Do a Cost Analysis

A cost analysis (also called cost-benefit analysis, or CBA) is a detailed outline of the potential risks and gains of a projected venture. Many factors are involved, including some abstract considerations, making the creation of a CBA more of an art than a science, though a quantitative mindset is still a must-have. A CBA is useful for making many types of business and personal decisions, especially ones with a potential for profit (though this need not be the case). Although conducting a CBA can be a complex task, you do not need to be a business major to learn how to do so. Anyone who's willing to brainstorm, research, and analyze data can make a top-quality CBA.

Steps

  1. Define your CBA's unit of cost. Since a CBA's aim is to determine whether a certain project or venture is worth the cost it would take to enact, it's important to establish what exactly your CBA measures in terms of "cost" at the outset. Usually, a CBA measures literal cost in terms of money, but, in cases where money is not an issue, CBAs can measure cost in terms of time, energy usage, and more.
    • For the purpose of demonstration, let's design an example CBA in this article. Let's say that we run a lucrative lemonade stand on weekends in the summer and that we want to perform a cost analysis to see whether it's worth expanding to a second location on the other side of town. In this case, we're primarily interested in whether this hypothetical second location would make us more money in the long run or whether the costs associated with expanding would be prohibitively high.
  2. Itemize the tangible costs of the intended project. Almost any project comes with costs. For instance, business ventures require initial monetary investments to buy goods and supplies, train staff, and the like. The first step of a CBA is to make a thorough, exhaustive, itemized list of these costs. You may want to investigate similar projects to find costs to include on your list that you may not otherwise have considered. Costs can be one-time events or ongoing expenses. Costs should be based on actual market prices and/or research when possible, but should be intelligent, researched estimates when this is not possible.
    • Below are the types of costs you'll want to include in your CBA:
      • The price of goods or equipment associated with the venture
      • Shipping, handling, and transportation costs
      • Operating expenses
      • Staffing costs (wages, training, etc.)
      • Real estate (rented offices, etc.)
      • Insurance and taxes.
      • Utilities (electricity, water, etc.)
    • Let's make a quick itemized list of the costs our hypothetical new lemonade stand will require to launch:
      • Supplies in the form of lemons, ice, and sugar: $20/day
      • Wages for 2 stand attendants: $40/day
      • Good quality blender (for smoothies): one-time cost of $80
      • High-volume cooler: one-time cost of $15
      • Wood, cardboard, etc. for stand and sign: one-time cost of $20
      • Our income from the lemonade stands isn't taxed, the cost of the water used to make the lemonade is negligible, and we have a policy of setting up our stands in public parks, so we don't have to account for taxes, utilities, or real estate expenses.
  3. Itemize any and all intangible costs. It is rare for a project's costs solely to be composed of tangible, real expenses. Usually, CBAs also take into account a project's intangible demands - things like the time and energy required to complete the project. Though these things can't actually be bought and sold, real-world costs can be assigned to them by determining the amount of money one would hypothetically be able to make if they were used for another purpose. For instance, though taking a year off from a job to write a novel is technically free, one must take into account the fact that doing so means going without wages for a year. Thus, in such a situation, we're basically exchanging money for time, buying a year for ourselves at the price of a year's wages.
    • Below are the types of intangible costs you'll want to consider for your CBA:
      • The cost of the time spent on a project - i.e., the money that could be made if this time was spent doing something else
      • The cost of the energy spent on a project
      • The cost of adjusting an established routine
      • The cost of any possible lost business during the implementation of the projected venture
      • The risk factor value of intangibles like safety and customer loyalty
    • Let's take into account the intangible costs of opening a new lemonade stand. We'll assume that our current stand generates about $20/hour for 8 hours each day, 2 days each week (Saturday and Sunday):
      • Closing the existing lemonade stand for one day so that the new stand can be built, signs can be made, and new sites can be scouted: one-time loss of $160 in profits.
      • Spending 2 hours each week for the first two weeks working out issues in the supply chain: one-time loss of $80 in profits over the first two weeks.
