written by: nataliajones•edited by: Ronda Bowen•updated: 7/1/2010
Entrepreneurs use the cost benefit analysis method to evaluate the choice of starting a new business. This article explores how this is done with specific reference to examples relevant to the business owner.
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What is a Cost Benefit Analysis?
A Cost Benefit Analysis is sometimes referred to as running the numbers because it simply looks at a situation and attempts to add up all the positive contributing factors and then subtract the sum of the negative factors. The end result is either a positive figure if the benefits listed outweigh the costs, or a negative if the reverse turns out to be true. The process is therefore easy to parallel to weighing the pros against the cons on a known scale.
There are instances when a cost benefit analysis is a simple matter because all the variables are known and easily quantifiable so finding the result is just a matter of simple subtraction. However, some instances are more complicated because they involve both tangible or quantifiable factors as well as intangible factors.
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Cost Benefit Analysis on a Start-Up Business
To perform a cost benefit analysis on a start-up business is a bit on the complex side because there are several factors that play into the decision to start a business and they are not all easily quantifiable. All factors must be quantified or assigned a value and then the sum of the costs must be subtracted from the sum of the benefits to arrive at an overall conclusion.
Some of the possible benefits of starting a business include but are not limited to;
The Potential for Sales Revenue. Making money is one of the principal reasons for starting a business, so naturally this must be listed as a benefit. This benefit may also be quantified using estimates of sales from similar businesses.
Improved Sense of Purpose. Another reason for starting a business is to fulfill a dream or to pursue a talent. This is not so easy to quantify and is therefore one of the reasons coming up with a proper analysis is difficult.
Higher Standard of Living. Assuming the business is a success this will positively impact on the entrepreneur's standard of living. This is not just in the sense of increased personal income, but may also include factors like status and time with family. Understandably this is also an area that may be difficult to quantify.
Some of the possible costs of starting a business may include the following;
Cost of Recurring Expenses. This could include things like rent, wages, cost of sales or materials and even utilities and other expenses. Different types of businesses would have different recurring expenses but almost all ventures incur some costs on a repetitive basis.
One-Time Costs. Sometimes to start a business requires an upfront investment of capital that is used to cover one-time only costs. Such costs commonly refer to the purchase of machinery or equipment to be used in the business, the cost of training to get the business started, licencing and registration fees and other costs that are only to be incurred once.
Risk of Starting the Venture. While the aforementioned costs are easily quantified, the risk that may be involved in starting the business venture is not. There may be considerable personal sacrifice involved from leaving permanent employment to investing savings as capital in the business.
Opportunity Cost. The choice to do something else is also one that should be included in any calculation of the cost benefit analysis of a business. Simply committing to a course of action might limit the flexibility to explore other options and this loss of flexibility can be quantified in terms of the potential benefit of the options not chosen.
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Deriving a solution from a cost benefit analysis may not be an easy endeavor but it is one well worth exploring because it forces an examination of factors on both sides of the equation. Even before embarking on a cost benefit analysis there may be a preferred course of action, but the act of analyzing both the pros and the cons before officially coming to a decision ensures that the best possible route is always chosen.