A cost-benefit analysis is crucial to every idea, project or already existing business. It puts our expectations to a different perspective and the numbers tell us what our next decision should be. In other words, whether a particular project makes sense from a financial point of view.
Indeed, some adjustments can be made during the process, but if the numbers are far from what we have expected, it is a great warning call for the project leader that the project should be killed or pivoted.
In this two-part article, you will find basic steps and reminders that are (from my point of view) essential to every cost-benefit analysis. There is no standardised set of rules of how you should perform the analysis but there are a few points that I follow and remind myself every time I analyse a project.
Every business needs to set goals regarding what the future numbers should look like. A cost-benefit analysis will help you to set your goals closer to reality and possibly forecast what you can expect if this or that happens (different costs - less or more; higher or lower prices of the product and so on).
Before we get into the guideline it is important to mention that there will be some perceptions and beliefs of how the future should look like. Try not to be influenced by those beliefs and misperceptions. Be as unbiased and objective as you can. Throughout your process seek continuous external feedback either from your colleagues or even from your friends that have an outside view on the case.
The feedback should mainly be on your parameters and expected expenses that are unique to every company or business model (different sunk cost, cost of labour, etc.).
In the first step of your process, you should make a thorough search on the world wide web and seek for every company that is similar to the project, service or at least business type you are about to analyse. Here are some links that might help with your search:
● and obviously google.com
You should also have a quick search on startup cemetery just in case your idea has already failed. On the cemetery website, you can also see the reason why a certain startup or business has failed which might be useful in order to make some changes to the business model or rethink the whole purpose of your idea.
In your second step, pick a company that is the most similar to yours and seek for every number you can get. If it is a Czech company your work suddenly becomes easier as almost every company will have several accounting reports on justice.cz. If the company is not Czech then you have to try and get any reliable reports or numbers perhaps from links listed in step one. A good research of the industry you are about to operate in is also very helpful.
● What is the business model of alike company (same or different?)
● How much do they charge for the product, service or what is the subscription model?
● What chunk of the market does the company approximately take - is it a monopoly, duopoly or is there a big competition?
● At what rate is the company growing - does the company grow in terms of revenue or perhaps in the number of employees?
● What is the potential market that your company can take - what makes you different that will take customers from your competition, how can you bring new customers to the market?
Take some time to think and try to find answers for each question before you get into numbers. This will help you to refine and set barriers of what is relevant and what not to take into consideration when you analyse a report. As I mentioned earlier, some of the variables will not be relevant to you, based on differences of your business to others for example.
Turnover is one of the main metrics you should look for. Turnover ought to be raising every year as the company grows. If you get access to the previous years' accounting reports, you can tell if the company is growing with the market or if it is stagnating. This one will be tricky and hard to find but if you are able to get an accounting report from current and previous years you surely can calculate the rate of growth of a particular company. The easiest way to calculate the rate of growth is by looking at the difference in revenue from year to year. It will give you an idea of how your company can grow and what to expect from future revenues. It will serve you as a baseline. Later on, if you get a number that will look odd you can always go back and check if it is close to being real. However, the rate of growth heavily depends on which market the company is operating in. If the turnover is not growing it might be that the lump of the company is already at its peak or that the company is struggling to boost the output or cannot compete with the price and therefore cannot gather bigger customer base (new competitor on the market, bad marketing, exogenous factors).
If you can find a detailed accounting report you will surely find a part where the expenses of a particular firm are separated into a few sections. The most important section you should look for will be related to people - “wage expenses”. This will tell you how much is spent on the workforce and how many people your business can afford.
Do not forget to look at other parts of the report (if available) such as rent, IT services, accounting, legal and marketing. We will look at what marketing expenses can tell us and how important this number can become in the next section.
It will be very useful if you are able to get the number of clients and the marketing expenses of a similar firm. Why? Because you will probably run a marketing campaign yourself at some point and it is quite important to know what the CPA of your concurrent is. That will set a goal and provide you with an idea of how much you will have to spend on marketing to get x amount of customers.
However, it will be very hard to get one or the other variable so do not worry if you will not be able to calculate the CPA of your project.
If you can get your hands on any accounting report you will probably be able to find a section with operational expenses. Carefully examine this section and try to find at least expense that are related to labour. This will tell you how big the company is in terms of the number of employees and how much money will you need to cover all the operations. Rent is quite relevant to where the HQ of the company is. Hence, look at this number just to have an idea of how much you will have to pay for your offices.
You should focus on EBITDA if there is the possibility of a takeover. Usually, you get the cost of acquisition by multiplying EBITDA by 5. Although there are many ways how to estimate the cost of acquisition and the final price heavily depends on negotiations, this measure will be close enough to reality.
After you do all of the work above, you will be ready for putting everything in the context of your business. You will have a great benchmark and an idea of what reality can bring. In the second part, we will set a framework and define parameters that will play a crucial role in our analysis. We will also go through some financial metrics that will be beneficial to your project. For now, take some time and think about the broader view of costs and benefits to the outside world that your project might bring indirectly. In other words, what is so different about the project that will provide you with trust/distrust from customers or investors. This will become very important later on.
Part two is coming out very soon.
Financial Analyst at Outboxers
Sassone, P. G., & Schaffer, W. A. (1988). Cost-benefit analysis: a handbook. New York: Acad. Press.