Definition: The cost benefit analysis (CBA) is a business decision-making approach that examines the pros and cons of pursuing a course of action.
What Does Cost Benefit Analysis Mean?
What is the definition of cost benefit analysis? The cost-benefit analysis is largely employed when estimating the cost of a transaction compared to the benefits derived, seeking to determine the optimum approach to achieve benefits. When it comes to monetary decisions, the cost-benefit analysis estimates the monetary value of the costs, and the monetary value of the benefits, and compares them to evaluate whether the decision is worth taking. To be comparable, though, all aspects of a project should be expressed in the same unit, most likely money.
Let’s look at an example.
Michael is a CFO in a software vendor that manufactures full enterprise software applications. He is asked to perform a cost-benefit analysis for the new software that the company is about to launch. So, Michael creates a spreadsheet as follows:
The sale price of the fully-developed software is $200,000, and Michael estimates an annual growth of 25% for the next five years. Hence, the benefits range from $0 in year o to $488,281 in the year 5.
The costs of the software development include $75,200 upfront costs in year 0 and $29,000 ongoing costs for the next five years.
Based on the total benefits and costs per year, the net cash flow of the software ranges between -$75,200 in year 0 and $459,281 in the year 5.
Then, Michael assumes a discount rate of 11% to estimate the discounted net cash flow. Given a discount factor of 100% in year 0 to 45% in the year 5, Michael calculates the discounted net cash flow, which ranges between -$75,200 in year 0 and $206,677 in the year 5.
Hence, the net present value of this project, i.e. the sum of the discounted net cash flows each year is $848,502. Based on the discounted net cash flows, the Internal Rate of Return (IRR) of the project is 213%.
Michael determines the project as profitable and signs on its launch.
Define Cost Benefit Analysis: Benefit-cost analysis means an examination of the relationship between expenses associated with taking an action and value gained from the action.