COST BENEFIT ANALYSIS
“Information is a source of learning. But unless it is organized, processed, and available to the right people in a format for decision making, it is a burden, not a benefit.”
– William Pollard, 19th Century Writer
Cost-benefit analysis seems straightforward, yet, in my experience, there is a lot more nuance and thought needed than most people think. We’ll go over the basics, some of the most common mistakes, and best practices.
What is cost-benefit analysis?
Cost-benefit analysis is calculating the benefits versus the costs, which equals the value of a potential project, investment, or decision. Strategic leaders use cost-benefit analysis to understand the value of a potential project, investment or decision.
The costs of a project or investment can include:
Investment costs – development and implementation
– Use of internal resources
– Business interruption
Ongoing and maintenance costs
– Licensing and upgrades
– Repairs and the costs associated with downtime
Often, the costs of an investment are fairly straightforward. The benefits of an investment can be much trickier and important to think through and calculate. In cost benefit analysis, typically one or two really big benefits are missing from the analysis.
Here are some of the typical benefits:
Cost savings in the form of less
– Product costs
Revenue & customer benefits in the form of more
– Loyalty & advocacy
– More spend per customer
– Employee morale
– Consumer perception
The time factor in cost-benefit analysis
Time is a large factor in doing a cost-benefit analysis, in particular, how do the costs and benefits evolve. Do they last five years, ten years? Do they improve or degrade over time? The value of an investment is based on the return of the investment over time.
Another way to calculate cost-benefit is to calculate the payback period, which is how long an investment takes to break even. If implementation costs equal $10,000, and the annual benefits minus ongoing costs equal $5,000, then there is a 2-year payback on the investment.
A few common issues with cost-benefit analysis
One issue that comes up a lot in cost-benefit analysis is incorrectly calculating labor cost savings due to increased productivity. Unless you reduce headcount, paid hours or overtime, you are not realizing actual cost savings. You are freeing up time to work on other things, and those other things are the benefit. Another significant issue in many cost-benefit analyses is focusing on the cost-saving benefits, but leaving out or incorrectly calculating customer benefits.
Smartphone-based mobile checkout example
To go over some of the nuances of making sure you have the right categories in a cost-benefit analysis, let’s go over an example of a retailer’s categories for a cost-benefit analysis on potentially rolling out smartphone-based mobile checkout. Take a look at the cost and benefit categories below.
If the customer benefits of more customers, higher loyalty and higher spend per customer pan out, then this investment is a no-brainer. The next step for the retailer would most likely be testing a cobbled together solution to understand the impact to the customer experience and behavior. Yet, just categorizing the benefits shows a pretty strong case for smartphone-based mobile check-out, given the customer benefits.
What are the best practices in cost-benefit analysis?
Cost-benefit analysis is a key exercise to do as you think through strategy and option sets of potential investments. Here are some of the best practices in doing cost-benefit analysis:
Get the cost and benefit categories right
You can spend weeks and months on detailed calculations of costs and benefits, only to produce the wrong answer if you don’t get the big cost and benefit categories right. I’ve seen it over and over again. Big presentations, tons of work, and a simple question to ruin it all, “How will this affect our customers?” “How much are we going to cut headcount to realize these savings?”
Do some ethnography, a pilot or get the voice of the customer
While guestimating is a necessary evil, try to get some facts to base your costs and benefits on. It could be as simple as observing employees or customers to understand how often or how long something takes. It could be doing a pilot, if you have the time and resources, or a hypothetical run through of a new process or practice. It could be a survey or focus group. Regardless of what it is, get the voice of the customer.
Try to tie everything to a dollar value, and when you can’t give it a magnitude score
Many cost-benefit analyses are a bunch of assumptions on top of assumptions, which can lead to a bunch of BS. When you don’t have a ton of confidence in the value of an assumption, give it a range or a magnitude score (e.g., very large, small, etc.). In the end, assumptions don’t have to be perfect, since you are typically just trying to compare different investment options. And, as accurate as you think you are, you’ll typically be at least +/-25% off on cost and benefit estimates.
Constantly calculate rough cost benefits
It is good practice to chart out the cost and benefit categories and estimate the order of magnitude of the categories tied to an idea or potential initiative. It often leads to great debates that build out the idea and helps orient the relative priority of the idea versus other ideas and initiatives.