How to conduct a cost-benefit analysis

By Leon Gettler

Good cost-benefit analysis ensures the small business will be making smart strategic decisions. It allows the business owner to determine whether a particular course of action is worth it, or whether it's too risky. And while it may sound like mathematic gobbledygook at times, the process is relatively easy. Calculate costs, calculate the benefits, then simply compare the results.

A well-managed cost-benefit analysis will ensure that cash flow remains healthy. It sets a standard for evaluating trade-offs and helps the business set priorities and make choices.

This is done by quantifying foreseeable costs and the expected quantifiable positive cash flow over a set period of time. Doing a cost-benefit analysis means examining all the costs and all the benefits and quantifying them. Nothing should be left out.

In a nutshell, the cost-benefit analysis takes all the benefits and then subtracts all the costs, or the negatives. What you are left with will determine whether the investment is worth it.

This will allow the business owner to address some key questions. For example, should extra staff be hired, or is it more economical to pay overtime? Should the cash flow be invested in more equipment?

Some small-business owners assemble a team to brainstorm potential costs and benefits of the change under consideration.

Step one: Calculate the costs

This should be thorough and include an actual dollar figure with each cost.

Costs can be direct and indirect. Direct costs would include the actual capital investment, that is to say, how much money has been put into the project. Direct costs might also include maintenance costs, subscription fees, consulting fees, licensing fees and tax outlay.

Indirect costs could include training, labour costs for implementation, leasing, telephone charges, computer support and transport costs. And if the investment is for a particular piece of equipment, what is the repayment period? The particular piece of equipment might last for 10 years but it might only be on the company's books for four years.

What are the "opportunity costs", that is to say, the potential benefits if you had spent your money on a different project? What are the costs if the investment fails to deliver? What are the costs if you had not gone ahead with the investment?

All this will provide you with those all-inclusive costs. These should also be calculated at the current rate and at the inflation rate.

Step two: Calculate the benefits

Calculating the benefits is a similar process. It needs to be all inclusive and once again, every benefit needs to be quantified with a dollar figure.

Most benefits are calculated in terms of improvements or cost savings. As with cost, inflation needs to be factored into the equation.

Potential benefits could include improved service delivery, reduced costs and greater efficiencies, compliance with government obligations, reduced exposure to litigation, increased output, achieving best-practice standards, reduced inventory costs, better relationships with suppliers, reduced supply-chain costs, the potential for new markets and customers, customer satisfaction and return on investment.

Step three: Analyse the difference

At the end of the process, the business manager needs to incorporate the calculations and findings of the cost-benefit analysis into a business case to support the proposed project.

With the cost-benefit analysis, the business can decide whether or not to proceed with the investment. Without the cost-benefit analysis, it's too big a risk.

 

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