Cost-Benefit Analysis

Overview

Systematically quantify costs and benefits to evaluate decisions, including NPV calculation, sensitivity analysis, and intangible factors

Steps

Step 1: Frame the analysis

Establish the scope and baseline for analysis:

1. DEFINE THE DECISION:

   • What specific decision are we evaluating?
   • What are we trying to achieve?
   • Who is the decision for?

2. IDENTIFY ALTERNATIVES: Always include:

   • The proposed action
   • “Do nothing” / status quo baseline
   • At least one other alternative if exists

   Each alternative should be mutually exclusive and complete.

3. SET ANALYSIS PARAMETERS:

   • Time horizon: How far out to project?
     • Capital investments: 5-10 years
     • Technology: 3-5 years
     • Operational changes: 1-3 years
   • Discount rate: Cost of capital or opportunity cost
     • Corporate: Often 8-15%
     • Government/public: Often 3-7%
     • Personal: Your alternative return rate
   • Currency and inflation handling

4. DEFINE PERSPECTIVE:

   • Whose costs and benefits count?
   • Organization only? Include externalities?
   • Single project or portfolio view?

5. IDENTIFY CONSTRAINTS:

   • Budget limits
   • Payback period requirements
   • Risk tolerance

Step 2: Identify and quantify costs

Create comprehensive inventory of all costs:

COST CATEGORIES:

1. UPFRONT/CAPITAL COSTS (Year 0):

   • Purchase price or development cost
   • Implementation and setup
   • Training and change management
   • Integration and customization
   • Infrastructure and equipment
   • Licensing (if upfront)
   • Consultants and external help

2. ONGOING/OPERATING COSTS (Years 1-N):

   • Maintenance and support
   • Licensing (if recurring)
   • Personnel (salaries, benefits)
   • Infrastructure (hosting, utilities)
   • Consumables and supplies
   • Insurance
   • Compliance and auditing

3. OPPORTUNITY COSTS:

   • What else could this money/time be used for?
   • Revenue from alternatives foregone
   • Other projects delayed or cancelled

4. RISK COSTS:

   • Expected value of potential failures
   • Mitigation costs
   • Insurance costs

5. HIDDEN/OFTEN-MISSED COSTS:

   • Transition and migration
   • Productivity loss during change
   • Coordination and management overhead
   • Technical debt created
   • Vendor lock-in costs (future switching)
   • End-of-life and decommissioning

FOR EACH COST:

1. Name and describe the cost
2. Estimate amount (use ranges if uncertain)
3. Assign to year(s) when cost occurs
4. Note confidence level (high/medium/low)
5. Document estimation methodology

Step 3: Identify and quantify benefits

Create comprehensive inventory of all benefits:

BENEFIT CATEGORIES:

1. REVENUE/INCOME BENEFITS:

   • New revenue enabled
   • Revenue protected from loss
   • Price premium achieved
   • Market share gained
   • Customer acquisition
   • Customer retention improvement

2. COST REDUCTION BENEFITS:

   • Labor savings
   • Efficiency improvements
   • Error reduction
   • Waste reduction
   • Infrastructure consolidation
   • Vendor cost reduction

3. PRODUCTIVITY BENEFITS:

   • Time savings
   • Throughput increases
   • Quality improvements
   • Faster time-to-market
   • Reduced rework

4. RISK REDUCTION BENEFITS:

   • Avoided losses (expected value)
   • Compliance risk reduction
   • Security risk reduction
   • Operational risk reduction
   • Reputation protection

5. STRATEGIC BENEFITS:

   • Competitive advantage
   • Market positioning
   • Capability building
   • Options created for future
   • Learning and knowledge gained

QUANTIFICATION APPROACHES:

• Direct measurement: When benefits are directly observable
• Proxy metrics: When direct measurement isn’t possible
• Comparison: Before/after or with/without comparisons
• Industry benchmarks: What others have achieved
• Expert estimation: Informed judgment with ranges

FOR EACH BENEFIT:

1. Name and describe the benefit
2. Define how it will be measured
3. Estimate value (use ranges if uncertain)
4. Assign to year(s) when benefit occurs
5. Note probability/confidence level
6. Document estimation methodology

Step 4: Calculate Net Present Value

Compute NPV by discounting future cash flows:

NPV FORMULA: NPV = Sum of [Cash Flow(t) / (1 + r)^t] for t = 0 to N

Where:

• Cash Flow(t) = Benefits(t) - Costs(t) for year t
• r = discount rate
• N = time horizon in years

STEP-BY-STEP CALCULATION:

1. CREATE CASH FLOW TABLE:

   Year	Costs	Benefits	Net Cash Flow
   0	…	…	…
   1	…	…	…
   …	…	…	…
   N	…	…	…

2. CALCULATE DISCOUNT FACTORS: Year 0: 1.000 Year 1: 1/(1+r) = 1/1.10 = 0.909 (at 10%) Year 2: 1/(1+r)^2 = 0.826 …

3. CALCULATE PRESENT VALUES: PV(t) = Net Cash Flow(t) x Discount Factor(t)

4. SUM PRESENT VALUES: NPV = Sum of all PV(t)

DECISION RULES:

• NPV > 0: Project creates value, generally accept
• NPV < 0: Project destroys value, generally reject
• NPV = 0: Breakeven, indifferent

