Companies often need to weigh one project against another to make business decisions. They need to evaluate all potential costs and revenues that can be generated from a project. The outcome of the analysis determines whether the revenue generated is sufficient to cover costs or the company should go for another financially feasible project. A cost benefit analysis is a methodology used by companies to estimate the likely costs and benefits of potential projects. Many companies also consider the opportunity cost into the decision making process. It helps companies to analyze alternative benefits that could have been realized when choosing one alternative over another.
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Importance of Cost Benefit Analysis in Decision Making
Simplifies complex business decisions
A cost benefit analysis template allows businesses to simplify complex business decisions. Companies might entail a variety of expenses in different types of projects at a low level. Performing cost benefit analysis allows companies to measure the benefits of a decision (benefits of taking action minus the costs associated with taking that action). It involves measurable financial metrics such as revenue earned, and costs saved as a result of the decision to pursue a project. This helps businesses to compare different projects based on net benefits irrespective of dissimilarities.
Provides a basis for rational comparison
This is one of the major benefits of performing a cost benefit analysis. With plenty of investments around, companies at times find it difficult to select the best alternative. Businesses who have invested time in projects may be predisposed to pursue those projects despite the availability of financially viable projects. Cost benefit analysis helps businesses to pick through available options, rank projects according to the order of their merit, and overcome biases for the good of the business.
Estimates the net benefit of a project
Predicting benefits is more difficult than predicting costs. Investment opportunities are many but resources at disposal are finite. For instance, a company might estimate the production cost, but it is difficult to predict the profit margins of any new product going on the market. However, estimating costs and benefits can help businesses get an idea of the lowest revenue a new project needs to produce to ensure the profitability of the project. Being aware of the Opportunity Cost or the next best alternative can help businesses if in case the desired revenues are not produced.
Estimating the net benefit and opportunity cost of a project can help you choose a financially viable project. Request a free demo of our procurement platform to gain exclusive insights into cost benefit analysis steps.
Improves credibility by performing sensitivity analysis
Situations might vary and change the estimated outcome. Sensitivity or “what if” analysis can be instrumental in improving the credibility of a cost benefit analysis. It is predominantly used when there is ambiguity over the discount rate. Companies can re-run the analysis with the possible values to test the sensitivity of the cost benefit analysis model.