What Is a Cost Analysis? (And How to Analyze Cost Benefits)
Updated September 30, 2022
A cost analysis is the business process of comparing different costs to gain insight into the benefits of various forms of spending. Companies usually analyze their costs by performing a cost-benefit analysis to determine whether a project's benefits outweigh its expenses. Understanding the types of costs that organizations analyze, and how to perform a cost-benefit analysis, is key to evaluating the worth of business costs accurately and effectively. In this article, we define cost analysis, explain when to use one, provide steps for performing a cost-benefit analysis, and provide an example to help you learn more.
What is a cost analysis?
A cost analysis is a comparison of expenses, usually to determine whether costs are beneficial to a business. The most common use for this type of expense analysis is a cost-benefit analysis, which reveals whether a cost can give a business a high ROI, or return on investment. A high ROI means that the company receives more value than the money it spent on a particular investment. For instance, if a business spends $1000 on placing an advertisement in a local newspaper, which results in a $2000 increase in profit, that's a high ROI.
The focus of analyzing these costs is to determine whether an expense is likely to have beneficial results. This might be a high ROI in terms of profit or the company achieving other business goals. Costs broadly fit into two categories, variable and fixed. Variable costs are those which change with fluctuations in the business's activity levels, whereas fixed costs don't vary with the output of the company and remain the same. Below is a description of each of these cost types:
Fixed costs are those which occur once and remain the same throughout the cycles of a business. They don't respond to changes in its activity levels, commercial output, or goods or services produced. For instance, fixed costs can be expenses, such as rent, salaries, advertising, or insurance costs.
Variable costs are those in which the total costs vary in relation to the business' activity. For instance, suppose an ice cream factory purchases milk to make its product. This milk is a variable cost, as the total cost to the business is variable dependent on the amount of ice cream it produces. If the factory has a low level of activity, only producing 1000 units, the cost of milk to the company is much lower than if it were to produce 20,000 units. You can determine the total variable cost with the following formula:
total variable cost = total output quantity x cost per unit of output
When to use an analysis of costs
It can be useful to analyze business costs when trying to determine if a cost may result in a benefit to the company. Analyzing a range of costs for a business can help teams and their leaders make decisions in a variety of sectors, including finance, government, software development, IT, education, and health care. Project managers often use analysis of their costs to determine the most advantageous course of action for their projects based on the cost benefits each option offers.
This cost-benefit analysis is a fundamental tool to determine the value of a potential outcome of a cost. You can even use a cost-benefit analysis to inform personal decisions, such as renting an apartment or buying a car. Here are some situations in which a company may use a cost-benefit analysis:
Comparing the benefits of different projects
Developing a new business strategy
Considering changing a business process
Assessing a new employee
Considering establishing a program
Deciding whether to expand sales to a new region
Deciding whether to make a purchase
Deciding whether to expand a business's space
Deciding whether to relocate an organization
Assessing investment opportunities
How to use a cost-benefit analysis
The simplest way to perform a cost-benefit analysis is to subtract a cost from the value of its benefits. Here, a positive result represents a profit. To do a more comprehensive analysis of the benefits or effects of a decision, there are a few more necessary steps. Below are nine steps required to perform a cost-benefit analysis:
1. Outline the project
To begin a cost-benefit analysis, you can establish the basic parameters of the decision to be made. This may be a discussion of the problem the project is aiming to solve, and a detailed description of how the solution solves it. Discussions of this sort help to establish the value of the project, who bears the cost, and the nature of the benefits. Through this step, you can outline the project's potential affects to all relevant team members and stakeholders.
2. List the project costs and benefits
To perform a cost-benefit analysis, the next step is to list a project's or decision's benefits and costs. The costs of a project can include physical resources, money, labour, training, or effort. Benefits of a project may be quantifiable financial benefits, or quality benefits, such as employee satisfaction, environmental protection, customer satisfaction, or health and safety. You can classify costs and benefits into the following categories:
Real: Real costs and benefits involve the raw materials and labour necessary to produce items.
Tangible: Tangible benefits and costs are easy to measure and quantify in terms of monetary value. They're identifiable and clear, such as rent, purchases, and payroll.
Intangible: Intangible costs and benefits are more subjective and non-monetary, such as changes in customer satisfaction or productivity levels.
Direct: These costs and benefits relate directly to production, such as with a project, service, or product.
Indirect: These benefits and costs don't directly relate to production, as with security and administration.
3. Determine the values of costs and benefits
Once you've listed and categorized your costs and benefits, you can assign a monetary value to each to establish their worth. Arranging these in a table can make this step easier. Then, add the various costs to get a total of the project's costs, and do the same with its benefits. With costs, you can consider both unexpected and basic project costs. For benefits, it's wise to consult with teams about the best way to value intangible benefits. You can review similar projects and their mission and purpose for insight into the value of certain costs or benefits.
4. Compare project cost and benefits
The next step in a cost-benefit analysis is comparing costs and benefits. You can subtract the costs of a project from its benefits to determine how feasible it is, or whether the business can afford to complete it. The formula for this process is as follows:
project's worth = total benefits - total costs
If the net or overall value of a project is below zero, that indicates that the company spends more resources or loses more money than it gains. If the result is positive, this means that the project is likely to result in a profit for the business. By analyzing costs like this, you find a simple indication of the basic positive or negative value of the project or decision.
5. Calculate payback time
Lastly, when determining the true value of a project or decision, it's vital to calculate the payback time, which is the time it may take for the benefits of the project to repay the costs. This is also the breakeven point, when the benefits equal the costs. Once the project breaks even, the costs pay off the initial investment, and revenue may return a positive ROI. To calculate payback time, you can determine a project's potential revenue per time period, such as a year. Here's the formula for calculating payback time:
payback period = total costs / net annual revenue
When you know the payback period, or how many years before your project can incur profit, you and other stakeholders understand the project in a time-sensitive context. Investors may desire payback within a specified timeframe, so determining how long it may take to return an investment is essential. If you can prove with your analysis of costs that it's possible to make a profit within their preferred period, this tool can help you keep investors involved.
Example of cost-benefit analysis
Here's an example of conducting a cost-benefit analysis to help you learn more about the concept:
Richard is creating an e-commerce business where he sells a range of products. He's considering hiring a web designer to help him build his brand and increase brand awareness. This service costs $400 and is likely to improve customer traffic, increasing revenue by $950. Richard conducts a cost-benefit analysis:
$950 - $400 = $550
This means the project can incur $550 of profit. Richard decides that it's a project he wants to implement. Here, Richard's analysis of costs clearly indicates that this decision is beneficial, and represents a return on investment.
Explore more articles
- Communication in Organizations (With Benefits and Types)
- Variations On "As Per Our Conversation" (With Examples)
- 30 Ways to Say "It Was a Pleasure Working With You"
- How to Make a Lateral Move
- How to Advertise a Job (With Examples to Help You Write One)
- How to Insert a Line in Word (With Tips and Skills)
- Personal vs. Professional References: What's the Difference?
- What to Do on Days Off (With Tips for Using This Time Well)
- Types of Business Attire for Men (With Professional Tips)
- Cost Variance Analysis: What It Is And How to Compute It
- 15 Fun Part-Time Jobs for Retirees (With Average Salaries)
- Undergraduate vs. Graduate Studies: What's the Difference?