ADDITIONAL METRICS:

IRR (Internal Rate of Return):

• The discount rate that makes NPV = 0
• If IRR > required return, project is attractive

Payback Period:

• Time to recover initial investment
• Simple payback: Without discounting
• Discounted payback: With discounting

ROI (Return on Investment):

• (Total Benefits - Total Costs) / Total Costs
• Doesn’t account for timing, use NPV when timing matters

BCR (Benefit-Cost Ratio):

• PV of Benefits / PV of Costs
• BCR > 1 means NPV > 0

Step 5: Conduct sensitivity analysis

Test how conclusions change with different assumptions:

1. IDENTIFY KEY VARIABLES: Which assumptions have the most impact on NPV? Common sensitive variables:

   • Benefit estimates (especially revenue projections)
   • Discount rate
   • Time horizon
   • Implementation costs
   • Adoption rates
   • Market conditions

2. ONE-WAY SENSITIVITY: Vary one variable at a time:

   • Pessimistic case (e.g., -20%)
   • Base case
   • Optimistic case (e.g., +20%)

   Calculate NPV for each scenario.

3. TORNADO DIAGRAM: Rank variables by impact on NPV:

   Variable	Low NPV	Base NPV	High NPV
   Revenue	-100K	500K	1.2M
   Costs	400K	500K	600K
   Discount rate	450K	500K	550K

4. BREAKEVEN ANALYSIS: Find the point where NPV = 0:

   • What revenue level breaks even?
   • What cost level breaks even?
   • What adoption rate is needed?

5. SCENARIO ANALYSIS: Test coherent combinations of assumptions:

   • Best case: All favorable assumptions
   • Worst case: All unfavorable assumptions
   • Most likely: Best estimates

6. MONTE CARLO (OPTIONAL for high-stakes):

   • Define probability distributions for uncertain variables
   • Run many simulations
   • Get probability distribution of NPV

Step 6: Assess intangible factors

Acknowledge and evaluate factors that can’t be quantified:

COMMON INTANGIBLES:

1. STRATEGIC VALUE:

   • Alignment with strategy
   • Competitive positioning
   • Market perception
   • Options created for future

2. ORGANIZATIONAL IMPACT:

   • Employee morale and satisfaction
   • Organizational learning
   • Culture change
   • Talent attraction/retention

3. CUSTOMER IMPACT:

   • Customer satisfaction
   • Brand perception
   • Customer relationships
   • Trust and loyalty

4. RISK AND RESILIENCE:

   • Flexibility and adaptability
   • Reduced dependency
   • Business continuity
   • Peace of mind

5. SOCIAL/ENVIRONMENTAL:

   • Environmental impact
   • Community impact
   • Ethical considerations
   • Sustainability

EVALUATION APPROACH:

1. List all relevant intangibles
2. For each, assess:
   • Direction: Positive, negative, or neutral
   • Magnitude: High, medium, or low impact
   • Confidence: How sure are we?
3. Consider if intangibles could override NPV conclusion:
   • Positive NPV but significant negative intangibles?
   • Negative NPV but strategic necessity?
4. Attempt rough quantification where possible:
   • What would we pay to have this benefit?
   • What would we pay to avoid this risk?

HANDLING IN DECISION:

• Document intangibles explicitly
• Don’t pretend to quantify what you can’t
• Make judgment call transparent

Step 7: Compare alternatives and recommend

Synthesize all analysis into a recommendation:

1. COMPARISON TABLE: For each alternative (including do nothing):

   Criterion	Option A	Option B	Do Nothing
   NPV	…	…	0
   IRR	…	…	N/A
   Payback	…	…	N/A
   Risk level	…	…	…
   Intangibles	…	…	…
   Constraints met?	…	…	…

2. DECISION MATRIX: Weight criteria and score alternatives:

   • NPV/financial return (weight: ?)
   • Risk/sensitivity (weight: ?)
   • Strategic fit (weight: ?)
   • Implementation feasibility (weight: ?)
   • Intangible benefits (weight: ?)

3. RECOMMENDATION:

   • Which alternative is recommended?
   • Why is it better than alternatives?
   • Under what conditions would conclusion change?

4. IMPLEMENTATION CONSIDERATIONS:

   • What needs to happen to capture the projected benefits?
   • What are the key risks to manage?
   • What milestones should trigger re-evaluation?

5. DOCUMENTATION:

   • Summarize key assumptions
   • Note what would invalidate the analysis
   • Set review date for assumptions

When to Use

• Before major investments or expenditures
• When comparing alternatives with different cost/benefit profiles
• For build vs buy decisions
• When evaluating new projects or initiatives
• For pricing decisions (does the revenue justify the cost?)
• When stakeholders need quantified justification
• For resource allocation across competing priorities
• When evaluating whether to continue or stop an initiative
• For policy decisions with broad impact

Verification

• All significant costs and benefits are included
• Estimates have documented basis (not arbitrary)
• NPV calculation is mathematically correct
• Sensitivity analysis covers key uncertainties
• Intangibles are acknowledged even if not quantified
• Recommendation follows logically from analysis
• Key assumptions are explicit and testable

Input: $ARGUMENTS

Apply this procedure to the input provided.