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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).

  1. 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.
  2. 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 take 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.

Key takeaways

  • 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

Try a case and apply a cost-benefit analysis: Paper Print or Rally racing

4 Comment(s)
November 20, 2015 22:22 -
Chad

You seem to be double counting the value of the advertising. I.e., you take the benefit of saving on the billboard, as well as the benefit of the resulting traffic due to the advertising on the truck. I assume that if you take the first benefit, you are stating that you would have invested in billboard advertisement if you did not have the truck. Therefore, the resulting foot traffic would be there regardless, as you will advertise one way or the other. This begs the question, though: why spend $2000/mo on advertising to bring in $240/mo in additional profits?

May 12, 2015 05:48 -
Dave

Regarding the ice-cream case, I think it would also be interesting to look at the cannibalization of in-store sales when using an ice-cream truck. The extra revenue being generated by the truck might actually stem from customers who would've otherwise visited the parlor.

May 08, 2014 15:13 -
Jan

Hi Thomas,
The cost of the truck is in the position "truck cost/season". This is basically the depreciation, if you sum up the $5000 over 10 years, you'll reach exactly the price of the truck. So the final profit stays at $5400/season

May 07, 2014 19:34 -
Thomas

Is it understood correctly that according to this the total profit from this is around $5400/season?
This would result in a total profit after ten year of $54000 - $50000 (Truck costs, 10 years usage) = $ 4000. Using a 2 % discount rate this have a PV = $3281. Doesn't seem to be a good use of $50000...

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