In this ‘Ask The Expert’ interview, Lucrum CEO Jeff Heybruck explains the importance of cost benefit analysis to small business owners. Read on to learn when this important decision-making tool should be used by small businesses, the steps to performing one, its limitations and more.
Q: Define cost benefit analysis and what is its purpose?
JH: A cost-benefit analysis (CBA) details potential risks and gains of a decision and is helpful for understanding short and long-term financial consequences. At the end of the CBA, business owners are better able to make a go/no-go determination. The exercise of a CBA is also a discipline that prevents impulsive decisions that may put a company in a poor financial condition. Think of the CBA as the ‘pause’ button before pressing ‘play.’
“Think of the Cost Benefit Analysis as the ‘pause’ button before pressing play.”
Q: What are some types of decisions where small businesses should perform a cost benefit analysis?
JH: Making a capital purchase, hiring new staff, opening a new location… or as big or small of an investment as the owner feels is worthwhile to do one and can benefit from the information provided.
Q: Is a ‘formal’ cost benefit analysis always necessary?
JH: Not necessarily. Some decisions are no-brainers or just so essential to the business that they must spend the money. Most cost-benefit analysis is done for expansion – adding to the fleet, not replacing. It may be as simple as figuring out how much usage we need to make it a breakeven situation to give the business owner confidence in the decision. For example, a construction business owner might be able to say “OK, I’m going to spend $X but all I need to do is use the machine for roughly 20 hours per week and it won’t ‘cost’ me anything.”
Q: What are some decisions made frequently by business owners where a CBA would be helpful, but typically isn’t done?
JH: Buying new equipment. Too often, we see business owners making the decision to purchase new equipment because they like having shiny new equipment or want ‘the next big thing.’ That fancy new piece of equipment might not fit into their operational model or even generate profits. We also see business owners undertaking expansions into complimentary or even new lines of business without fully evaluating the opportunity. Sometimes the expansion just happens to work out great, but we’ve seen times where it ends up consuming a lot more time and cash than the business owner originally expected or budgeted for. The old carpentry adage rings true here – “measure twice, cut once.”
Q: What are the steps for a cost benefit analysis?
JH: There are 7 steps to a cost-benefit analysis. 1. Define the Goal 2. Make a chart 3. Itemize tangible costs 4. Itemize intangible costs 5. Estimate and list all of the proposed benefits 6. Do the math 7. Make a decision. That’s at a high level, but we’ve written a more detailed post on how to do a cost benefit analysis here.
Q: Cost-benefit analysis assumes costs and benefits weighed are accurate, but they might play out much differently. Does this mean that a CBA is limited?
JH: Of course. Like the German military strategist Helmuth von Moltke once said, “no battle plan survives contact with the enemy.” Anytime a plan meets the real world, the real world wins. Dwight Eisenhower said, “In preparing for battle I have always found that plans are useless, but planning is indispensable.” If these two great strategists feel that strongly about a life and death battle, think how much a CBA can help make a business owner more prepared for what to expect and think through eventualities. Too often folks convince themselves of a rosy picture and that everything will work out like they are thinking, but it’s not based on reality. The CBA can help them have a much more accurate picture of what is coming up re: the new venture or the new equipment.
Q: What about projects that will run really far into the future. Can a cost-benefit analysis be effective in these situations?
JH: Like any forecast, the longer it goes out the less accurate it’s going to be. It still can be helpful or serve as a comparison when real results start coming in. Think about going into a meeting to analyze the new venture 6-12 mos. in. “OK guys, here’s what we thought we would see, let’s look at what we are actually doing. Where did we go wrong, where did we have unrealistic expectations, and where did we overestimate?” This analysis can help update the forecast and make it more accurate going forward.
Q: Are there any other tools for evaluating small business decisions other than cost benefit analysis that you would recommend?
JH: It depends on the investment amount, the owner’s risk tolerance, or the type of asset. A developer client doesn’t look at his projects via a CBA, he’s more interested in IRR analysis or cash on cash return.
One client wanted to turn their entire fleet because we realized the downtime and maintenance cost was killing them. In this case, we didn’t do a formal CBA because we simply looked at the current payments and the repair costs compared to the potential cost of having an entire new fleet (sum of monthly payments). Comparing the two showed a minor additional monthly spend with ZERO maintenance risk (warranty).
Finally, some other well-seasoned business owners see a new opportunity and do some market analysis and jump in with both feet knowing they have the cash to fund the losses or that the benefit of tying up a market or the rights to an area will always be worth their initial amount. I’ve heard folks look at those investment like a stock- if the concept does well, owning the rights to NC for XYZ franchise will always be worth more than their initial investment even if their individual locations don’t play out.
Q: Who should perform a cost-benefit analysis within the organization?
JH: Certainly, a controller or CFO level person and someone who has done them before, or a business owner can sometimes rely on a mentor to look over their shoulder. The worst thing would be to do a CBA, make a minor mistake that costs a business owner a ton of time and money because the result from the CBA gave the wrong advice, rate or return, or payoff timeframe.
Performing a Cost-Benefit Analysis for your Small Business?
If you don’t have resources experienced in performing cost-benefit analysis on staff, don’t risk it. Instead, opt for a fractional CFO service that allows you to tap into the C-level financial expertise needed to perform an accurate CBA. If you have additional questions or are interested in our CFO services, you can schedule a complimentary consultation with one of our CFOs.