Cost-Benefit Analysis, sounds complex but we do it every day

TIFO about Cost-Benefit Analysis

So what is a Cost-Benefit Analysis?

A Cost-Benefit Analysis (CBA) is an analysis performed based on the advantages and disadvantages of a strategic move taken by a company. It analyses both the economic and opportunity cost of the move along with its advantages. Most major companies make many big decisions based on the CBA of that decision, and so do a lot of people in their lives.

How do I do a Cost-Benefit Analysis?

Well, a good CBA is quite tricky. However, whether you are doing it for a company or for yourself, there are a few tips and tricks which you can follow. The first and most important thing to find out is the monetary cost of making that decision along with any monetary benefits which it might bring. Let's take the example of a couple who is remodelling their house's kitchen. Just as an estimate, we can assume that the cost of the remodel would be $50,000 and that the remodel would increase the value of their house by $20,000. At this point in time, the CBA indicates that it will not be a good decision. However, there are a few more parameters that might change that. The next thing to look at is the satisfaction value or how satisfied the people using the facility would be with and without it. In the same kitchen example, the satisfaction value would be how satisfied the people living in the house would be using the remodelled kitchen vs the current one. In this case, we can assume that the people using the kitchen would be a lot more satisfied after the remodel than they would be right now. Finally, you need to look at the opportunity cost. The opportunity cost is what you are giving up by making that decision. It is assessed by what you gain by making another choice vs what you gain by making this one. If the couple decided not to remodel the kitchen, what would they do using the $50,000 instead and would it be better in terms of money and/or satisfaction than this choice? Assume they put the $50,000 aside for their kids' college funds or for their next car, would these give them more value for their money or more satisfaction with their purchase? In business, the companies look at one more parameter. They look at what the possible advantages and implications the decision might have in relation to their competitors. For example, if a company wants to open a new factory, they will have to see what good the factory will do for them with relation to their competitors and weigh it against the very likely scenario that their competitors might make another factory as well, which would cause the market to have a much higher supply of the product with the same demand levels and which could cause the price of their product to drop. Their profits would increase for a few months, but their costs would double, and in the long term it wouldn't work. 

Is there any other situation where we might use a CBA?

When we go to the supermarket, for example, we use a CBA to determine whether to try a new brand or go with what we usually buy. We analyse the cost of the two products, assess the benefits and costs of each and decide whether we want the new one, the old one or both. If we have been referred to the new product by someone else like a gym instructor or doctor, we are more likely to buy the new product, at least to try, even if the new product is significantly more expensive. In this situation, we assume that even though the cost is higher, the benefit of the newer drink must be significant. In this way, our previous ideas about the product shape our analysis of its cost and benefit. 

Are there any issues with a CBA?

Definitely. Cost-Benefit Analyses assess multiple situations which may be relevant to short and medium-term decisions, but larger decisions require an analysis of multiple factors. Buying a shampoo or choosing what to eat at a restaurant can be decided using CBA, but other decisions are more complex. Buying a car requires us to think about the depreciation, the type of fuel, the environmental impact of the car and various other factors. Investing in real estate requires an analysis of the location, the likelihood of the land prices increasing, the probability that this plot may become part of a more expensive neighbourhood, etc. However, in our daily lives, a CBA is probably one of the easiest and best ways for us to optimise our decisions.

What about you? What's your favourite TIFO moment? Tell me down in the comments below.