Cost-benefit analysis

Cost-benefit analysis looks at proposed transactions from an economic viewpoint, comparing the cost of the improvement to the benefits derived from the improvement. At the very least, business wants the economic benefits of the improvement to be greater than the cost of the improvement. In American businesses, supervisors and managers ask their superiors for money to purchase more supplies, new equipment, additional employees, and a variety of other reasons. Money, however, is a scarce resource, and, usually, the total amount of money requested is greater than the money available to be spent. Higher level managers must evaluate the spending requests and decide which ones to approve. Cost-benefit analysis is a frequently used technique to evaluate spending requests. For instance, if production levels can be increased by 60 percent with the purchase and installation of new automated manufacturing equipment and the cost of the equipment is $100,000, the return to the company must be $100,000 before there is a breakeven point. If the company cannot earn a good financial return on the expenditure, then it may decide to leave the money in the bank to earn interest or spend it on other projects with a higher rate of return. Companies often set standards for the desired rate of return for an expenditure. If that standard is 2.0, then the improvement must generate economic returns that are twice its cost in the first year of operation. This introduces the term payback. If an improvement generates returns of twice its cost in a year, then the improvement has paid for itself in six months. The returns earned during the second six months of operation are incremental profits to the company. Companies are more willing to spend money for improvements with shorter payback times than longer. Cost-efficiencies are related to be both cost-benefit analyses and payback period. When a manager compares different potential improvements that have the same potential benefit, he/she should select the improvement that has the lowest overall cost. This results in requesting the improvement with the greatest cost-efficiency and, similarly, the shortest payback period. Determining the lowest overall cost is important because it goes beyond the immediate purchase price and includes additional considerations, such as projected life of the machine, equipment reliability, and potential cost of repairs. When costs are incurred initially with benefits expected to be realized over a longer period of time, present value analysis is used to adjust costs and benefits into the current time period. Cost-benefit analysis is an important consideration, but not all purchase decisions are primarily driven by economic factors. Improvements may be authorized to assure a safe work place, free of recognized hazards or to protect the environment from pollution.
See also DISCOUNTING, PRESENT VALUE.
John B. Abbott