How to do a cost-benefit analysis – Detailed walkthrough

Cost-Benefit Analysis Matrix: This handy tool helps you compare the potential costs and benefits of a project or decision.

6-Steps to conduct a cost-benefit analysis

To conduct an effective cost-benefit analysis, you'll need to use a systematic approach. Below is a six-step method you can apply to a broad range of project types or business initiatives where you need to work out if the investment is worthwhile and justified.

By following this structured approach, you’ll avoid common project pitfalls while ensuring your analysis captures all relevant factors.

Step 1: Define project or scope and framework

Establishing clear project boundaries and analytical parameters forms the foundation for your entire cost-benefit analysis. Without proper scope definition, you risk missing critical costs or benefits. You may even create an analysis too broad to be actionable.

In this first step, you should cover the following:

• Document specific project objectives, timeline, and stakeholder boundaries
• Identify all decision-makers, affected departments, and external stakeholders who might experience costs or benefits from your project
• Record your assumptions about market conditions, inflation rates, and business environment stability that may impact results.

By mapping out all the stakeholders, you'll make sure you don’t overlook important perspectives during cost and benefit identification.

Also, identifying the potential environmental assumptions that might impact subsequent calculations lets you run a more sensitive analysis where you include factors that might not seem obvious or linked initially.

Step 2: Identify all costs and benefits

Next up is making the most comprehensive list of costs and benefits you can muster. The important thing here is to make sure nothing significant is left out or overlooked.

There are three types of costs:

1. Direct costs include the obvious expenses tied directly to project execution. These costs are typically easiest to identify and quantify accurately.
2. Indirect costs are overhead allocation, support services, and secondary expenses that result from your project.
3. Opportunity costs represent the value of alternative projects or initiatives you forego by committing resources to this project.

And two types of benefits:

1. Tangible benefits include measurable positive outcomes like increased revenue, cost savings from process improvements, or efficiency gains that translate to labor cost reductions.
2. Intangible benefits are the less obvious short-term improvements that might be hard to quantify, such as brand reputation or competitive positioning. These are important ot list because they often determine long-term project success and shouldn’t be ignored in your analysis.

Tip: The most accurate cost-benefit analysis requires input from diverse stakeholders who understand different aspects of your project’s impact. Now, this may not be necessary for small projects, but it is a must for large-scale, complex project management. A good way to make sure you don't miss anything is to set up cross-functional brainstorming sessions. That way, it will be easier to surface costs and benefits that might not be immediately apparent to any single stakeholder.

Step 3: Assign monetary values

The accuracy of your entire cost-benefit analysis depends on realistic valuations of all the costs and benefits in your list. You need to assign monetary values that are neither overestimated in terms of benefits nor underestimated in relation to total costs.

The best advice we can give you for this step is to set monetary values by using a combination of hard data, industry benchmarks, and careful estimation techniques.

Below is a list of how to approach setting values for certain types of costs and benefits:

• Tangible costs are the ones that are straightforward because they are readily available within your systems, quotes, and current market rates. If you need a freelancer for your project, you know the going rate is $45 per hour.
• Intangible costs require more creative approaches, such as survey data showing that SaaS businesses that invest in user-generated content see a 20% increase in revenue.
• Revenue benefits should be based on sales forecasts, market analysis, and customer lifetime value calculations. If your project increases average customer lifetime value by $2,500, multiply this by your expected customer acquisition rate to estimate total revenue impact.
• Cost savings need process improvement studies and efficiency measurements to translate operational improvements into dollar amounts. Document exactly how a 20% reduction in processing time translates to specific labor cost savings or overhead expense reductions.

Tip: When you don't have clear-cut numbers, be conservative with estimates – especially for benefits that depend on market conditions or customer behavior. You should also document all assumptions and sources so others can understand and validate your approach.

Also, use ranges rather than point estimates for uncertain factors. Instead of saying exactly $50,000 in annual savings, use a range of $40,000-$60,000 to reflect estimation uncertainty.

Step 4: Calculate Present Value (PV) and Net Present Value

Step four is the most difficult part of the cost-benefit analysis method. It involves converting future costs and benefits to present value. It accounts for the time value of money, recognizing that a dollar today is worth more than a dollar received in the future.

This calculation only needs to be applied where costs and benefits stretch across multiple months or years. Service businesses, such as marketing agencies, might apply this formula when they're about to onboard a large client on a retainer that requires a hefty investment in terms of creative assets, market research, or new talent.

