Updated: May 6, 2019
In life, people come across versions of the cost benefit analysis all the time. Should you indulge in that piece of triple chocolate cake? Do you really need a new pair of pants? In life, you weigh the costs (unnecessary calories or $120 pants) against the benefits (delicious dessert or a new style) and come out with a decision that, in theory, adds the most value to your life.
What is a CBA (Cost Benefit Analysis)?
A CBA is a process that is used to analyze and quantify the risk reward of a project or opportunity. In the business world, this means comparing the costs (time, money, etc.) it takes to execute on a project against the benefits (revenue, expense saving, etc.).
Is it worth it?
Yes. Any way you want to cut it, performing a CBA (even just a “back of the napkin” quick version) on a business project or opportunity is worth it. In a world ruled by data, it’s important to know your numbers and provide quantified reasoning behind your business decisions.
Before you even get to a final value or quantification of the risk reward associated with a project, performing a CBA starts to pay off. It forces you to realistically think about the project instead of getting lost in the excitement of a new opportunity. Excitement is good, but it doesn’t pay the bills. Going through the project end to end forces you to think about the total amount of effort required to make the project happen and how it will improve the company.
That can come off with a negative connotation, but it shouldn’t. It’s just doing your due diligence. When you can go to your boss with an exciting new project and really sell the concept, and then on top of that show it’s financially worth it… that project is getting a quick “yes”. It can also make something boring like a direct mail marketing campaign seem a bit more exciting if the benefits significantly outweigh the small costs.
When looking at different potential projects with the context from a CBA, decision making becomes much easier. You can quickly establish prioritization of projects by determining which ones have the most bang for their buck.
Say you’re back looking at that boring direct mail campaign and you’re comparing that against a Facebook ad. Yes, the Facebook ad will probably win, but by how much? Maybe, through your research (that you’re more inclined to do since you’re performing a CBA), a $500 and $600 Facebook ad have the same impact, so therefore it’s more beneficial to spend the extra $100 on a different project like a cheap direct mail campaign.
How do you properly perform a CBA?
Here's the quick overview:
Consider everything for costs and benefits
Think positively about the "consider everything"... maybe by getting a client from a specific project, you are more likely than usual to get a referral as well.
A classic example is whether or not to hire a new employee. Not only do they have a salary, but also things like insurance costs (health insurance for the employee, but also a potential increase in something like your workers' compensation insurance).
When you’re going through the assumptions for hiring an employee, where do you start? Maybe you’ve never hired someone before – how do you build a CBA with no experience to reference?
Research Assumptions - Costs
These are typically easier to quantify.
For estimating a salary, you can find good estimates online, or even look at job boards for similar jobs and see what the market is paying for the employee you want to hire. Things like insurance costs are potentially explained by your insurance company or explained in articles online, and the rough cost of offering a 401K can be calculated given the known maximum contributions, and how much you would match as an employer.
Research Assumptions - Benefits
These can be a bit harder. How do you make assumptions for a new employee in a new role at a new company?
Luckily, there are a few options. For one, online is a decent place to start again. There are probably articles on the general type of employee you're looking to hire so you could get an educated guess about what your employee is going to accomplish.
Another way is to base it off expectations of what you need out of an employee. If you need a Sales Rep, and 50 sales a month to grow significantly, you can then determine how likely it is that a sales rep will get you those 50 sales. Perhaps you would need someone top tier (and pay top tier price) for that to happen.
If you need an Analyst, it might become an equation around time usage and efficiency. If it’s taking you 20 hours a week to perform analysis (or you don’t even have 20 hours for analysis), and you know an analyst could do it in less time and get better results, then you can quantify the time benefit. Not only would you get better analysis, but you would also get 20 hours of your own week back to, in theory, spend on things you are better at and therefore add more value to the company.
The most thorough and likely most accurate way is to establish a range for each of the options you look at and take an average to get the best estimate.
You know what happens when you assume… sometimes you’re right! But often you can’t predict the exact cost and benefit of a small direct mail campaign, let alone hiring an employee, so that’s why you scenario test.
Start with the baseline assumptions and adjust your assumptions up and down to create low, medium, and high scenarios.
For the low scenario, you don’t have to go absolute worst-case scenario because odds are that won’t happen. It’s nice to know, on the off chance the project/employee flops and produces nothing positive, but that doesn’t need to be your low scenario. For the sales rep, maybe they only get 40 sales a month, and maybe the analyst only relieves 10 hours of your time. On the high end, bump up the expectations – 60 sales and 30 hours saved.
Your high scenario shouldn't be the absolute best case either. There is a common trap of getting really excited when you see a bunch of dollar signs, and start to think… “what if?” Suddenly you wind up bringing in a business-changing $100,000 from a $250 marketing campaign and reality has escaped you.
Don’t forget that you can change costs too. There is typically less variability, but they can be reasonably changed too.
Now you’ve got an expected range, and a good feel for where everything will shake out. You might see the low scenario has you losing a tiny bit, the medium has the project/employee contributing a solid amount, and the high has the business really being able to grow.
You can now weigh the scenario likelihoods against each other – you should have the medium being the most likely – and you can establish an expected value. You don’t always need to complete a full 5 year NPV (Net Present Value) and MIRR (Modified Internal Rate of Return) analysis – that walkthrough is your next read – because some projects end up being a bit simpler (but it is always important to consider that mindset).
After weighing the options, it’s important to consider non-quantifiable impacts (if they apply) as well: employee satisfaction, public image, etc.
You may realize that a top tier sales rep would add immense value to your business, or you may realize the analyst you needed isn't worth adding a full-time employee and decide to go with a consultant instead.
Quick Wrap Up
Performing a CBA is an incredibly value process for business owners to go through. It helps you think about all aspects of a project, get a good feel for how much risk you are taking on versus the rewards, as well as adding strong decision-making capabilities to your team.