The 10 Most Asked Questions of Cost Benefit Analysis
When dealing with decisions using Cost Benefit techniques it is very important to follow the proven principles. The health of your company and your reputation depend on it. If these rules are not followed then your decisions could be flawed. Let's start, shall we? Question #1. Is this technique suitable for the small business owner? Yes. The theory works equally as well for small business as it does for big business and government.
Cost Benefit Analysis is a decision-making technique that assesses the positive outcomes (benefits) as well as the negative outcomes (costs) of different decision alternatives. The trick is to make its implementation easy for the small businessperson. Once you have basic knowledge of the theory and can enter data into a spreadsheet then the rest is not too difficult. Question #2. Is this all I need to make better decisions? No.
Cost Benefit Analysis is a tool to assist in making better financial decisions. It is not an end in itself. However, part of the Cost Benefit process requires that you think widely on all options before making a final decision. This is often where most people fail in their decision-making attempts. Cost Benefit Analysis is also very skilful at providing a single viability output for each competing option, making comparisons objective and easy. Question #3. What do I include as the Costs and the Benefits? Costs. All costs attributable to the project are to be included. Some of these are listed below: - Asset Costs (both Capital and ongoing) - Supply costs for purchased items - Extra administrative effort required to manage project - Delivery costs if to your account - Replacement of assets in future years - Tender preparation costs - Any specialised tooling associated with the project Revenue. Revenue can only be attributed to a project if it were not received were the project not to go ahead.
Asset Disposal and Residual Values. Some assets may be retired prior to the end of their useful lives or may be salvaged at the end of the project. This value is to be included in the cash flows (less the costs associated with their sale or disposal). Cost Savings. All cost savings attributable to the project are to be included. Wage and salary cost savings must include their overheads and on-costs. Question #4. How do I treat non-financial costs and benefits? Since only cash transactions (both costs and benefits) are included in Cost Benefit models, non-financial costs and benefits are usually described by way of notes. If the Benefit Cost Ratio is = to 1 or > 1 then the use of non-financial costs and benefits would not be required since the project is already VIABLE. Normally these non-financial costs and benefits would be included when comparing competing options whose Benefit Cost Ratio is close to each other.
Question #5. How can I test my assumptions? You are best placed to make assumptions based on your own experience and judgement. However, you can use a technique to show others how robust your assumptions really are. This technique is called Sensitivity Analysis. This technique is important to understand because you have made many assumptions in your analysis. These could have been, for instance, the level of new income generated, the savings generated or the residual value of the asset at the end of the project life. These assumptions are at the heart of your analysis and have contributed to your final Benefit Cost Ratio outcome. Since the future cannot be accurately predicted there is a high probability that some of your assumptions may prove incorrect. Using this technique will add conviction and weight to your proposal by showing how changes to costs and benefits affect the Benefit Cost Ratio. Do small changes move the project from VIABLE to UNVIABLE? Question #6.
How can I be sure that the project is VIABLE? You have made your assumptions based on your project knowledge and experience. You have constructed the model that shows the project to be VIABLE. If you have followed the proven principles it should work out OK. Once the project has been authorised it is important to ensure that the assumptions are correct and in fact are deliverable. To ensure this happens follow up on these items: - Any labour savings must be delivered - re-assign affected resources - Cost savings due to process changes must be acted upon swiftly - Increased revenue from price rises must be implemented urgently A Post Completion Review undertaken a year from the project's implementation will show you if all or some of your assumptions proved correct. It will also teach lessons on how this could done more successfully next time rather than making the same mistakes again. Question #7. How can I implement this technique in my company? There are a number of ways as follows: - Use Cost Benefit Analysis yourself in a pilot project - Convince the CEO of its benefits to the company and use that authority - Use Cost Benefit Analysis in a specific business unit All of these ways require a thorough understanding of the theory, the reasons for its implementation and the expected payoffs. A training program would need to be undertaken so that all those involved understood the technique.
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