The Benefit and Cost of Information
Cost-benefit analysis Opens in new window applies to all types of planning decisions. One planning decision is whether to choose to gather further information before making another planning decision. The manager may ask for another accounting report or a marketing survey.
Once again, a cost-benefit analysis Opens in new window is appropriate. If the benefit of further information is greater than the cost, the additional information should be produced or purchased. The problem is measuring the cost and benefit of the information.
- The cost of more information includes the cost of acquiring, modifying, communicating, and analyzing the information.
- Resources, including cash and employee time, are used in the process.
Each of these resources has an opportunity cost Opens in new window. In addition, costs can be incurred by delaying the decision until more information is received and analyzed.
If reading the Wall Street Journal (WSJ) leads to better investment decisions, then the WSJ has a benefit. If reading the WSJ does not change any decisions, then the WSJ has no benefit as an information system.
The differential benefit of new information is the difference between the expected benefit of making a decision with the new information and the expected benefit of making the decision with existing information.
For instance, you can choose an MBA program without further information. But information on the quality and nature of alternative MBA programs would be beneficial in deciding which MBA program is best for you.
Consider, for example, Ken Hwang, who is choosing among MBA programs for the upcoming year. Ken believes that an MBA degree will increase his future career opportunities, as well as his salary.
He has been accepted into two schools, Eastern and St. Margaret’s. Both charge similar tuition and fees. However, the two MBA programs differ on other dimensions.
- Eastern delivers its full-time program over 12 months, while St. Margaret’s offers flexible, part-time studies.
- Faculty reputation, class size, and international focus are other areas in which they differ.
While Ken prefers small classes, he considers faculty reputation and international experience to be more important. Therefore, he will make his final choice based on an analysis of these two factors Opens in new window.
Ken does not have much time to decide or much money for an extensive search. He plans to visit the websites of both programs for further information, as an Internet search is low cost and timely.
The particular decision being made also affects the benefit of additional information. A weather report is unlikely to have much value in selecting an investment, but is likely to improve the choice of whether to have a picnic or to go jugging.
In doing a cost-benefit analysis for information choice, the decision context must be known.Information that improves more than one decision is likely to be more valuable. In designing its decision-making system, firms should design the system that provides the greatest benefit for a large number of decisions. The ability of a decision-making system to satisfy the demands of many users increases its benefit.
Numerical Example
UK pharmaceutical firm is about to mix a batch of a drug. There is one-in-five chance of the batch failing due to bacterial contamination.
This risk can be reduced to one in seven, if a £5,000 diagnostic test is performed first. If the batch is started but scrapped due to the bacterial contamination, the loss to the firm is £25,000.
Solution
- If the firm does not spend the £5,000 to gather information about the presence of the bacteria, the expected loss is 1/5 (-£25,000) + 4/5(£0), or - £5,000.
- If the firm spends the £5,000, the expected loss is 1/7 (-£25,000 - £5,000), or -£8,573.
The expected loss when the test is undertaken is greater than the expected loss of not performing it.
Therefore, the test should not be performed as the expected benefit from gathering this additional information exceeds the expected cost.