Decision Makingby Ian Moore
Cost benefit analysis
What ails the truth is that it is mainly uncomfortable, and often dull. The human mind seeks something more amusing, and more caressing.
At its simplest, a very basic cost benefit analysis just lists all the costs associated with a decision and all the benefits (in monetary terms).
If the costs outweigh the benefits, then don’t do it.
If the benefits outweigh the costs, then do it.
Of course, in real life the complications arise in
- Listing all the costs and benefits
- Assigning accurate monetary values to them.
Most research into the effectiveness of cost benefit analyses suggests that people consistently underestimate the costs and overestimate the benefits.
Dealing with time
Over the period that it takes to implement a decision, costs and benefits need to be converted into some common form, so that they are comparable. Usually this is ‘current value’.
In a simple example, if it costs us £1 million to implement a decision and in one year’s time we expect a benefit of £1.1 million, we cannot say that the benefit is £0.1 million. We need to convert the £1.1 million in a year’s time into the equivalent in today’s terms. At the very least we need to take into account the rate of inflation for the year and reduce the value of the £1.1 million appropriately.
In complex decisions, where many costs and benefits will occur over the time period, this is by no means a trivial task and it also requires an accurate estimation of the factors which will affect the costs and benefits.
If you didn’t spend the £1 million, what other opportunities might there be?
At the simplest, you need to consider how much the £1 million would grow if invested. In six months’ time might we need this money for another decision – one that we may not even have thought of yet? Other already-planned decisions may be adversely affected by this decision – what would be our losses if these other decisions are not implemented?
We need to be able to factor risk in as well. As we all know, not all decisions that we make actually work out. Can we estimate the percentage likelihoods of success and failure at each point in the implementation and adjust the costs and benefits appropriately?
A decision might not be a complete failure. Can we estimate the benefits from a partial success and the likelihood of this happening?
Not just money
A good cost benefit analysis will take into account factors other than money, which will tend to be even harder to quantify. For example, a failure could result in a loss of reputation, how much is that worth and can it be quantified? At the very least an educated guess should be included for this. Will a success be copied by competitors?
When doing cost benefit analyses, it is important to put mechanisms in place that will capture inaccuracies in your predications. These can then be learnt from and fed into future analyses. Some events will be unpredictable, but most will have some element of predictability in them and capturing this information will be invaluable to future analyses. Some key issues to be aware of are
- An over reliance of similar past projects
- Overestimating benefits
- Underestimating costs
- Overly enthusiastic staff.
Running an analysis
- List all benefits and costs
- Include opportunity costs
- Include risk factors
- Include less tangible aspects of success and failure
- Implement a review mechanism for improving future analyses
- Assign a value to each element considered
- Convert all values to ‘current values’.
If after all this your analysis suggests that the benefits outweigh the costs, then take the decision; if not, then don’t.