  4. Itemize the projected benefits. The purpose of any CBA is to compare the benefits of a project to the costs - if the former clearly outweigh the latter, the project will probably be given the go-ahead. Itemizing the benefits is done in the same way as the cost portion of the analysis, though you will most likely need to rely on educated estimates more than you will with the costs. Try to back up your estimates with evidence from research or similar projects and assign a monetary amount to any tangible or intangible ways in which you will see a positive return on your venture.
    • Below are the types of benefits you'll want to consider in your CBA:
      • Income produced
      • Money saved
      • Interest accrued
      • Equity built
      • Time and effort saved
      • Repeat customer business
      • Intangibles like referrals, customer satisfaction, happier employees, a safer workplace, etc.
    • Let's calculate the projected benefits of our new lemonade stand and provide a rationale for each estimate:
      • Due to high walking traffic, a competing lemonade stand near the hypothetical site of our new stand makes a whopping $40/hour. Since our new stand would compete with this stand for the same customer base and we don't have word-of-mouth recognition in this area yet, we'll conservatively assume we'll make less than half that - $15/hour or $120/day - and that this will potentially grow as word of our lower prices spreads.
      • Most weeks, we end up throwing out about $5 of lemons which have spoiled. We project that we'll be able to more efficiently split our supplies between the two stands, eliminating this loss. Because we're open two days each week (Saturday and Sunday), these savings are about $2.5/day.
      • One of our current stands attendants happens to live very near to the site of the new stand. If we allow her to work at the new stand (by hiring someone to replace her at the old stand), she estimates she would be able to use the reduced commute time to keep the stand open for an extra half hour each day, which equates to about an extra $7.5/day, given our estimate of the stand's money-making potential.
  5. Add up and compare the project's costs and benefits. This is the crux of any CBA. Finally, we determine whether the benefits of our project outweigh the costs. Subtract the ongoing costs from the ongoing benefits, then add up all the one-time costs to get a sense of the size of the initial investment needed to start the project. Using this information, you should be able to determine whether a project is profitable and feasible.
    • Let's compare the costs and benefits of opening a second lemonade stand:
      • Ongoing costs: $20/day (supplies) + $40/day (wages) = $60/day
      • Ongoing benefits: $120/day (income) + $7.5/day (extra half hour) + $2.5/day (lemon savings) = $130/day
      • One-time costs: $160 (closing the first stand for a day) + $80 (supply chain issues) + $80 (blender) + $15 (cooler) + $20 (wood, cardboard) = $355
    • So, with an initial investment of $355, we can expect to make about $130-$60 = $70/day. Not bad.
  6. Calculate a payback time for the venture. The quicker a project can pay for itself, the better. Taking the cost and benefit totals into account, determine the amount of time it will take to recoup the projected costs of your initial investment. In other words, divide the cost of your initial investment by the projected income per day, week, month, etc. to determine how many days, weeks, months, etc. it will take to pay back your initial investment and start generating profit.
    • Our hypothetical lemonade stand has an initial cost of $355 and is estimated to generate $70/day. 355/70 = about 5, so we know that, assuming our estimates are correct, our new stand will pay for itself in about 5 days of operation. Because our stands are open on the weekends, this equates to about 2-3 weeks.
  7. Use your CBA to inform your decision about whether to pursue your project. If the projected benefits of your venture clearly outweigh the costs and the project can pay for its initial investment in a reasonable amount of time, you may want to consider putting your project into action. However, if it's not clear that a project can generate additional profit in the long run or pay for itself in a reasonable amount of time, you will probably want to reconsider the project or even scrap it all together.
    • Based on our CBA, our new lemonade stand looks like a sure thing. It's projected to pay for itself in just a few weeks, after which point it will generate profit. Summer is several months long, so, with any luck, we'll be able to make much more money in the long run this summer with two lemonade stands than with one.

Tips

  • Each and every venture will have different costs and benefits. Be as thorough as possible when listing those projected amounts, and leave nothing out. Remember that every little bit counts.
  • Calculate the value of an intangible using the possible cost (or return) of the intangible and its statistical likelihood of happening. For example, a customer may send you a referral, netting your business an additional 20 dollars. The statistical likelihood of a customer sending you a referral is 30 percent. This would result in a cost benefit analysis value of 6 dollars for that customer referral.
  • You can also do cost management by identifying which are most revenue and non revenue generating activities.

Related Articles

  • Calculate Oee

Sources and Citations

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