A business owner using the cost-benefit analysis to make a business decision.
Entrepreneurship

Cost-Benefit Analysis: How to Make Business Decisions

August 7, 2023 / 488 Comments

Making huge decisions in your business can be paralysing. Looking at how your decision may affect your business in the near future can be overwhelming enough, let alone thinking about how your decision can affect your future opportunities. Short of being able to look into the future, how can you make informed business decisions?

There are a lot of different ways that business owners make their business decisions. Let’s talk about how to make business decisions using a cost-benefit analysis.

What Is a Cost-Benefit Analysis

A cost-benefit analysis is a little bit like a pros and cons list for businesses. Businesses have finite resources, so they want to maximise the return on the resources they spend (also called ROI.) A cost-benefit analysis allows businesses to see the following:

  • Costs – The resources that would be used and what using those resources may prevent them from doing.
  • Benefit – The expected results and the opportunities those results may provide in the future.

This allows businesses to look at the decision from all angles so they can make an informed decision.

A cost-benefit analysis should assign specific numbers to the costs and benefits. In some cases, these numbers may be monetary values, hours, or units of materials. There may be some costs or benefits that have both hours and monetary values.

Example Cost Benefit Analysis

Let’s look at an example cost-benefit analysis where a business owner is considering a project that would book that business out for the entire year. On the surface, the project is extremely lucrative and would mean they don’t have to market to or onboard any new clients. However, the business owner decides to do a cost-benefit analysis to make sure.

Cost-Benefit Analysis

CostBenefit
-Not enough time to perform recurring work with current clients (£80,000 worth of work + loss of loyal clients.) 
-£10,000 in software costs due to the client using different software.
-Travel costs to client’s offices estimated at £20,000.
-Probable impact on brand recognition due to stopped advertising (even if organic audience nurturing continues)
-Pursuing this type of deal would mean entering a new and fiercely competitive market. 
-2 members of staff with salaries totalling £60,000 would not be needed in carrying out this contract. (potential loss of valuable employees or costs with no return.)		-A £200,000 1-year contract.Eliminate advertising budget for 8 months (saving of $50,000).
-Marketing team would have 50 hours per week spare (due to stopping advertising) to create marketing assets. 
-Potential to leverage the results of this contract into more contracts of this size in the future.
-The knowledge from this contract can create a process to handle future contracts more efficiently.


Example cost-benefit analysis

A cost-benefit analysis does not mean that the decision is black and white. In this case, the business owner may examine the reasons why they are reluctant to take the contract and look for ways to mitigate or eliminate the costs. For example, they may consider what resources they would need to perform their recurring work for current clients on top of this contract and create a second cost-benefit analysis that explores that option.

A cost-benefit analysis informs an objective, data-driven business decision.

Why Do Businesses Do Cost-Benefit Analyses?

The main advantage of a cost-benefit analysis is it puts ROI (return on investment) at the centre of your decision-making. It allows you to remove your emotions from the equation to see the data behind the decision. That doesn’t mean that emotions or intangible factors have no place in business decision-making – they definitely do.

The second advantage of a cost-benefit analysis is that it simplifies the decision-making process. You can sometimes over-talk a decision in meetings or end up with too much data and no way to weigh up the importance of various factors. The cost-benefit analysis lays it all out plainly so you can understand what each option would mean for your business.

A third advantage of a cost-benefit analysis is it allows you to identify the costs so you can mitigate any risks or costs of your preferred option. For example, if you are considering a deal, you can then brainstorm ways to restructure the deal to reduce some of the costs or risks while retaining the benefits. This provides you with more information to act upon after you’ve made your choice than you would have if you just chose an option.

How to Do a Cost-Benefit Analysis

There are 5 steps to a cost-benefit analysis. If you have a team (internal or external), ask for their help creating the cost-benefit analysis. They will be able to give you insights into how different variables will impact their department and things that are happening in their field that may impact your decision-making.

Here are the 5 steps to a cost-benefit analysis.   

  1. Write down the clear financial numbers of your decision. What are the costs of your current situation? What are the costs of the option you are considering? Consider everything that may be a cost or saving. For example, the costs of materials, inventory storage, additional employee wages, utilities, and employee training. Costs go in the COST column, and savings go in the BENEFIT column. 
  2. Look at the other resources involved, like employee hours, equipment usage, and your time. Put the costs in the COST column and the savings in the BENEFIT column.
  3. Consider the intangible costs like delivery and supply lead times, employee happiness, and customer satisfaction. Another important factor is how the decision weighs up against your values and goals – both business and personal. 
  4. Identify the opportunity costs of the costs and benefits you identified in the previous 3 steps. If your resources are tied up in that decision, how will it impact other parts of your business or things you want to do in the future? If your customer perception or satisfaction changes in the way you’ve identified in your cost-benefit analysis, how will that impact your future sales or your ability to grow in the future?
  5. Consider the risks or advantages that you would have if you took this decision. Would you have more or less competition? Would you be ahead of market trends, or are you playing catch-up? Would there be regulatory restrictions?

It is important to remember that there will always be some variables that you can’t account for. There may be factors that you are unaware of or unexpected events (2020, anyone?) that your cost-benefit analysis doesn’t account for. All you can do is make a decision with the information you have available to you.

Once you have your cost-benefit analysis, look at what the data says the best option is. If you are considering a deal or a project (or anything else open to negotiation), do your cost-benefit analysis in a spreadsheet. This will allow you to create a copy of your cost-benefit analysis where you can examine how the costs and benefits change when you change different factors. You can then use that information when negotiating or structuring terms.

Are You Going to Use a Cost-Benefit Analysis to Make Business Decisions?

There are multiple ways you can make business decisions; a cost-benefit analysis is just one of them. So try out the cost-benefit analysis for yourself and see if it helps you to make decisions for your business.

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