Cost benefit analysis involves the weighing of the costs associated with a decision against the benefits arising from that decision. The analysis is used to decide whether to proceed with a course of action or not.
Cost benefit analysis can include both quantitative and qualitative factors. For example, the analysis of a decision to construct a facility in a particular city could include quantitative factors, such as the amount of tax breaks that can be obtained, as well as qualitative factors, such as the rating of the schools in that city to which workers would send their children.
For decisions involving large amounts of invested funds, the emphasis of a cost benefit analysis tends to be on the cash flows associated with the investment. This may include the initial and subsequent investment of funds, as well as the tax effects of depreciation, maintenance costs, and projected price points. In this situation, qualitative factors tend to be addressed after a “hard” quantitative analysis has already been completed.
Examples of decisions to which cost benefit analysis can be applied are:
- Whether to expend funds on a new fixed asset. The analysis is the cost to buy the asset, versus the benefit of any cash flows to be derived by using the asset.
- Whether to hire staff to design a new product. The analysis is the cost of the new staff, versus the cash flows to be derived from sale of the new product.
- Whether to hire quality assurance staff to reduce product failures. The analysis is the cost of the new employees, versus the costs to be avoided by maintaining higher product quality levels.
Cost benefit analysis works best when most of the costs and benefits can be reduced to financial terms, so that they can be more easily compared. The analysis does not provide consistent results when the decision maker must compare qualitative concepts, without being able to convert them to financial outcomes. The concept can also yield inconsistent results when cash inflows and outflows are expected to occur over long periods of time, since it can be quite difficult to accurately predict the amount and/or timing of the more distant cash flows.