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.