Cost-Benefit Analysis

Learning to Use Cost-Benefit Analysis

Decisions in businesses should be made after a careful analysis of benefits and costs.

Cost-benefit analysis is the process of analyzing alternative decisions to determine which decisions has the greatest expected benefit relative to its cost.

We all informally use cost-benefit analysis in making day-to-day decisions. For example, a common decision may be whether to ride your bicycle or drive your car to campus.

The benefit of riding a bicycle is more exercise, but the cost is longer travel time and possibly the need to take a shower after arriving at school.

The benefit of driving is a shorter commute time, but the cost is the gasoline, and payment of parking fees or fines. Some uncertainties also exist. For example, the probability of rain, an accident, or a traffic jam should affect the expected benefits and costs of travelling to campus.

To make a decision, you identify, measure, and compare the expected benefits and costs of each alternative and choose the alternative with the greatest net benefit (total benefits less total costs).

Managers or entrepreneurs Opens in new window should use cost-benefit analysis to make planning decisions, but the benefits and costs are not always identified and measured.

One method of avoiding the measurement of all the benefits and costs of each alternative is to compare only those costs and benefits that differ among the alternative decisions.

The difference in benefits is known as the differential benefit and the difference in costs is known as the differential cost.

A comparison of the differential benefits and costs will lead to the same decision as a comparison of all the benefits and costs because the remaining costs and benefits are not affected by the decision. For example, in 2013 hmv Canada Opens in new window decided to launch its own digital download and streaming music service, The Vault.

This move was a strategic response to the decline in in-store sales, growing market share and demand for music access in this format, and the emergence of strong market competitors offering digital downloads. It also reflected the firm’s strong brand image in Canada in terms of matching its offerings to customer preferences.

The differential benefit of launching the digital service was the increased sales from Internet traffic, the improved quality of customer information gathered from the Web, and the ability to link online and retail sales to provide a customized sales experience.

The differential cost of launching the service was the cost of building this technology into existing websites and its retail operation, the cost of hiring extra staff to maintain service, the cost of purchasing new computer hardware and software, and the potential impact of the digital sales on other music formats.

In summary, hmv Canada should have launched the digital service as long as the differential benefit exceeded the differential cost.

The remaining benefits and costs generated by hmv Canada were irrelevant to the website decision, since they were the same whether it decided to launch the digital service or not.

Numerical Example 1

The manager of Kemp Sports must decide whether to rent only mechanical or only manual stringing machines for the squash racquets that it manufactures.

The rental cost for a mechanical stringing machine is $100 per hour and the rental cost of a manual stringing machine is $10 per hour.

The cost of electricity for a mechanical stringer is $8 per hour. Labor cost is $14 per hour. Kemp must produce 120 tennis racquets per hour to meet customer demand.

To produce 120 racquets, either two mechanical or 12 manual machines are required. The other manufacturing processes are not affected by the choice of stringing machines.

Solution

The rest of Kemp Sports is not affected by the choice of stringing machines and the revenues will be the same with a sufficient number of stringing machines (two mechanical or 12 manual).

The decision, therefore, hinges on the differential costs of the two types of machines. The differential costs for each type of machines are:

Type of CostManual MethodMechanicalDifference
Rent(12 hr. x $10) = $120(2 hr. x $100) = $200-$ 80
Labor(12 hr. x $14) = $168(2 hr. x $14) = $ 28+$140
Electricity(2 hr. x $8) = $ 16-$   16
Totals$288$244$   44
The mechanical method results in lower costs and is the preferred choice.

The decision, however, overlooks possible qualitative costs and benefits of this choice, such as the effect on quality and employee morale.

Even with differential costs and benefits, not all costs and benefits can be easily identified and measured when performing cost-benefit analysis.

Problems in Identifying and Measuring Benefits

The benefits of making a particular decision depend on the goals of the organization.

The achievement of some goals is not easily identified and measured. For example, most automobile dealerships have the goal of customer satisfaction.

When you purchase a new vehicle, you receive a survey from the dealership inquiring if you are satisfied with your new car and the services provided. Since many buyers never return these surveys, the measurement of customer satisfaction is not necessarily accurate.

Benefits to organizations are often measured in terms of cash inflows; yet the cash inflow from a decision is not always known and must often be estimated.

For example, the benefit of introducing a new product would be estimated by forecasting future sales.

These cash inflows occur in the future; therefore some uncertainty in measurement exists. Also, cash flows from different time periods should be adjusted for the time value of money before they are accumulated.

Not all the benefits of a decision have immediate monetary implications. Benefits, such as training and development, a better work environment and increased employees satisfaction, are difficult to identify and measure in financial terms. These benefits have monetary consequences in later years.

In 2004, Air France and KLM merged to create the Air France-KLM group with an emphasis on coordinating its flight operations instead of completely integrating the two airlines.

In making this decision, the executives of each airline attempted to measure the benefits of the merger.

Some benefits are obvious.

A merged airline would bring reduced maintenance costs through combined services, and greater bargaining power with suppliers, including aircraft purchases.

Other benefits, however, are less direct.

By merging, the new airline group had access to two airport hubs, Amsterdam Schiphol and Paris-Charles de Gaulle. It also had a wider range of routes to offer passengers.

The executives believed that a merger would secure a competitive advantage over its rivals, enabling the new firm to become a pan-European market player and a global industry leader.

These benefits are more difficult to measure. The costs of this merger are discussed as follows.

Problems in Identifying and Measuring Costs

Costs are the use of organizational resources, and are easy to identify and measure when cash is the resource being used. For example, the purchase price of a new car is easily identified and measured in monetary terms.

Some costs, however, do not have immediate or obvious monetary implications. For example, requiring employees to work overtime may adversely affect employee morale and have long-term cost implications, such as increased staff turnover and greater difficulty in attracting new employees.

Measuring the cost of using non-cash resources is also a problem. For example, what is the cost of using raw materials in inventory?

Possibly answers include the purchase price (historical cost), the current market price, or the future replacement cost.

What is the cost of using the current labor pool or facilities?

Once again, numerous possible answers exist. The next post introduces the concept of opportunity cost to address these questions.

In the case of Air France-KLM, some cost estimates are not easy to calculate.

The two airlines had different organizational cultures Opens in new window. Each was strongly identified as the national ‘flag’ carrier.

It would be difficult to estimate the impact of the merger on staff morale and on the citizens of France and the Netherlands, especially as it could become an emotional issue for both staff and passengers.

Information technology and reservation systems needed to be integrated; yet determining accurately the cost to do so is not straightforward, given the complex nature of these systems and the potential downside if the integration were delayed or poorly achieved.

The merged airline has continued to adapt its strategic plans due to market uncertainties and increased competition, implementing cost-reduction and additional restructuring initiatives to improve its bottom-line performance.

For example, the merger of United and Continental Airlines and subsequent integration problems generated a 2012 loss of $723 million.

Switching to a single passenger-information system created problems with its website and frustrated customers and customer service agents who struggled with the software, thereby creating long lines at airports.