There are decisions that do not work out the way we expected. This is not a perfect world and most certainly not one that is totally predictable.
Besides those decisions there are the other, more embarrassing choices. In private, at least, most successful entrepreneurs and managers will admit to a few bonehead decisions they made. Some of these may have been particularly memorable because they placed a fragile young company’s future in jeopardy.
One of the characteristics that so many of these flawed decisions have in common is that they were doomed from the start. Contrary to the popular saying, they didn’t make sense at the time.
The reasons why poor decisions are so often made, especially by inexperienced entrepreneurs and managers, sometimes involve deep psychological issues best left to the experts to analyze. Most often, though, they are due to the decision-maker’s falling in love with an idea and closing his or her mind to the information that should have set off warning bells.
There is no foolproof way, literally, to prevent foolish decisions. Still, we are creatures of habit and developing a good habit — using cost-benefit analysis — can help us avoid many, maybe even most, of them.
Cost-benefit analysis is systematized common sense. That is what makes it all the more valuable in a time where common sense is an increasingly rare and endangered.
What is involved in a cost-benefit analysis? In its simplest form, it is simply a listing of the total benefits, usually savings or additional revenue and a listing of the total expenditures necessary to obtain those benefits.
For a labor-saving device of some sort, for example, the benefits would include the work-hours saved multiplied by the full hourly costs of the workers whose time would be saved. This assumes, of course, that the hours saved will either be put to good use or show up directly as a payroll reduction. The cost side of the analysis would be the acquisition cost of the labor-saving device, including any up-front and periodic maintenance fees.
That’s the simplest form, and as we all know real life is rarely that simple. One of the reasons that equipment rentals are so popular is that they often make cost-benefit analysis considerably simpler. Many businesses have found that the less visible costs of equipment acquisition, maintenance, and management are a resource sink and chronic budget busters. The rapidly growing popularity of “the cloud” over purchasing, operating, and maintaining one’s own equipment is just the most recent example of management’s desire to simplify the process.
Sometimes, however, real life can be refreshingly uncomplicated. A recent decision by the Snohomish County Public Utility District, popularly referred to as “PUD,” for example, was buttressed by a straightforward cost-benefit analysis.
The decision involved whether they should replace the existing HPS (High Pressure Sodium) street lights with more energy-efficient LEDs (Light-emitting Diodes.) There are more than38,000 streetlights involved, so they looked at a five-year project schedule and determined the costs of replacing them to be:
Costs (Including LED acquisition and installation)
Total Costs: $8,946,885
Benefits
Energy Savings: $4,873,080
Operations and Maintenance Savings: $1,401,495
Total Savings: $6,274,575
That means that the costs exceed benefits by $2,672,310. On a five-year time horizon, then, the project is underwater by more than $2.5 million dollars. At that point, though, the replacement LED installation costs drop out, while the energy and operations savings continue. In year six, the net savings will be $1.7 million and will clear its accumulated deficit during year seven. After that it’s all savings. PUD estimates the Net Present Value — the future savings discounted because we have to wait for them — of the project, on a 20-year time horizon, is about $6.4 million.
You might wonder why present the analysis at the five-year level, then, when it is underwater. There are at least two good reasons: (1) cash flow — the finance chief needs to know how much cash this project is going to need; and (2) the installation project will be completed in five years even though its financial tail will wag on.
Experienced hands will tell you that not all cost-benefit analyses are that straightforward.
Calculations are a lot easier with today’s spreadsheets; Net Present Value, for example, is a ready-built formula setup in Excel. By and large, though, the biggest problems come not from calculating what was included but what was left out; typically some significant costs, benefits or side-effects.
Cost-benefit analysis can really help managers of all businesses, large or small, by sharpening the thinking process that goes into decisions. It will not drain the creativity or productivity out of an individual or organization…but it will make us stop and think. And that’s the key to avoid a bonehead play.
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