Cost Benefit Analysis

Cost Benefit Analysis

Cost Benefit Analysis is the process of taking calculated business decisions. The benefits or profits associated with a given actions or situations are summed up and the total costs associated with are subtracted. The resultant profit or loss determines the decision. Before an investment decision is taken a manager will analyze the data pertaining to the costs and the potential profits of taking up a project. This step will ensure that a good investment is being made which would be profitable to the organization.

Every organization should have formal procedures for determining whether recommendations for improving the control system are cost justified. Cost-benefit analysis or risk analysis examines the cost of new control procedures in the context of the benefits to be derived from eliminating a control weakness. In other words, it compares the likely cost saving that would accompany reduction of risk with the out-of-pocket expense of risk reduction. Cost benefit analysis should be conducted subsequent to discovery of an internal control weakness or introduction of a new type of transaction, but prior to implementing new control procedures.

The following sequence is useful in applying cost-benefit analysis to internal accounting controls:

1.    Identify the internal accounting control weakness.
2.    Determine the importance of the weakness with respect to
   • Magnitude of possible risk
   • Probable frequency of occurrence
3.    Identify controls that could be implemented
4.   Identify cost elements, both quantitative and qualitative. Costs frequently include:
   • Direct expenditure on controls (includes actual expenditures and employee time involved to perform the control)
   • Negative morale in response to any new restrictions.
5.   Identify benefit elements, both quantitative and qualitative. Benefits frequently include:
   • Reduction in probable loss of resources
   • Improved public image

Assign a monetary value or priority ranking to cost and benefit elements. Personal estimates and judgments are often required.

Execute cost-benefit analysis and document premises upon which a final decision is made.

Controls should be implemented if total benefits derived exceed the total costs of controls. If alternative control procedures are available, the control that yields the highest net benefits should be selected.

A key concept in cost-benefit analysis is incremental costs and benefits – each additional dollar expended on controls should normally produce at least an additional dollar of benefits. The results of this cost-benefit analysis should also be presented to the board to ensure the board’s concurrence.

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This article is in continuation with our previous articles on Finance and Accounting which include Corporate Finance, CAPM Model, Bond Valuation, Internal Rate of Return