Cost-benefit analyses are used to assess the attractiveness of investments
Investments or single business cases need to be evaluated based on a certain set of criteria. Since financial performance is the key criterion in most cases, you need to have an idea about future financial impacts. A key tool to assess this impact is the cost-benefit analysis, which is used to determine the net effect of potential revenues and costs. In case of multiple options this net effect can be considered as opportunity costs of an option.
A thorough cost-benefit analysis of all available alternatives is the foundation of every decision
Solving a case is a lot about coming up with hypotheses and then testing your ideas. If you have several ideas, you have to base your decision on analyses. A cost-benefit analysis helps you evaluate your ideas with respect to 1) feasibility and 2) relative attractiveness (comparisons, benchmarking).
- The feasibility analysis covers quantitative and qualitative aspects:
- The quantitative aspect: Check the consequences of your decision quantitatively. E.g., determining number of customers or prices, leading to calculation of revenues and costs, and the corresponding profitability of the idea.
- Qualitative aspect: This might be more important in the final decision making. E.g., culture of the firm. Remember that even though it is more critical to quantify the business idea/decision in terms of profitability, you must not ignore the qualitative aspects, which often give insights about the implementation of decisions/ideas.
- Relative attractiveness is extremely crucial. Evaluate various options using a cost-benefit analysis, compare them all and pick the most attractive one in terms of financial benefits and risks (qualitative aspects).
From a financial aspect, although it is usually neglected as it mathematically complicates the case solution, you can make your analysis more precise by applying the discounting concept on future income or cost streams. This is especially appropriate in case of highly volatile streams that occur in a distant future. In such cases, the net present value as output of your cost-benefit analysis is the best metric to base your decision on.
Apply the cost-benefit concept in every case, in which you need to make decisions
The cost-benefit framework is the basic tool for valuation and M&A cases and you probably already apply it intuitively here. In addition, it works well for questions with a broad array of possible solutions. For example, “how can we achieve more revenue/growth”-questions, market entry cases, new product cases, among others. This way, you transform the question into a profitability case.
Example: You have an ice-cream parlor and now you are looking for further revenue options.
Among other options, one is to use an ice cream truck. Assume the truck is used during the summer season of about 5 months or 150 days.
- Use a cost-benefit analysis as a framework to check feasibility and compare options.
- Use quantitative and qualitative costs-benefit analyses to show competency in both aspects.
- If you have time left, try to quantify qualitative data.