The Present Value formula is:

PV = FV ÷ (1 + r)^n

Where:

• FV represents future value
• r equals your discount rate
• n indicates the time period

Scenario example:

A mid-sized marketing agency with 30 people is considering whether to onboard a global client, which requires substantial investment for a 12-month retainer.

The breakdown of costs and benefits is as listed:

Total upfront (year 0): $85,000

To land the PV, calculate present values for each year’s costs and benefits separately, then sum them to get the total present value for each category. This year-by-year approach helps you understand when costs and benefits occur, which affects both cash flow planning and risk assessment.

The PV for this scenario would look like this:

Year 0: -$85,000 ÷ (1.10^0)= -$85,000

Year 1: $243,000 ÷ (1.10^1) = $220,909

To calculate Net Present Value, use the formula:

NPV = ∑ [(Benefit - Cost) ÷ (1+r)^n]

In simple terms, this is the sum of all present value benefits minus the sum of all present value costs.

If we apply the example from above, the NPV calculation will look like this:

NPV = -$85,000 + $220,909

= $135,909

A positive NPV indicates that benefits exceed costs when properly adjusted for timing, suggesting the project is a worthwhile investment for your organization.

Tip: Remember that NPV calculations depend heavily on your chosen discount rate. Higher discount rates reduce the present value of future benefits more than current costs, potentially making longer-term projects appear less attractive than they actually are.

Step 5: Calculate Benefit-Cost Ratio

Another calculation you might like to include in your analysis is the Benefit-Cost Ratio. This figure lets you compare total present value benefits directly to total present value costs. The metric complements NPV by showing how much benefit you generate per dollar of cost.

The Benefit-Cost Ratio (BCR) formula is:

BCR = Total Present Value of Benefits ÷ Total Present Value of Costs

If we use the example from above, our BCR would look like this:

PV of benefits = $378,000 ÷ 1.10 = $343,636

PV of costs where:

• Year 0: $85,000 ÷ 1 = $85,000

• Year 1: $135,000 ÷ 1.10 = $122,727

PV of costs = $85,000 = $122,727 = $207,727

Now we can calculate our BCR:

BCR = $343,636 ÷ $207,727 = 1.65

A BCR greater than 1.0 indicates that benefits exceed costs. So in our agency scenario above, for every $1 invested, the agency gets $1.65 in discounted returns.

Many organizations establish minimum acceptable BCR thresholds between 1.2-1.5 to account for estimation uncertainty and ensure adequate returns.

Tip: You can use BCR to compare client project profitability and then use it to rationalize how you prioritize resources and do capacity planning for your business. Projects with higher benefit-to-cost ratios typically deliver more value per dollar invested.

Also, consider the relative costs and complexity when interpreting BCR results. A project with a 2.0 BCR generating $100,000 in net benefits might be preferable to one with a 1.8 BCR generating $500,000 in net benefits if the smaller project requires significantly effort, attention, or carries lower risk.

Step 6: Perform sensitivity analysis and make a decision

Sensitivity analysis tests how changes in key assumptions will affect your results. These could be variables that most influence project viability, such as labor costs.

For example, you can test critical variables by adjusting them by specific amounts.

You can trial:

• Labor costs by ±20%

• Modify revenue projections by ±15%

• Adjust your discount rate by ±2%

These variations reveal whether small assumption changes drastically impact your project's viability.

Tip: Identify break-even points where NPV equals zero or BCR equals 1.0. Understanding these thresholds helps communicate project risk and the conditions necessary for success.

Before you make the final decision whether or not a project is worth pursuing, consider all direct costs, future costs, and net present value. Use scenario planning that includes best case, worst case, and most likely outcomes to present your cost-benefit analysis. This approach acknowledges uncertainty while providing decision-makers with a realistic range of potential results.

Finally, make your final recommendation based on quantitative results of net present value and benefit cost ratio (NPV and BCR), sensitivity analysis findings, strategic alignment with organizational objectives, as well as qualitative factors that couldn’t be quantified.

Remember, a thorough cost-benefit analysis provides the analytical foundation, but business judgment determines final decisions.

Using cost-benefit analysis in projects and agency management

Integrating a cost-benefit analysis into project and agency management processes can enhance decision-making at various stages.

• Project Planning: In the planning phase, a cost-benefit analysis helps identify direct costs, indirect costs, and potential future costs to determine project feasibility.

• Project Execution: During the execution phase, it facilitates cost tracking and benefits realization, allowing for necessary strategy adjustments.

• Evaluation Phases: The evaluation phases aid in comparing the actual benefits and costs against the initial projections.

