Five key steps in conducting a cost-benefit analysis

The current COVID-19 crisis places a microscope on the decisions governments and not-for-profit organizations make. It is essential for decision-makers to understand the impacts of their decisions, as they have a fiduciary responsibility as stewards of the public funds they manage. A cost-benefit analysis is a critical tool for all public sector managers to leverage when making difficult financial decisions that will become commonplace as COVID-19 response and recovery processes continue.   

Most people do not realize that they conduct a cost-benefit analysis when making everyday decisions. The decision can be for something simple, for example, choosing whether to use beef or a plant-based alternative to make chili. It can also be more complex, such as deciding whether to purchase a property in a suburb with a large yard or a luxury loft condominium with breathtaking city views. A cost-benefit analysis is simply a systematic approach that individuals and organizations can use to analyze the risks and rewards of a project and select the optimal solution.

Cost-benefit analysis is a vital component of the decision-making process for governments and not-for-profit organizations. It is often used when considering a new program, eliminating services or even deciding which initiatives the organization will support as a component of its strategic mission.

Cost-benefit analysis includes the five fundamental steps outlined below.

Identify the scope – likely a project, initiative, program or service offering

To establish a framework, details of the proposed program, new project, strategic initiative or service offering must be outlined. This allows organizations to understand what is being evaluated, as well as the relationship it has to the problem or challenge being addressed.

Once the change or new program is outlined in detail, the current state of that environment will need to be outlined. This would include identifying the background, current challenges and performance of the environment related to the change or program.

Determine the scope

• Demographics need to be determined related to the decision and the population that it will impact. Key stakeholders should be identified and taken into consideration during the decision-making process. A time frame or period should be determined related to the decision-making process and implementation of the change or new program.

Determining the cost

Total utility = explicit costs + implicit costs

Once the scope is defined, costs should be identified and categorized. To clearly compile a comprehensive list of costs, as a best practice, consider the external and internal costs of the project. Assumptions can be made regarding cost and should be disclosed and supported with evidence. It is important to distinguish whether costs are one-time, fixed or variable. The primary cost categories that should be considered are:

Explicit costs

• Real costs are considered to be expenses in developing a program or service, such as labor costs
• Directs costs are associated with the production of a product or service 
• Indirect costs are not directly accountable to a service or product, such as overhead costs

Implicit costs

• Implicit costs are intangible costs that are not easy to identify (e.g., performance levels or satisfaction of the community)

Note that it is important to consider costs over time. If we are expected to utilize or benefit from the project/program/initiative/service for many years, remember to consider the costs over that same time period. Ignoring long-term financial impacts only “kicks the can” down the road.

Determining the benefits

After identifying costs, benefits should be documented and classified. Benefits can be challenging to narrow down and determine because many cannot be genuinely quantified. Benefits that are identified should be monetized or associated with a value. Similar to costs, external and internal benefits to the organization should be documented.

• Explicit benefits can be quantified (e.g., additional revenue or reduced costs)
• Implicit benefits are difficult to quantify (e.g., satisfaction levels, increased retention or utilization/access to services or programs)

Similar to costs, it is important to measure benefits over time.   

Compute calculations of the cost-benefit analysis

In order to understand the impact of the costs and benefits, an analysis needs to be conducted to understand the net benefit (or cost). Typically, during this step, various calculations can be completed that can result in values or ratios that would be compared.

• Net present values should be determined with the application of discount rates over a time period and cost subtracted from benefits
  -Various discount rates can be considered, such as hurdle rates or annual effective discount rates
• Calculate the return on investment (ROI) for each option
• Identify if user fees will cover the cost of a project. If not, and the project it is still deemed beneficial by the key stakeholders, it is important to disclose that the benefits outweigh this fact

Compare the cost and benefit results with a what-if analysis 

There are several factors that will impact a government’s or not-for-profit organization's ability to make a meaningful decision. During this step, the return on investment calculated for each of your options can be compared with a what-if analysis to support overall decision-making.

• For simple analyses, a what-if-analysis can be performed using the goal seek function in Microsoft Excel to compare all possible scenarios (i.e., options) available to arrive at the desired result. This will provide additional context that can be compared with the cost-benefit analysis conducted in step three.

Assumptions and limitations that impact decision-making

It is imperative to identify the assumptions considered and the limitations that could impact a government’s or not-for-profit organization's ability to make a decision. A few examples of assumptions and limitations include:

• Assume that over time, costs and benefits may vary based on the market and changes to a user's tastes and preferences
• Do not assume that the greatest monetary net benefit is always an indication that the option is the best choice
• It can be a challenge to assess the implicit benefits of an option. For example, the value of a person's wellbeing or happiness

It is critical to avoid bias, as it is easy to build in assumptions that prove the desired outcome. Have an independent and objective party take an unbiased look at the analysis and attempt to poke holes.

Once governments and not-for-profit organizations have conducted their analyses, there are a few items to keep in mind when presenting the analysis to stakeholders:

• Present the results in a simple manner; if you get into the weeds on a concept that is confusing (e.g., implicit costs), you will lose the audience and possibly miss the opportunity to make an optimal decision on an important topic
• Visualization, such as interactive charts, graphs and maps, can be utilized to help convey the differences in the impact of your options
• Use consistent formulas as a baseline across different options
• Microsoft Excel is a great tool to utilize for quick analyses

Conclusion

Now you have a better understanding of the critical steps to conduct a cost-benefit analysis and the impact of assumptions, limitations and leveraging a what-if analysis. These helpful tips for government and not-for-profit organization decision-makers facilitate a comprehensive understanding of the impacts associated with the decisions that are made.

For more information on this topic, or to learn how Baker Tilly public sector specialists can help, contact our team.