6.7 Cost-benefit analysis
17. Does the case clearly and unequivocally demonstrate that benefits outweigh costs?
In some contexts ‘cost-benefit analysis’ implies some specific formal method of assessing costs in relation to expected benefits. For example, in the UK public sector, there are particular protocols for carrying out cost-benefit analysis to demonstrate that public money is being used to best advantage (see, for example, The Green Book published by central government (HM Treasury, 2003)). However, here the term ‘cost-benefit analysis’ is used generically, to mean the weighing in the balance of the expected costs and benefits of your proposed change. The most straightforward method is to reduce all costs and benefits to monetary values and do the arithmetic. Conventional investment appraisal techniques do just that. The big drawback of these methods is their inability to take into account benefits that cannot be quantified, or benefits that accrue beyond the timescale considered by the appraisal. Many organisations have their own preferred method of investment appraisal and/or cost-benefit analysis, and you will need to work within your own organisation's framework, whatever constraints or other difficulties it poses for your particular proposal.
Overall your objective is to demonstrate that the net result of implementing the change is positive – that the benefits outweigh the costs. Irrespective of how much of the case can have hard figures attached to it, the audience must be persuaded that the expected benefits are almost certainly worth significantly more than the expected costs.
It is probably appropriate to include some form of sensitivity analysis to demonstrate that your argument is robust under a variety of circumstances. Sensitivity analysis asks the question ‘What if …?’ For example, what if the equipment installation takes a bit longer than the estimate and cash inflows are delayed by 2 or 3 months? What if additional help is needed from the supplier and costs rise as a consequence? Sensitivity analysis re-works financial and other appraisal with modified parameters. Ideally a net gain should still be projected under a wide range of different circumstances.
The critical parameter is often the time frame to be considered. Benefits and costs over the entire system life cycle should be included in the analysis. For example if the predicted life of a piece of process equipment is ten years then this should be the life cycle time to be considered. Such an approach requires not just the costs of purchase and ongoing operating costs associated with use of the equipment to be considered, but also the costs of end-of-life disposal, and perhaps increased maintenance requirements later in the life cycle to be taken into account. The problem with this approach is that it tends not to match the normal methods of accounting and investment appraisal. Many organisations use simple payback methods, where the time required for the proposed investment to pay for itself in terms of the cashflow benefits is calculated. Thus an up front investment of £100,000 is paid pack in less than two years if it generates net cash inflows of £5000 per month. Typically, organisations demand a payback period of no more than two years, nowhere near the system life cycle for most significant investments in process technology, for example. It may be necessary to carry out two sets of analysis, one to deal with your organisation's chosen methods of investment appraisal that will be recognised by the board, and another to show more complete life cycle analysis, as a more true-to-life approach.
Some proposals by their very nature consist entirely of non-financial benefits. Feasibility studies, trials and experiments usually fall into this category. For example, a proposal to try out a new e-commerce business model by testing customer response to a self-service technology has no net financial gain. Considerable costs go into the trial and its evaluation but little if any additional revenue is generated. The benefits lie in the new knowledge the trial will provide that can be used in subsequent organisational decision-making – typically whether or not, and how, to go ahead with a wider roll out of the system. In effect the purpose of such trials or experiments is to reduce the risk attached to large scale change. Some organisations have separate investment budgets for these sort of ‘experiment’ proposals, and do not require the same financial return criteria to be applied (Ross and Beath 2002).
These issues make for a very real practical dilemma for many managers. On any objective assessment their proposal makes good ‘business sense’ for the organisation, but this may be impossible to demonstrate using the organisation's specified investment appraisal methods (Currie, 1989). So what actually happens in practice? The following are examples of how this dilemma is ‘handled’ or not:
The proposal fails, because of the board's unwillingness to remove the hurdle of conventional investment appraisal techniques, even though the proposal as presented stressed the positive outcome when the complete system life cycle is considered and the significance of the non-quantifiable strategic benefits.
The proposal succeeds because the board is willing to make an exception to the normal financial criteria in view of the exceptionally strong case made by the project proposal based on significant long term/strategic benefits.
The proposal succeeds because the organisation routinely allocates a proportion of its investment budget to proposals that cannot be assessed on financial criteria but have significant non-financial benefits.
The manager persuades one or more board members, prior to formal consideration of the proposal, of the strategic competitive value of the proposal to the firm and gains their personal support. Their influence is such that the proposal gets the go ahead in spite of failing on the normal financial criteria.
The board adopts a more enlightened approach to investment appraisal allowing long term benefits (and costs) to be taken into account (such as Real Options thinking). The proposal goes ahead as a result of this more wide-ranging analysis.
The manager manipulates the data in the proposal to overstate the short-term benefits and/or underestimate short-term costs, in order to force the proposal to meet conventional financial criteria. The project is approved. Subsequently the project fails to meet its over-ambitious targets, reflecting badly on the manager concerned, and making the board reluctant to approve similar projects in the future.
There is no universally preferred answer to this dilemma. The fundamental issue is usually the time frame that decision-makers are willing to consider, coupled with attitudes to the higher levels of uncertainty inevitably associated with longer time scales. You will need to address problems of this sort in ways that best suit your project and its context in your organisation. Certainly there should be no assumption that reason will prevail and that the organisation will adopt new methods of investment appraisal – Real Options thinking, for example, is used by only a very few organisations. Organisational politics may need to play a part in your thinking, especially gaining the personal support of those with particular influence on the decision.