Cost Benefit Analysis

The cost benefit analysis is a basic analysis framework that involves weighing up the costs and benefits of one course of action against another

 

 

 

 

 

 

 

 

IN YOUR consulting case interview you will most likely be required to make a recommendation on a hypothetical business problem. Understanding how to use the cost benefit analysis could come in handy.

The cost benefit analysis

One of the most basic analysis frameworks you can use to solve a business problem is the “cost-benefit analysis”. This method is fairly self-explanatory. It involves weighing up the total expected costs and benefits of one course of action against another. Having done this, you will be able to formulate a more well-thought-out solution to the business problem.

For example, consider the following business problem (Project Gold Mine). Your client says to you, “Currently we run a single gold mine (Mine A) and are trying to decide whether we should expand Mine A or build a second mine (Mine B). Which project should we undertake?” In this problem there are three possible recommendations: (1) expand Mine A, (2) build Mine B, or (3) do nothing (i.e. maintain the status quo). To make a recommendation, you will need to consider the benefits and costs of each course of action.

Evaluating the benefits

In considering the benefits, you will mainly want to think about revenue (Revenue=quantity x price); more on this in a later post.

Counting the cost

As far as I’m aware, there are four types of costs that you need to pay attention to: sunk costs, fixed costs, variable costs, and opportunity costs. I will consider them in turn.

1. Sunk costs

Sunk costs are expenditures that have already been made and cannot be recovered. As such, sunk costs should not be factored into your decision-making process. For example, in Project Gold Mine the original cost of building Mine A is a sunk cost. This money has already been spent and cannot be recovered, it is therefore a sunk cost, and should not be factored into the decision-making process.

2. Fixed costs

Fixed costs are costs that do not vary with the quantity of output produced. In the Project Gold Mine example, fixed costs might include things like rent, land taxes, utilities and other overheads.

It is important to understand that fixed costs are fixed only in the short term. In the short term, the cost of labour may be a fixed cost if the mining company cannot vary the number of employees due to contract obligations. In the long run, these contracts can be renegotiated. In the long run, nearly all costs are variable, even things like rent, because the mining company could move its operations overseas to a country where operating costs are lower.

3. Variable costs

Variable costs are costs that vary with the quantity of output produced. In the Project Gold Mine example, the main variable costs would be the cost of extracting the ore from the ground, and the cost of transportation.

When making decisions in the short run, variable costs are the only costs that should be considered because, in the short term, a company cannot change its fixed costs.

4. Opportunity costs

The opportunity cost of an item is what must be given up to obtain that item.

In the Project Gold Mine example, failing to consider opportunity costs could lead to the wrong decision being made. Consider the following hypothetical:

If the mining company expands Mine A the profit is $1 million, and if it builds Mine B the profit is $2 million. Which project should it undertake? Building Mine B is the more profitable of the two projects; however, the company also needs to consider the opportunity cost of building Mine B. In this hypothetical example, the profit obtained from not undertaking either project is $3 million. So, although building Mine B is the most profitable project, doing nothing is even more profitable.

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