Cost-benefit analysis

Definition

Cost-benefit analysis is a systematic approach to evaluating the strengths and weaknesses of alternatives in decision-making, where the costs of a project or decision are weighed against the expected benefits. This technique is crucial for determining whether a particular action is financially viable and helps organizations allocate resources efficiently by comparing the potential financial returns against the associated expenses.

5 Must Know Facts For Your Next Test

1. Cost-benefit analysis helps businesses determine the feasibility of projects by providing a clear comparison between costs and expected benefits, allowing for informed decision-making.
2. It often involves quantifying both tangible and intangible factors, such as financial returns, customer satisfaction, and environmental impacts.
3. The analysis can be applied to various scenarios, including new product launches, marketing campaigns, and operational changes within an organization.
4. Sensitivity analysis is often conducted alongside cost-benefit analysis to assess how changes in key assumptions can impact the overall outcome of a project.
5. Properly executed cost-benefit analysis can lead to more effective budget allocation, maximizing returns on investments while minimizing unnecessary expenditures.

Review Questions

• How does cost-benefit analysis assist in making informed decisions regarding resource allocation?
  • Cost-benefit analysis provides a structured framework for evaluating different options based on their associated costs and benefits. By clearly laying out potential financial returns against the required expenditures, decision-makers can identify which projects offer the best return on investment. This systematic approach ensures that resources are allocated towards initiatives that align with organizational goals and provide maximum value.
• In what ways can cost-benefit analysis account for both tangible and intangible factors when assessing a project's viability?
  • Cost-benefit analysis can incorporate tangible factors like direct financial gains and expenses, as well as intangible factors such as customer satisfaction or brand reputation. To evaluate these elements, analysts might assign monetary values to non-financial impacts or use qualitative measures to understand their significance. This comprehensive assessment allows organizations to gain a clearer picture of a project's overall worth beyond just immediate financial implications.
• Evaluate the importance of sensitivity analysis in enhancing the reliability of cost-benefit analysis outcomes.
  • Sensitivity analysis plays a critical role in cost-benefit analysis by examining how variations in key assumptions affect overall results. By altering inputs such as estimated costs, projected revenues, or market conditions, decision-makers can understand potential risks and uncertainties associated with their choices. This added layer of scrutiny enhances the reliability of cost-benefit outcomes and empowers organizations to make more resilient decisions in the face of changing circumstances.

Related terms

Net Present Value (NPV):

A financial metric that calculates the difference between the present value of cash inflows and outflows over a period of time, used to assess the profitability of an investment.

Return on Investment (ROI):

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

Opportunity Cost: The potential benefits an individual, investor, or business misses out on when choosing one alternative over another.