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Cost-benefit analysis techniques are a common business activity owners and managers use to assess various projects. These techniques essentially compare the total capital investment for the project against its potential returns. Several techniques are available, with the most common being the payback period, net present value, and rate of return. Companies can use one or all of the cost-benefit analysis techniques. The assessment occurs after the company has all necessary information and prior to investing capital into one or more of the projects.
The payback period is generally the simplest of all cost-benefit analysis techniques. The method uses all the same information as the other techniques, except the calculation process is quite different. First, a company must compute all costs associated with a project. This includes investment in fixed assets, costs for employees, and lost production time for training or implementation. Second, the company divides the total for all these costs by the potential financial returns, resulting in the time it will take for the project to pay for itself.
The net present value technique is a bit more technical than the payback period. The cost accumulation process is the same as the payback period. The company then uses the cost of capital associated with outside funds to pay for starting the new project. The estimation of future financial returns is also the same as the other cost-benefit analysis techniques. A financial manager will discount the total future financial returns using the company cost of capital to determine if the current value of the return is higher than the investment’s cost.
The rate of return is a common method a company can use for single or small investments. The basic formula for this process is the total gains from the investment less its total associated costs. Dividing the difference between these two items by the investment’s cost produces a percentage return. Owners and managers use this percentage to determine if the investment is a worthwhile use of capital. Rate of return may be a hybrid method among different cost-benefit analysis techniques as companies can compare the return percentage to the cost of capital.
Companies may also use other cost-benefit analysis techniques. These techniques essentially all test the same information. The purpose of using different techniques, however, is to determine which one provides the most accurate information. Financial members may use multiple analysis formulas for different projects. The purpose behind this is to match a formula to the information on hand so the company will be able to accurately assess various projects.
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