When managing a project, one is required to make a lot of key decisions. There is always something that needs executing, and often that something is critical to the success of the venture. Because of the high stakes, good managers don’t just make decisions based on gut instinct. They prefer to minimize risk to the best of their ability and act only when there is more certainty than uncertainty.
But how can you accomplish that in a world with myriad variables and constantly shifting economics? The answer: consult hard data collected with reporting tools, charts and spreadsheets. You can then use that data to evaluate your decisions with a process called cost benefit analysis (CBA). An intelligent use of cost benefit analysis will help you minimize risks and maximize gains both for your project and your organization.
What Is Cost Benefit Analysis?
Cost benefit analysis in project management is one more tool in your toolbox. This one has been devised to evaluate the cost versus the benefits in your project proposal. It begins with a list, as so many processes do.
There’s a list of every project expense and what the benefits will be after successfully executing the project. From that you can calculate the return on investment (ROI), internal rate of return (IRR), net present value (NPV) and the payback period.
The difference between the cost and the benefits will determine whether action is warranted or not. In most cases, if the cost is 50 percent of the benefits and the payback period is not more than a year, then the action is worth taking.
The Purpose of Cost Benefit Analysis
The purpose of cost benefit analysis in project management is to have a systemic approach to figure out the pluses and minuses of various paths through a project, including transactions, tasks, business requirements and investments. Cost benefit analysis gives you options, and it offers the best approach to achieve your goal while saving on investment.
There are two main purposes in using CBA:
- To determine if the project is sound, justifiable and feasible by figuring out if its benefits outweigh costs.
- To offer a baseline for comparing projects by determining which project’s benefits are greater than its costs.
The Process of Cost Benefit Analysis
According to the Economist, CBA has been around for a long time. In 1772, Benjamin Franklin wrote of its use. But the concept of CBA as we know it dates to Jules Dupuit, a French engineer, who outlined the process in an article in 1848.
While it’s not clear if this Founding Father followed this exact process, it has evolved to include these 10 steps:
- What Are the Goals and Objectives of the Project? The first step is perhaps the most important because before you can decide if a project is worth the effort, you need a clear and definite idea of what it is set to accomplish.
- What Are the Alternatives? Before you can know if the project is right, you need to compare it to other projects and see which is the best path forward.
- Who Are the Stakeholders? List all stakeholders in the project.
- What Measurements Are You Using? You need to decide on the metrics you’ll use to measure all costs and benefits.
- What Is the Outcome of Costs and Benefits? Look over what the costs and benefits of the project are, and map them over a relevant time period.
- What Is the Common Currency? Take all the costs and benefits you’ve collected, and convert them to the same currency to make an apples-to-apples comparison.
- What Is the Discount Rate? This will express the amount of interest as a percentage of the balance at the end of a certain period.
- What Is the Net Present Value of the Project Options? This is a measurement of profit that is calculated by subtracting the present values of cash outflows from the present values of cash inflows over a period of time.
- What Is the Sensitivity Analysis? This is a study of how the uncertainty in the output can be apportioned to different sources of uncertainty in its inputs.
- What Do You Do? The final step after collecting all this data is to make the choice that is recommended by the analysis.
How to Evaluate the Cost Benefit Analysis
The data you collected is used to help you determine whether the project will have a positive or negative consequence. Keep the following things in mind as you’re evaluating that information:
- What are the effects on users?
- What are the effects on nonusers?
- Are there any externality effects?
- Is there a social benefit?
It’s also important to apply all relevant costs and benefits commonly. That is, the time value of the money spent. You can do this by converting future expected costs and benefits into current rates.
Naturally, there is risk inherent in any venture, and risk and uncertainty must be considered when evaluating the CBA of a project. You can calculate this with probability theory. Uncertainty is different than risk, but it can be evaluated using a sensitivity analysis to illustrate how results respond to parameter changes.
How Accurate is Cost Benefit Analysis?
How accurate is CBA? The short answer is it’s as accurate as the data you put into the process. The more accurate your estimates, the more accurate your results.
Some inaccuracies are caused by the following:
- Relying too heavily on data collected from past projects, especially when those projects differ in function, size, etc., to the one you’re working on
- Using subjective impressions when you’re making your assessment
- The improper use of heuristics (problem solving employing a practical method that is not guaranteed) to get the cost of intangibles
- Confirmation bias or only using data that backs up what you want to find
Are There Limitations to Cost Benefit Analysis?
Cost benefit analysis is best suited to smaller to mid-sized projects that don’t take too long to complete. In these cases, the analysis can lead those involved to make proper decisions.
However, large projects that go on for a long time can be problematic in terms of CBA. There are outside factors, such as inflation, interest rates, etc., that impact the accuracy of the analysis.
There are other methods that complement CBA in assessing larger projects, such as NPV and IRR. Overall, though, the use of CBA is a crucial step in determining if any project is worth pursuing.
Cost benefits analysis is a data-driven process and requires a project management software robust enough to digest and distribute the information. ProjectManager.com is a cloud-based project management software with tools, such as a real-time dashboard, that can collect, filter and share your results in easy-to-understand graphs and charts. Try it today with this free 30-day trial.