(This post is part of the 31010 Series of posts on Risks & Ventures. For more information on this series of posts please follow this link).
As we have said in some of our previous posts, there are several formal, recognised risk assessment techniques which quite closely resemble things that many of us already do, without us actively thinking that we are doing risk management, and certainly without knowing that the technique we are using can be found in the world’s most widely used set of risk management standards.
Cost Benefit Analysis is one of these, and in one respect all of us do some weighing up of costs and benefits every time we make any decision at all, including for example whether the benefit of the taste and sugar of a cupcake is worth more than the calories and financial cost.
However if you have ever found yourself sat with a cup of coffee or tea and writing a list of pros and cons – reasons why you should do something along with a list of reasons why you shouldn’t do it – this means that you will have already done a slightly more formal kind of Cost Benefit Analysis. The tea or coffee isn’t essential of course but many of us do have a tendency to make these types of lists during scheduled pauses in our daily activities when we have might have a little extra headspace to think.
Some of you may make pros and cons lists regularly while others might only consciously do it when assessing ‘bigger’ life decisions, but almost everyone reading this post will be familiar with the idea of making lists like this.
How Do I Do Cost Benefit Analysis
When it is used in formal risk management practice the technique of Cost Benefit Analysis is usually a bit more complicated than just writing out lists like that, but the general idea and pattern is the same, and it involves taking the following three steps:
1. Identifying up all the total costs, or potential costs, associated with a particular activity or decision including future predicted ones.
2. Identifying all the total benefits, or potential benefits, associated with the same activity.
3. Comparing the different options this analysis gives you to decide which out of the two or more options you have looked at is the optimal one.
If it’s possible to do so in formal risk management financial values should be assigned to the costs and benefits so you can have a final total figure of what the activity is worth to you, or alternatively how much it could lose you. In risk management this would be called the Net Present Value. (1)
Of course it isn’t always necessary, easy or even possible to do this type of financial analysis depending on the kind of information you are considering, and there are also other ways you can introduce some numeracy to your analysis without using financial figures, for example by scoring pros and cons out of three, five or ten based on their importance.
The more detailed and comprehensive you try to make the analysis the harder it gets, and this is why Cost Benefit Analysis at its extremes can be both one of the most straightforward risk assessment techniques that you may ever use and then also one of the most complicated, requiring significant levels of specialist skill and knowledge.
Strong Cost Benefit Analysis should consider multiple layers of costs and benefits, including indirect, secondary and intangibles costs and benefits as well as the more obvious, tangibles one. Intangible costs and benefits are things that do not physically exist but may still be relevant, for example a business’ reputation or a strength of a personal relationship. These can be particularly hard to value and in the case of certain aspects of our personal lives it might not be desirable at all to try to. (i.e. to put some kind of score or a financial value on a friendship).
Indirect and secondary costs and benefits will also include the costs and benefits to stakeholders that might be effected by a particular course of action. For example, a business might ask ‘if we start to offer new services on our value chain vertical how will our customers and suppliers react to that?’ or a couple of parents might ask ‘if we move cities how much will it cost our parents to get to see their grandchildren’.
More complicated versions of Cost Benefit Analysis may also examine values for different levels of cost and benefit probability. This could include some sensitivity analysis in order to see how a change in the probability of a single specific cost or benefit effects the overall picture. For example if you are discussing how affordable a mortgage is with your partner, you might come to the conclusion that you can afford a particular mortgage payment on your current joint salary but not if you were to both lose more than 25% of your working hours, with the sensitivity analysis being done of the variable of working hours.
The Cost Benefit Analysis process is also an intrinsic part of making business cases, where an opportunity is evaluated along with the uncertainties and hazards associated with it; but like other risk assessment techniques the quality of the analysis depends heavily on the quality of the information that goes into it, and if you are not sufficiently aware of enough of the most important potential costs and benefits of an opportunity, then the results of that analysis are going to be flawed, perhaps very seriously flawed. (2)
Bad Information = Bad Decisions
While engaged in some business development consultancy work this author was once asked to assist with the development of the business case for a venture which a North American company was planning to implement in a Middle Eastern country. This company’s management team needed a formal permit for what it was proposing to do and as part of that process they were required to present a business case to the relevant business licensing authorities.
I was confident that the team could write a business case document and presentation in the format and style that was needed, but I personally had some knowledge gaps in some aspects of the venture, particularly in relation to probable levels of demand and pricing. (Which, by the way I was completely open about with the boss of the business when he asked me to work on this assignment).
We worked through a couple of late nights to get the business case finished and the boss was pleased because it showed a potential likely net annual profit of around $4 to $5m which on a 25% margin easily cleared his acceptance criteria. However as I handed over the final documents to him I told him that although it looked good he *absolutely* had to get other opinions on what the realistic levels of demand would be before proceeding further, reminding him that these estimates had come primarily from another manager who also had a vested interest in the venture going ahead because he was ear-marked to run it, and therefore far from a neutral party.
I don’t know if this boss did find ever find someone else for a second opinion on these demand projections, but the venture was approved, did get regulatory approval, but demand did turn out to be much lower than predicted in the business case and the business was a complete failure. In this example the actual cost benefit model that I created was sound, but this one very important piece of information going into it wasn’t.
I’ll quickly mention two final things to consider: the opportunity cost and the costs of common goods.
The opportunity cost is the cost and benefits of the things that you won’t be able to do if you pursue a particular course of action, so in my example because this boss wasted a lot of time and money on this failing venture this meant he wasn’t able to use that time and money in a different way, and in this case even just putting that money in a bank at a low interest rate would have been a much better use of time and money.
Common goods usually mean things like air, water and other types of natural resources, which businesses are notoriously bad at factoring into their Cost Benefit Analysis, either because the consequences are too distant for them to consider or too difficult to attribute or they just don’t want to factor these into their analysis.
For example, would the owner of an industrial process which causes high rates of greenhouse gases factor the full costs of this pollution into their business case, unless they are required to by regulation or legislation; likewise will a company making disposal plastic goods which end up washing up on a beach in a distant country ever consider the health of humans and wildlife and the costs that third party countries have to sustain while removing them to their analysis? They probably should, but realistically most don’t.
Cost Benefit Analysis in Everyday Life
As we said earlier Cost Benefit Analysis can be one of the easiest risk assessment techniques to use and it can be one of the most difficult depending on the level of detail that is necessary.
For starters if you don’t make pros and cons lists very often why not try to use them a little more, and also maybe in different circumstances than you would normally to see if it the technique is helpful for you.
If you already do use these types of lists why not start to look at each line in a little more detail, and maybe try to start assigning some values to your options, or perhaps trying to identify some intangible costs or benefits that you hadn’t thought about before.
Several of the other techniques we have written about before in this series of posts can also be used as part of a Cost Benefit Analysis too, but just remember always to be honest with yourself about which bits of information you are using that you are confident about as well as the ones that you are not.
(1) (NPV = Present Value of All Benefit minus Present Value of All Costs)
(2) For more information on some of the factors to consider when evaluating a business opportunity please take a look at our post on the concept of STEEPLED (which is also more commonly also known as PESTLE or PESTEL) https://www.risksandventures.com/2020/02/11/what-does-steepled-mean-in-risk-management/