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Avoiding Four Common Errors of a Cost Benefit Analysis

written by: N. Plowman • edited by: Michele McDonough • updated: 9/24/2014

A cost benefit analysis can be an excellent decision-making tool, as long as some common mistakes are avoided. Learn four of the most basic errors and how to avoid them.

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    A cost benefit analysis (CBA) is used to evaluate the total anticipated cost of a project compared to the total expected benefits in order to determine whether a proposed project is worthwhile for a company or team.

    Although this evaluative method is relatively easy and straight forward, there are many potential errors that can be made, which can result in inaccurate and misleading results.

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    The Four Most Common Errors

    1. Forgetting to account for indirect cause-and-effect relationships.

    One of the most common errors when creating a cost benefit analysis is omitting, whether accidentally or on purpose, relevant costs and benefits. Most cost benefit analyses are incomplete because significant costs and benefits are not included, resulting in inaccurate and misleading results.

    One of the easiest ways to avoid making this error is to consider all direct and indirect causal effects of a proposed action by making a cause-and-effect flow chart. It's critical that monetary and non-monetary items be accounted for to ensure the analysis is complete and accurate.

    2. Use ambiguous or overly ambitious valuation mechanisms.

    Problems Another common error is overestimating the value of a potential benefit or underestimating an anticipated cost of a proposed action. Sometimes this occurs because an evaluator uses an ambiguous and overly simplistic or generic appraisal technique, which is not suitable for every item on a cost benefit chart.

    The easiest way to avoid this is to assign values based on actual market data for similar projects or actions, to consult with a valuation specialist to suitably quantify and identify project costs and benefits, and to consider past experiences that involved similar costs or benefits. Be realistic and somewhat pessimistic when assigning monetary values to intangible items.

    3. Relying too much on past projects and experiences.

    Although the last error suggested that past experiences can be used to estimate costs and benefits, it is not advised to rely too much on past experiences. Sometimes, when a past project or experience is given too much weight, an evaluator forgets to consider alternative costs and benefits, thus omitting those items not present in the past project or experience.

    In order to avoid making this error, it's best to give some consideration to past projects and experiences, but only after all other brainstorming and market research efforts have been exhausted. This ensures that the former project is being used as a final resource rather than a single source of information.

    4. Projecting too far into the future.

    A final common error involves forecasting. One can unrealistically forecast anticipated inflation or a rate of return, thus resulting in under-discounting a cost or benefit in a present value calculation. Also, one might project costs and benefits too far into the future based on a simple relationship when long-term results differ drastically due to unforeseen influences.

    The best way to avoid this error is to estimate a project’s costs and benefits roughly six to eight years into the future. This will result in an accurate estimation of the project’s lifespan. Furthermore, one should only use a single discount rate that accounts for the anticipated degree of inflation, which typically averages between 1.5 to 3 percent per year.

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    Download

    To accurately account for this discount rate, download this cost benefit analysis template available as an Excel document.