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Have you ever struggled with making a big decision, such as whether to buy a car or to take college courses? These decisions can seem overwhelming. Many of us talk through our options with friends and family, who offer thoughts and suggestions. At some point, you may have jotted down pros and cons. What may surprise you is that this simple decision-making technique of making a pro/con list can be expanded for a more complex technique: cost-benefit analysis.
Cost-benefit analysis is a method used to evaluate the merit of a decision, a program, or a policy before taking action. In a cost benefit analysis, the total value of the estimated costs and the estimated benefits of the decision are tallied up and compared. Cost-benefit analysis is not unique to economists; rather it is a method used by individuals from all walks of life to evaluate all kinds of decisions. But a crucial additional step beyond a simple pro/con list is that non-monetary costs and benefits will be given an estimated monetary value if at all possible, in order to allow for a more complete comparison.
For instance, when you make a pro/con list about buying a car, it might look something like this:
Con: Expensive; need to find parking; bad for environment
Pro: Easier to visit family outside the city; can get a cheaper apartment farther from the train
If you were to make a cost-benefit analysis for the same decision, it might look something like this:
Costs:
Price of used car - $15,000
Car insurance - $1,000
Parking - $1,000
Impact on the environment - unknown amount
Benefits:
Value of total time saved when visiting family - $5,000
Rent savings from moving farther from the train - $6,000
Enjoyment of having a car - unknown amount
To complete the analysis, you would add up the monetary estimates in the costs and benefits lists and compare the totals. In this case, the cost of the new car would be $17,000 and the benefits would be $11,000, so you would have to think carefully about the importance of those unquantifiable items (environmental impact and enjoyment of car ownership) to determine whether this would actually be a good purchase.
When businesses make financial decisions related to projects, they weigh the project’s costs against its benefits. Organizations like the Center for Disease Control (CDC) consider health-based interventions based on cost-benefit analysis. And when governments evaluate regulatory policy, a cost-benefit analysis is a necessary starting point.
When you conduct a cost-benefit analysis, it is important to make sure that the problem being analyzed is clear and simple.
EXAMPLE
Suppose that a valued employee retires. The hiring manager needs to make a decision about hiring a replacement. An unclear problem might generate a question like “Do we have enough employees?” A clear problem might generate a question like “Do we hire a replacement or not?”Once you have a clear understanding of the decision, document all of the possible benefits and all possible costs of the decision. Consider short and long-term consequences of each possible decision. Some costs or benefits may lie further in the future. Weigh the options one-by-one, comparing the costs to the benefits. Then you make an informed decision, taking into consideration whether the total benefits outweigh the total costs or whether the total costs outweigh the total benefits.
Let’s consider a common business decision: whether or not to fill a job vacancy. Suppose a long-time employee, Kamille, informs her manager that she is planning to retire. The manager, Anna, has to decide whether to hire someone new for Kamille's role or to distribute Kamille's duties to other members of the team. How might Anna use cost-benefit analysis to assess whether or not to fill the job vacancy?
Anna would first develop a list of all of the benefits and costs. Doing this will allow her to carefully consider all aspects of the benefits and costs of hiring a new employee.
First, Anna would consider the costs involved in hiring the new employee by listing each cost and assigning an estimated value to each cost. Some costs may not be known, or may be hard to put in monetary terms. In such a case, Anna would note that the cost is not known or not predictable. The costs involved in hiring the new employee are as follows:
| Cost | Cost in $$ |
|---|---|
| New employee salary per year | $44,000 |
| New employee benefits per year | $2,400 |
| Expenses of recruitment (advertising, interviews, background checks) | $1,600 |
| Onboarding and training new employee | $500 |
| Productivity loss due to the vacant role during the hiring process | $2,000 |
| Revenue loss due to the vacant role during the hiring process | $3,000 |
Next, Anna would consider the benefits of hiring a new employee. She would assign a value to each benefit or note that the value of a benefit is not known or predictable. It is easy to assign a value to some benefits. Other benefits are more difficult to assign a value because the specific impact might be unknown or hard to determine. If there are benefits with unknown value, Anna would note that. The benefits of hiring the new employee are as follows:
| Benefits | Benefits in $$ |
|---|---|
| New employee's work will directly benefit the company | $44,000 |
| Increased team productivity | $3,000 |
| Improved team morale, boost company loyalty, and reduce employee turnover | $5,000 |
| Opportunity to diversify the team | Unknown |
To make a decision, Anna would compare the two lists and add up the total costs and the total benefits.
| Cost | Cost in $$ | Benefits | Benefits in $$ |
|---|---|---|---|
| New employee salary per year | $44,000 | New employee's work will directly benefit the company | $44,000 |
| New employee benefits per year | $2,400 | Increased team productivity | $3,000 |
| Expenses of recruitment (advertising, interviews, background checks) | $1,600 | Improved team morale, boost company loyalty, and reduce employee turnover | $5,000 |
| Onboarding and training new employee | $500 | Opportunity to diversify the team | Unknown |
| Productivity loss due to the vacant role during the hiring process | $2,000 | ||
| Revenue loss due to the vacant role during the hiring process | $3,000 | ||
| Total: | $53,500 | Total: | $52,000 |
In this scenario, what is the right decision to make? If Anna only considers the monetary values, then the decision would be to not hire someone new for Kamille's job, because the known total monetary costs ($53,500) outweigh the known total monetary benefits ($52,000). However, some benefits are not yet known, and others are identified but lack an assigned dollar value, making a cut-and-dry determination more difficult. In a situation like this, Anna could draw on her experience to make a judgment call about the potential value of hiring the new employee and make a final decision.
A limitation of the cost-benefit analysis method is assigning appropriate values to both present and future options. As with your own analysis, it is possible to overlook a significant advantage or disadvantage or not account for the voices of all who have a shared interest in a decision, or stakeholders.
In this scenario, Anna might not place high importance on the unknown potential benefit of increasing team diversity with a new hire. But what if the company's leadership has recently decided to invest more seriously in diversifying the company's hiring practices? In that case, there would be other stakeholders in this decision who would have a different opinion on the value of having an opportunity to increase the team's diversity.
In a later unit, you will have more opportunities to explore cost-benefit analysis.
Source: THIS TUTORIAL WAS AUTHORED BY SOPHIA LEARNING. PLEASE SEE OUR TERMS OF USE.
