Cost benefit analysis is a tool for evaluating the outcome/desirability of a decision by weighing the total estimated cost against the total expected benefit of one or more option. The costs and benefits are assessed in terms of the individual's/organization's willingness to pay for the benefits or pay to avoid costs. In its simplist form this tool says, if the financial benefits out weigh the costs then the option is worth proceeding with.
When you first look at cost benefit analysis it appears to be a straight forward idea. However, in practice calculating measures of costs and benefits over the lifetime of a project can be very difficult. For example to more accurately reflect costs not only are the costs of a proposed option calculated but also the cost of not being able to do the next best option (the opportunity cost of the option). Similary, to calculate costs and present them fairly with respect to time a discount rate is chosen. This is then used to calculate all future costs and benefits and present them in present-value terms.
Business organizations tend to focus their cost benefit analysis on the rate of return indicator. While government agencies rely on a range of indicators such as:
NPV (net present value)
PVB (present value of benefits)
PVC (present value of costs)
BCR (benefit cost ratio = PVB/PVC)
Net benefit (= PVB - PVC)
NPV/k (where k is the level of funds available)
Example: Cost Benefit Analysis for a project to sunset an old software service product and migrate customers to its replacement.
Cost of migrating customers from the old to the new service $100,000
Cost of shutting down the old service's hardware $80,000
Cost of additional enhancements and capacity for the new service $200,000
Total costs = $380,000
Customers benefit from using the latest service and so $200,000 revenue loss is avoided
By migrating to new service the $250,000 cost of having to replace the old service's hardware is avoided
Maintaining two services result in an additional $60,000 in support costs
Maintaining two services results in configuration and support errors. These errors result in $50,000 revenue loss
Data center power and space will be freed for use by other services $40,000
Total benefits = $600,000
Pay back period = $380,000 / $600,000 = 0.63 years