How to: cost-benefit analysis

how to cost benefit analysis

Are you facing a decision that requires a significant investment? Not sure you are weighing all the factors? Worried about the risk of not earning a solid return? Most of us seek to choose the best option. But how can we be confident that we will make the right choice, especially with a weighty decision, such as purchasing a home, committing to a career or selecting a college.

Completing a cost-benefit analysis can help to ensure that you identify the highest value option. You see, some options that at first appear to deliver value might in fact cost more than they are worth. For example, you wouldn’t want to pay five times more for something and only receive two times the benefit. The trick is to select the option that provides the highest benefit for its cost, maybe even one that is worth more than it costs.

Calculating benefit

The first step in completing a cost-benefit analysis is to figure out how to determine benefit. One way to do this is to generate and weight criteria. A criterion is a standard, rule or test on which a judgment or decision can be based. For example, if you are selecting a college, criteria might include “distance from home,” “quality of social life,” “number of clubs,” or “access to preferred major.” Of course, criteria typically have different weights. It may be more important to have “access to preferred major” than it is to have a “quality social life.” Then again, maybe not.

Once you have a set of options and know the relative importance of your criteria, you can calculate each option’s total benefit using a weighted criteria matrix. The table below illustrates a hypothetical analysis of six colleges using eight weighted criteria. It assumes four previous steps: defining the criteria, weighting the criteria, assessing each option’s contribution to the criteria using a 1 – 9 scale, and calculating the weighted score for each cell. (For detailed information on how to complete these steps, please see How to: Multi-criteria Analysis .)

Column 1 lists the six colleges. Columns 2 through 9 display scores quantifying how each college scored against each weighted criterion. Column 10 displays the total benefit of each college. The total benefit is simply the sum of the weighted scores — that is, the total contribution of an option to the set of weighted criteria.

GREEN = Higher   < –>   ORANGE = Middling  <–>   RED = Lower

Understanding costs and benefits using a tradeoff analysis

The matrix ranks the options based on their total benefit. It also facilitates an easy, visual analysis of tradeoffs. A tradeoff is the giving up of one thing in return for another. When choices are made to accept having less of one thing in order to get more of something else, the results are called tradeoffs. Evaluating tradeoffs — when done carefully and systematically — involves comparing the costs and benefits of each of the available alternatives with each other.

In the hypothetical above, Syracuse has the highest total benefit and scores high on eight of the nine criteria. It has just one minor tradeoff, a middling score related to “Major.” In short, Syracuse provides a lot of benefit for just a small cost. Villanova

scores second highest on total benefit but that high score comes with four costs: it scores very low on “% Grads Employed” and low to middling on “Facilities,” “Major,” and “Food.” SUNY Binghamton scores second lowest in total benefit. Its two moderate benefits, “% Grads Employed” and “Major,” require accepting significant costs: two criteria score lowest; four score middling. LeMoyne scores fourth on total benefit and comes with significant costs related to “Major,” “% Grads Employed,” “Food,” and “Clubs.” Temple scores lowest on total benefit and has no individual benefits relative to the other five schools. Colgate’s third highest total benefit score and high scores on five criteria come with three costs: “On-time grad,” “Distance” and “Social Life.”

The beauty of the weighted criteria matrix is that it allows you to see the trade-offs explicitly and to explore them easily. You can begin to understand the cost and benefits of each option. Based on the hypothetical analysis, Syracuse, Villanova and Colgate are the top three choices. And we can easily see the different cost-benefit calculus that comes with each school based on the tradeoffs.

Value = (Benefit/Cost)

Value = Total Benefit/Cost ($)

In other words, you can ask, What is the benefit per dollar spent delivered by each option? This changes the picture completely. In the hypothetical example, SUNY Binghamton — previously the second lowest scorer — is now the highest scorer. Its extremely low annual cost (less than half of Syracuse, Villanova or Colgate) makes it the highest value. At SUNY Binghamton, each $1000 spent buys 76 benefit points. In contrast, at Syracuse and Le Moyne each $1000 spent only buys 45 benefit points; Villanova and Temple, 42 points; and Colgate, 37 points. This makes the decision even more informed and — perhaps — wrenching. Is it worth abandoning SUNY Binghamton, the highest value option, and paying a premium of more than 50% to gain the added benefits of a Syracuse or Villanova? These are critical questions. But having completed the cost-benefit analysis, at least you are now informed enough to ask them.

For your convenience, you can download a working spreadsheet to complete the entire analysis above.

Value = (Benefit – Cost)

Value = Total Benefit – Cost ($)

This approach requires normalizing the Benefits and Costs columns so that these two unlike numbers can be can be added or subtracted. In the table right, Prism’s Group Decision Support System™ has normalized the numbers where the column’s mean = 100. This formula produces the same results as the one above. The higher benefits delivered by Syracuse, Villanova and Colgate cost more than they are worth. The lower benefits of SUNY Binghamton are worth more than they cost. (If this approach is of interest, please see this help file describing how to normalize in Excel.)

Completing a cost-benefit analysis will take some of your time and effort. That cost will return these benefits: an understanding of each option’s total benefit, inherent trade-offs and relative value. Armed with that information, you will more confidently select the highest value option. And that is not a bad return on your investment.

Credits: Thanks to George Land. Tom McNamee and Andrew Tait for years of insights related to cost-benefit calculations.

Source: www.prismdecision.com

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