As the economy grows, business owners and managers might find themselves in the fortunate position of having enough profit to reinvest back into their enterprises. Using retained profits rather than giving them to owners and shareholders is a fairly safe low-risk option. Voting procedures will need to be followed and the proposals officially agreed by all the stakeholders and shareholders who might have been looking forward to their dividend cheque.
Another way of funding new projects is through an injection of funds into the enterprise from an external source. This may come from shareholders, bank loans or other third-party investors, and involve costs such as interest, a percentage of future profits or shares.
However a new project is funded, it is important to ensure that it will improve the bottom line and that it is not based on vanity, unrealistic hopes or wishful thinking. A cost-benefit analysis can be used to look in detail at how the cost of a course of action will be outweighed or balanced by its benefits. It is an essential tool for managers to identify how an action, involving a financial cost, will bring increased benefits to the enterprise.
Benefits versus costs
In simple terms, a cost-benefit analysis weighs up the benefits of a course of action or decision against the costs of implementing that action or decision. It can be used for a wide variety of actions - from building a production glasshouse, purchasing plant and equipment in a landscaping company to employing a marketing assistant in a garden retail establishment. It should even be used by middle or junior managers to help with decision-making.
A cost-benefit analysis is easier when there are tangible benefits - for example, installing a security system in a garden centre should reduce theft and this is measurable by a reduction in shrinkage. Increasing production of a best-selling plant can be measurable by greater sales income and automating a manual process by purchasing equipment can be measured by a reduction in the labour bill.
Sometimes, however, the benefits might be intangible. This is where the cost-benefit exercise becomes harder but equally important. Intangible benefits include things such as staff morale, a better image, and increased PR opportunities.
It is important to identify all the costs of a project. The total cost of an action encompasses everything, from production to the time consumed and the opportunity cost - the cost of opportunities missed and not pursued - of the forgone activities. Even while reading this article you have incurred an opportunity cost by not perusing another activity, although the benefits to your business in the future will of course outweigh those costs.
Accuracy is paramount
The main point to remember is that all of the costs and benefits will need to be predicted with a high degree of accuracy. Getting the cost-benefit analysis as precise as possible will help you to make a decision but it will not remove all uncertainty - that will still exist. Welcome to the world of entrepreneurship.
Hopefully you are convinced of the need to do a cost-benefit analysis for decisions involving more than a minor outlay. Following the steps listed below will make the process as effective and painless as possible:
Step 1 Define the unit of cost that you want to use. In most instances this will be a literal cost in terms of cash, but it might also mean measuring hours saved or energy saved, all of which will result in a literal cash saving anyway.
Step 2 List all the tangible costs of the course of action. For example, purchasing a new vehicle has a host of tangible costs - the cost of purchasing (or cost of finance), the cost of routine maintenance, the daily operating cost of fuel, the cost of insurance and tax etc.
Step 3 Identify the intangible costs associated with the course of action. For example, building a new extension to a dispatch yard might have an intangible cost by reducing efficiency in that operation while the construction is ongoing. This is the harder part but still needs to be considered. Also consider opportunity costs here. What alternative uses for the money might you now have to sacrifice?
Step 4 Focus on the benefits of the course of action. These are calculated in the same way as the costs and of course include tangible benefits such as, in the case of purchasing a new vehicle, a reduction in fuel consumption or intangible gains such as a better image among your customers. The problem here is that in some cases the predicted benefits are less reliable than the costs.
Step 5 Once the project's costs and benefits have all been assessed, you can add up and then compare them. This enables you to determine whether the benefits outweigh the costs. To compare the costs and the benefits, simply subtract the ongoing costs from the ongoing benefits and then add up all the one-time costs. This gives a sense of the size of the initial investment needed to start the project. Using this information, you should be able to determine whether a project is profitable and feasible.
Assess project suitability
This simple process can be used by owners and managers alike to identify the suitability of a project or planned capital expenditure - essentially, it stops people from making an ill-informed decision based on a gut reaction. It also stops purchasing decisions being made on a whim and, even if you can afford to make the proposed investments and you are awash with cash, recent economic events have shown that it is best to be prudent.
Finally, it is also worth calculating the payback time for your investment. The quicker that your planned investment can pay back the returns identified in the cost-benefit analysis, the better for your business. To do this, simply divide the cost of your initial investment by the projected income per day or week to determine how many days, weeks, months or years it will take to earn back the initial investment and start bringing in profit.
How often have you looked back at a decision and asked was it worth it? The question is easy to answer when all the data and consequences are there. Ironically, it is also at this point when little can be done about it had they not been known. We need to change our thinking in business and become more proactive, asking "will it be worth it?" much more often, even if calculating the answer at this stage takes more work and effort and a little more of our time. Doing cost-benefit analyses will cost us less in the end.
Neville Stein is managing director of business consultancy Ovation