• Agile or Waterfall Methodologies: Within Agile methodology, the cost-benefit principle supports quick, iterative decision-making. When used in the Waterfall approach, it provides a financial framework for the linear project stages.

• Project Risk Management: Cost-benefit analysis helps you quantify the potential financial impact of risks, aiding in creating effective risk mitigation strategies.

• Decision-Making Frameworks: The cost-benefit analysis method supports objective and informed decision-making within various project frameworks by offering quantitative data.

• Internal efficiency projects: When deciding to implement new software, such as project management or marketing automation platforms.

• New service launches: A cost-benefit analysis helps forecast if projected revenue outweighs setup costs for introducing new services such as influencer marketing or video production.

• Hiring decisions: Most agencies combine in-house and freelancers to meet their workload needs, so a cost-benefit analysis can paint a clear picture of when it might be more affordable to transition to all in-house labor.

How can a cost-benefit analysis be helpful?

A cost-benefit analysis (CBA) can be an extremely helpful technique for multiple scenarios. It gives you an official document to use when you need to back your arguments and make informed decisions based on numbers.

• Informed Decision-Making: CBA provides a quantitative basis for making decisions. By comparing the costs and benefits of different options, decision-makers can choose the most advantageous path.

• Resource Allocation Optimization: This can help identify which projects or initiatives provide the best return on investment, allowing for a more effective allocation of resources.

• Risk Identification and Mitigation: By considering all potential costs, including possible risks, CBA can help spot and mitigate risks before they become significant problems.

• Enhanced Project Justification: A thorough CBA can demonstrate the value of a project or initiative to stakeholders, providing strong justification for its implementation.

• Stakeholder Alignment: CBA results can be used to align stakeholders on a project's expected costs and benefits, reducing disputes and misunderstandings.

• Improved Financial Planning: By providing a clear view of expected costs and benefits, CBA can help with financial planning and budgeting processes.

• Increased Project Success Likelihood: Projects that undergo a thorough CBA are more likely to succeed, as they are based on careful analysis rather than assumptions.

• Improved Project Performance: Regularly performing CBA throughout a project's lifecycle can help track performance and make necessary adjustments to stay on track with objectives. It ensures that the project consistently delivers the expected benefits at the projected costs.

Limitations of cost-benefit analysis

While a cost-benefit analysis model is a valuable tool for decision-making, it does have several limitations:

• Difficulty in quantifying benefits: Not all benefits can be easily quantified or measured in monetary terms, so you get an actual figure for your cost-benefit analysis. For instance, the value of improved employee morale or customer satisfaction may be hard to measure.

• Subjectivity in assigning monetary value: The process of assigning monetary value to tangible and intangible factors can be subjective and vary greatly depending on the person doing the analysis.

• Ignoring non-monetary factors: Cost-benefit analysis primarily focuses on monetary aspects and may overlook important non-monetary factors that could impact the decision, such as social or environmental impacts.

• Inaccurate cost estimates: Estimating the costs of a project or initiative can be challenging and often involves making assumptions that may not hold.

• Discounting future benefits: Cost-benefit analysis often discounts future benefits, which means projects with long-term benefits might not seem as valuable as those with immediate returns.

• Risk and uncertainty: While cost-benefit analysis can help identify risks, it cannot entirely account for unexpected changes or uncertainties that could affect the costs and benefits.

• Time- and resource-intensive: Conducting a thorough cost-benefit analysis can be time-consuming and resource-intensive, which may not be feasible for all organizations or projects.

ActiveCollab: The tool that stores all your project costs data

One of the most difficult parts of doing a cost-benefit analysis for agencies is getting accurate data. Project management and productivity tools like ActiveCollab make this part super easy. How? By letting you set up projects with assigned budgets and then giving you the tools you need to gather and collate all that data in real-time.

When the project wraps up, you can generate dozens of dashboards and reports that instantly tell you how much time was spent where, who did how many hours, and how the budget was broken down.

You can then use all this data to make more accurate monetary value estimates for all the direct and indirect costs and benefits associated with similar projects, so you can better understand the true resource needs of incoming projects.

At its core, what ActiveCollab does is help agencies run profitably with the help of their project data. The tool also lets you plan client campaigns and projects, manage resources, do capacity planning, and run entire projects from start to finish.

Instead of switching between multiple apps to understand project financials, ActiveCollab lets you keep everything in one place – from the initial client estimate to the final invoice and post-project profit reporting.

Need a tool that centralizes project, client, and financial management? Check out ActiveCollab.

Sign up for our 14-day free trial or book a demo with one of our people to see how the tool works.