option”. In other words, it is other benefits that could have been recognized when choosing one alternative over another.

Cost benefit analysis is appropriate for short and medium size capital expenditure alternatives in short and medium time intervals. When it comes to large size of capital expenditure and long term projects, CBA might be unsuccessful to consider other financial concerns such as interest rates, inflation, and the present value of money.

Supply and Demand

Supply and demand are interrelated terms in both economic and business speech. There is no supply without demand. The demand of a specific product or service becomes an idea for a new business to start and a new way to satisfy customers. In this article, we are going to have a simple justification for supply chain and business folks about both demand and supply from two common standpoints, i.e. economic perspective and business perspective.

The Supply is a wide used term that has its own definition according to its position in the speech. If we are going to discuss the term supply in an economic speech, it can be defined as “the capability of providing product and services to the market to meet its needs”. This capability can be presented as Supply Curve.

Supply curve is an illustration of a positive relationship between price and quantity of a supplied product or service. When the quantity supplied of a specific product increases, the price will increase. The price increase is not absolute as it is affected by other factors such as the price of the substitutes, production technology or labor costs.

While in business speech, we can identify it as “A continuous flow of raw materials, final products, and services into the market according to its demand”. When demand is seasonal, the products flow is seasonal, i.e. summer season for ice cream products or Christmas season for buying gifts and gadgets.

The Demand is described as “the desire to obtain a specific product or service based on a tenacious need and to pay for its agreed market price”.  No one is going to pay for a product without necessity and proper price. This relationship between the quantities needed and the desired price can be presented as Demand Curve.

Demand curve is a diagram for a negative relationship between price and quantity of a demanded product or service. When the quantity demanded of a specific product increases, the price will decrease.

Every supply chain or business folks need to understand how to match supply with demand in any market. Since demand and supply are solid terms, the next graphic displays both demand and supply curves to identify the fair market price and the feasible quantity of products to be produced and sold to achieve the equilibrium state of the market.

The Equilibrium Point is when the quantity supplied by businesses is equal to the quantity demanded (Q*) by customers at the fair market price (P*). Above this point the quantity demanded is lower than the quantity supplied so there will be a product surplus that will affect the business through obsolete inventory. On the other side, when quantity supplied is lower than the quantity demanded, there will be a product shortage. To avoid that, the equilibrium point is managed through the price mechanism by the market through shifting the demand or supply curves and define new reasonable market price.