Cost-benefit analysis is one of the most widely used methods used by companies and governments to compare alternatives and drive decision making. What makes this method so popular is its quantitative basis and relative simplicity – the concept of cost-benefit analysis is easy for almost anyone to grasp. But is this evaluation tool being over-used and leading to bad decisions?… perhaps.
The general premise of cost-benefit analysis is that the total costs are compared to the total benefits of an option – yielding a value that can be compared easily against other options in a portfolio – to provide an apples-to-apples comparison of alternatives. In concept that’s great… but there are a number of disadvantages and limitations to this method that you should be aware of.
- Under-valuing of factors that cannot be quantitatively expressed – often referred to as ‘intangibles’, there are a large number of considerations that aren’t easily quantified for inclusion in cost-benefit analysis either because they deal with unknowns or involve a high degree of subjectivity in the way they are assessed.
- Benefits are often based on hidden assumptions about the current environment – When decision makers and analysts quantify benefits, they are usually framed in the context fo the current business/operational environment or a ‘most-likely’ set of assumptions about the future. Both of these benefit framing techniques have a strong bias towards option that influence factors that are known and can cause highly innovative opportunities to be overlooked.
- Both cost and benefit estimates tend to be overly optimistic – there is some degree of subjectivity involved even in quantitative analysis methods. As a general trend, analysts tend towards being optimistic and over-estimate benefits and under-estimate costs. If done consistently and used only in a comparative evaluation, this isn’t a problem, however cost-benefit analysis frequently is used to set stakeholder expectations on the chosen-alternative.
- Failure to properly consider opportunity costs – very few organizations have unlimited resources and that is why they are performing the cost-benefit analysis in the first place (because a decision needs to be made). A common mistake when making decisions is to only consider direct alternatives as the opportunity costs of the choice being made, instead of considering the broader set of alternatives that the organization could use its resources for. When this happens, companies often select one of the given alternatives when the best choice is to select none of the options and re-allocate the resources elsewhere.
- Timing of costs and benefits in the context of a portfolio – most options in a set of alternatives include some variation in the timing of costs and benefits. The typical method for normalizing timing factors in cost-benefit analysis is through the use of net present value calculations. What NPV doesn’t take into account is the impact that timing plays on the cash-flow of the organization as a whole in combination with other investments being made in the portfolio. Considering only the total cost and benefit of each alternative can lead to sub-prime optimization of the organizations resources.
Cost-benefit analysis can be a powerful tool for portfolio analysis and decision making but it has limitations that are often over-looked in its simplicity- leading to bad decisions. By considering these limitations and supplementing cost-benefit analysis with other portfolio analysis techniques, the common pitfalls can be identified and mitigated leading to better quality and more consistent outcomes from your portfolio decisions. The key is for the decision maker to look at the bigger picture of this decision in the context of the organization as a whole – balancing quantitative techniques like cost-benefit with other (qualitative) methods.