What Is Cost Analysis?

While it’s natural to harbor uncertainties about the best course of action when facing critical decisions in business, you can use cost analysis to help you choose the most lucrative path forward. Whether you're evaluating the feasibility of a proposed project or contemplating a shift in sales strategy, cost analysis serves as a guiding compass, offering insights into a business decision's potential benefits and drawbacks. Essentially, you can implement this tool to determine how much a project will cost and then compare that to how much the project can produce. 

Read on to understand the nuances of cost analysis, including effective comprehensive analysis strategies. 

Why is cost analysis important?

Cost analysis, or cost-benefit analysis (CBA), is a systematic approach that helps you evaluate an endeavor or project's financial implications and benefits. Essentially, a CBA quantitatively compares the estimated costs and benefits. The outcome provides a numerical indicator (total benefits minus total costs) that helps you assess whether a proposed project is economically sound. 

For instance, consider the launch of a new product line. Performing a cost analysis would help you discern the preliminary expenditure, potential revenue (tangible benefit), and the overall financial viability of this endeavor. Armed with this information, stakeholders within your firm can make well-informed financial decisions, thereby contributing to the success of the new product line.

What are the direct outcomes of conducting a cost analysis?

If you conduct a cost analysis, strategic budgeting is one of the direct outcomes. Stakeholders, including investors, need relevant data for budgeting decisions. When you provide transparent cost analysis, you foster collaboration, ensuring stakeholders contribute meaningfully to budgeting. 

Read more: What Is a Pricing Analyst?

Steps involved in cost analysis

A universally agreed-upon method for conducting a cost-benefit analysis doesn’t exist; however, most techniques have the following steps in common:

1. Define project goals and scope.

Setting explicit objectives can help enhance the accuracy of your cost-benefit analysis. For example, you might want to conduct a CBA to assess the cost and benefits of adopting a remote work policy within your organization.  

After outlining your project scope, choose a metric for comparing the associated benefits and costs. You can choose to use job hours, actual currency, or customer satisfaction index as a metric, depending on the nature of your project. If you use a specific currency as a metric, ensure that costs and benefits are expressed in the same currency for an accurate comparison. 

2. Record estimated costs and benefits.

Create two lists to document the estimated costs and benefits associated with your project. Costs can be direct (labor, inventory, raw materials, and manufacturing expenses), indirect (utilities and rent), opportunity (missing a chance to do something cheaper, an example being hiring additional employees when you don't need them), or intangible (advertising expenses, branding costs, market research, and legal fees). 

Like costs, benefits can be direct (increased revenue from a new product line), indirect (strengthened customer loyalty and positive word-of-mouth), competitive (establishing market leadership by introducing unique features or services), or intangible (elevated company reputation, stronger brand image, and improved employee morale). 

3. Set a value for every cost and benefit.

After compiling all costs and benefits, assign a value, such as a dollar amount, to each for comparison. Note that quantifying intangible and indirect costs/benefits may not be straightforward. Nevertheless, you can utilize analytical tools to determine probable values.

4. Compare total costs with total benefits.

You can sum the costs, and then you can deduct that result from the total benefits. If total benefits exceed total costs, proceed with your business goal(s). If total costs surpass total benefits, you may want to reevaluate your set target(s) because you could lose money if you move forward with the project. 

Example: A small café is contemplating the introduction of a new specialty coffee blend to attract more customers. Emily, the café owner, conducted a cost analysis to check for feasibility. 

The direct costs for the new blend include coffee beans and packaging materials, totaling $300. Indirect costs, covering utilities and additional staff, amount to $150. Intangible costs, like potential disruptions and research, are capped at $50. 

The total costs sum up to:

• $300 (direct) + $150 (indirect) + $50 (intangible) = $500.

As a next step, Emily enlists a financial analyst to gauge probable benefits. If the new blend sells well, the analyst forecasts an additional $700 in revenue for the café. 

Finally, to complete the cost-benefit analysis, the financial analyst subtracts the onset cost from the expected revenue:

• $700 (benefit) - $500 (cost) = $200

The analysis reveals a potential profit of $200, coupled with the competitive advantage of offering a unique specialty coffee blend. Encouraged by the positive outcome, Emily proceeds to make the required investment. 

When should you conduct a cost analysis?

The gains resulting from a cost-benefit analysis extend beyond launching a new product, service, or policy because you can also use it for employee training and expanding your business. The following scenarios demonstrate the analysis’ versatility in guiding your decisions across different aspects of a business:

1. Implementing employee training programs

Scenario: Investing in digital training platforms for staff development

Rationale for CBA: Evaluating the costs of training against anticipated improvements in employee skills, productivity, and organizational performance

2.  Adopting sustainability 

Scenario: Incorporating eco-friendly packaging to limit carbon footprint

Rationale for CBA: Assessing the costs of adopting sustainable practices against long-term benefits such as improved brand image and potential cost savings

3. Introducing customer loyalty programs

Scenario: Establishing a customer loyalty program to enhance customer retention

Rationale for CBA: Determining the costs of the program against projected gains in customer loyalty, repeat business, and overall customer satisfaction

4. Expanding geographic presence

Scenario: Considering expansion into a new city or country

Rationale for CBA: Analyzing expansion costs versus potential market growth and profitability 

Pros and cons of cost analysis

If you own a firm or are in charge of the finances of a business, conducting a CBA can help you with the following: 

• Present fact-based data or evidence to support new project ideas.

• Identify and track not-so-obvious or hidden costs, such as intangible costs.

• Mitigate the impact of subjective biases like personal opinion or judgment that may inadvertently influence decision-making.

While CBA has its perks, it’s important to note that it’s not without limitations. Here are a few notable ones:

• It requires a substantial amount of data. Analysis based on insufficient data can lead to faulty conclusions.

• Completing a cost-benefit analysis requires a considerable time investment.

• CBA is less effective for long-term projects, with factors like inflation compromising forecast accuracy.

A common misconception in cost analysis

It may be natural take the most economical solution, but cheaper is not always better when it comes to cost analysis. While cost analysis can accurately measure profitability, it cannot ascertain whether the least expensive option is the best overall.

For example, consider a technology company evaluating software solutions based on licensing costs alone. While a conventional cost analysis might emphasize the economic benefits of a particular software package, it may neglect vital non-financial aspects like compatibility with current systems, user-friendliness, and the potential for future upgrades.

Cost analysis vs. return on investment

Return on investment (ROI) helps measure tangible gains against the costs of implementing your proposed project or solution. In contrast, cost-benefit analysis (CBA), which is more complex, aids in measuring both tangible and intangible costs and benefits. Since ROI is slightly more simplistic, you can show it to executives as evidence that your proposal is sound. Typically, an ROI needs to be greater than zero for executives and investors to support your project.

ROI = (net benefits/total cost)*100

Net benefits = total benefits - total costs

Get started with Coursera. 

Learn the fundamentals of product and service costing with the Cost Accounting Specialization, on Coursera. Offered by the Technical University of Munich (TUM), this Specialization includes quizzes and interactive learning options to help you identify relevant costs, track overhead rates, assess profitability, and more. Upon completion, gain a shareable Professional Certificate to include in your resume, CV, or LinkedIn profile.