Cost benefit analysis involves the weighing of the costs associated with a decision against the benefits arising from that decision. The analysis is used to decide whether to proceed with a course of action or not. Cost benefit analysis can include both quantitative and qualitative factors. For example, the analysis of a decision to construct a facility in a particular city could include quantitative factors, such as the amount of tax breaks that can be obtained, as well as qualitative factors, such as the rating of the schools in that city to which workers would send their children.
For decisions involving large amounts of invested funds, the emphasis of a cost benefit analysis tends to be on the cash flows associated with the investment. This may include the initial and subsequent investment of funds, as well as the tax effects of depreciation, maintenance costs, and projected price points. In this situation, qualitative factors tend to be addressed after a “hard” quantitative analysis has already been completed.
Examples of decisions to which cost benefit analysis can be applied are:
- Whether to expend funds on a new fixed asset. The analysis is the cost to buy the asset, versus the benefit of any cash flows to be derived by using the asset.
- Whether to hire staff to design a new product. The analysis is the cost of the new staff, versus the cash flows to be derived from sale of the new product.
- Whether to hire quality assurance staff to reduce product failures. The analysis is the cost of the new employees, versus the costs to be avoided by maintaining higher product quality levels.
Cost benefit analysis works best when most of the costs and benefits can be reduced to financial terms, so that they can be more easily compared. The analysis does not provide consistent results when the decision maker must compare qualitative concepts, without being able to convert them to financial outcomes. The concept can also yield inconsistent results when cash inflows and outflows are expected to occur over long periods of time, since it can be quite difficult to accurately predict the amount and/or timing of the more distant cash flows.
Quantitative factors are numerical outcomes from a decision that can be measured. These factors are commonly included in various financial analyses, which are then used to evaluate a situation. Managers are typically taught to rely on quantitative factors as a large part of their decision making processes. Examples of quantitative factors are:
- Direct labor hours. A change in the number of labor hours required to complete a task if automation is used.
- Direct materials cost. A change in the per-unit cost of materials if a purchase is placed in a larger order volume.
- Interest cost. The amount of additional expense that will be incurred if a loan is used to buy a fixed asset, rather than selling stock.
- Product returns. The cost of the product returns that will occur if the decision is made to use lower-quality materials in the construction of a product.
While quantitative factors certainly should form a large part of any decision, there are other issues to consider. For example, the outcome of a decision to shut down a factory will impact the local community, which has supported the business for many years. Or, the numbers may state that a single product within a product line should be cancelled, but the company needs to present a complete product line to its customers, and so elects to retain the product.
The decision to use quantitative factors is considered more important when a large amount of funding will be deployed, since there is a greater risk of losing or at least under-utilizing the money. Quantitative factors are less important when there is less money that will be impacted by the decision.
Qualitative factors are decision outcomes that cannot be measured. Examples of qualitative factors are:
- The impact on employee morale of adding a break room to the production area.
- The impact on customer opinions of a business if an investment is made in answering their phone calls in less time by adding customer support staff.
- The impact on investors of conducting a road show to meet as many of them as possible.
- The impact on the local community of allowing employees to spend a few hours of paid time assisting with community projects.
- It may be possible to use somewhat cheaper components in products. However, if this is done too much, it may create an overall impression of reduced quality, which may lead customers to buy fewer products.
A manager should consider qualitative factors as part of his or her analysis of a decision. Depending on the manager and the level of investment involved, qualitative factors can be the deciding point in whether to engage in a certain activity. For example, if a large investment of funds is involved, the key decision factors are more likely to be quantitative, since the investing business has a great deal at stake in the decision. However, if the investment of funds is minor, the impact of qualitative factors could play a more important role in the decision.
From a branding perspective, qualitative factors can be particularly important. Proper branding requires high expenditure levels to establish and maintain an aura of quality, which a purely quantitative analysis might not justify.