Cost-benefit analysis is a simple technique for comparing the business value a project will produce with the cost of producing it. Project managers use cost-benefit analysis in the project initiation phase to show the value of doing a project. During project initiation, the sponsor and project manager must justify the project to get the organization’s approval to spend the money. The cost-benefit analysis compares the project’s costs to the business value it will deliver. Few organizations want to go ahead with projects that will cost more than the value they will produce. So project managers conduct the cost-benefit analysis by gathering data on the value of the benefits and the cost of the project.
Cost-benefit Analysis: Examples
Let’s say you determined that the benefits produced by the project would be worth $15,000. And you calculated the cost of producing those benefits at $10,000. Then you would divide the benefits (15,000) by the costs (10,000) and calculate the cost-benefit ratio of 1.5.
Many organizations have rules about what cost-benefit relationship the project must produce for gain approval. In some organizations, new projects must have a cost-benefit ratio of 1.2 to be approved. That means the benefits of the project exceed the costs by 20%. From an external point of view, a project that pays back its costs plus 20% of its costs sounds like a pretty good investment. Other organizations use higher or lower cost benefit ratios.
In a cost-benefit analysis, you compare the dollar value of the cost of a project, a deliverable or a change request to the dollar value of the benefits you expect it to produce. Here is another example. You may calculate a project will produce benefits worth $290,000 and will cost $272,500. So it’s benefits exceed its costs by $17,500 or 6%. Cost-benefit analysis on a small project is as simple as dividing the benefits by the costs to calculate the benefit-to-cost ratio: 290,000/272,500 = 1.06.
You can use cost-benefit analysis to test a particular alternative or compare several alternatives. It is usually a very simple process to come up with the cost of an alternative. You have access to list prices for equipment, materials and labor rates for people’s time. This is not to say there are never disputes about the costs. But the data is usually readily available.
You can also make the cost-benefit analysis more advanced by making comparisons over time and by adding elements such as the net present value of the benefits or the cost of cash flow.
Cost-benefit Analysis: Foundation for Calculations
The cost-benefit analysis is also the foundation for these calculations:
The details of these calculations will be subjects for later discussions.
Cost-benefit Analysis: The Tricky Part
Whatever level of sophistication the organization prefers, the difficult part of a cost-benefit analysis is coming up with quantified measures of the benefit of a project or an alternative. The computation is simpler when the benefits come from cost savings. But it is much more difficult to put a dollar figure on the benefits when they are in the form of increased customer satisfaction or improved employee satisfaction. In fact, it is usually the benefit part of a cost-benefit analysis that is the source of conflict and disagreement.
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