Cost-benefit analysis

Definition

Cost-benefit analysis is a systematic approach to evaluating the strengths and weaknesses of alternatives in terms of costs incurred and benefits gained. It helps decision-makers determine the most efficient way to allocate resources by quantifying potential impacts, allowing for informed decisions that maximize benefits while minimizing costs.

5 Must Know Facts For Your Next Test

1. Cost-benefit analysis can be qualitative or quantitative, with quantitative analyses using numerical data to derive measurable benefits and costs.
2. It is often used in project management to help prioritize projects based on their expected economic return.
3. A major component of cost-benefit analysis is identifying and assigning monetary values to non-monetary benefits, such as social or environmental impacts.
4. Sensitivity analysis is commonly employed within cost-benefit analysis to understand how changes in key assumptions can affect outcomes.
5. While useful, cost-benefit analysis has limitations; it relies heavily on accurate data collection and may overlook intangible factors that are difficult to quantify.

Review Questions

• How does cost-benefit analysis assist in resource allocation decisions?
  • Cost-benefit analysis assists in resource allocation by providing a framework for comparing different options based on their anticipated costs and benefits. By quantifying these factors, decision-makers can identify which alternatives yield the greatest net benefit. This structured evaluation helps prioritize projects or investments, ensuring that resources are directed toward initiatives with the highest potential for positive impact.
• Discuss how opportunity cost influences the outcomes of a cost-benefit analysis.
  • Opportunity cost plays a critical role in cost-benefit analysis by emphasizing what is sacrificed when one choice is made over another. When conducting this analysis, it's essential to consider not just the direct costs and benefits but also what potential gains might be missed by not selecting an alternative option. By incorporating opportunity costs into the evaluation, decision-makers can gain a more comprehensive understanding of the true economic implications of their choices.
• Evaluate the challenges faced when quantifying intangible benefits in a cost-benefit analysis.
  • Quantifying intangible benefits in a cost-benefit analysis presents significant challenges, as these benefits often lack clear monetary values. For example, improvements in employee morale or environmental sustainability can have profound effects but are difficult to measure directly. This ambiguity can lead to underestimating or overlooking important factors that influence overall project success. Addressing these challenges often requires creative methods for estimation or reliance on expert judgment, which introduces additional variability and uncertainty into the analysis.

Related terms

Return on Investment (ROI):

A performance measure used to evaluate the efficiency of an investment, calculated by dividing the net profit from an investment by the initial cost of the investment.

Opportunity Cost: The potential benefit that is lost when one alternative is chosen over another, representing the value of the next best option that is not selected.

Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a specified period, used to assess the profitability of an investment.