Cost Benefit Analysis Definition

1. Cost- Benefit Analysis

Cost- Benefit analysis is used to analyze decisions made by businesses, summing up the benefits of a decision or actions related with the business, and then subtracting the costs related to this action. Before coming up with a new plan or taking on a new project, successful managers run a cost-benefit analysis as a “means of evaluating all the potential costs and revenues that may be generated if the project is completed” (Investopedia). This conducted analysis will determine whether the project is worth continuing or if another project should be considered (Investopedia).

The analysis should start with a list of all cost and benefits related to the project. Costs should include: Direct costs, Indirect costs, Intangible

It is clear that if benefits are greater than costs, the project should continue, but in the case that costs are more than benefits, the project should be reconsidered and checked again to see if it is possible to make any new repairs, so that benefits can increase and/or decrease costs. In cases where changes are not possible, the project may be rejected to continue (Investopedia).

The effectiveness of the cost-benefit analysis depends on the length and outlay of a project. For example, for small and short-term projects, a cost-benefit analysis is sufficient to come to a decision, in contrary to large and long-term projects, where the cost-benefit analysis is not enough to effectively determine whether to continue or not with project, because it fails to calculate “important financial concerns such as inflation, interest rates, varying cash flows and the present value of money” (Investopedia).

Recently, the cost-benefit analysis has been used to analyze public-sector projects. The most important costs analyzed are social costs, because they help to answer questions such as: “Shall we turn this busy urban street into a pedestrian zone?” (The economist,

Relevant costs for decision making

In the process of decision-making, there are some particular costs that are taken into consideration, and the relevant cost method is important for not taking unrelated data into account, thus eliminating excess information. This makes decision-making process easy and not complicated (Accounting Tools, 2013).

Managers, in the process of calculating the cost related to decision-making, should ignore sunk costs, which have been acquired before the decision process; apportioned costs are split between units of production based on allocation method; and unavoidable costs cannot be avoided despite the decision made (ACCA Global, 2016). On the other hand, opportunity costs are included in the relevant costs, and they have an important role in the decision-making process, because organizations need to calculate both explicit and implicit costs when making decisions (The Strategic CFO, 2016). Relevant costing is useful for short-term financial decision, but in some cases it is not as efficient for long-term decisions, and it happens because some of the costs that are irrelevant for short-term decisions become important for long-term ones