Cost/Benefit Analysis

You may have been intensely creative in generating solutions to a problem, and rigorous in your selection of the best one available. This solution may still not be worth implementing, as you may invest a lot of time and money in solving a problem that is not worthy of this effort.

Cost Benefit Analysis or CBA is a relatively* simple and widely used technique for deciding whether to make a change. As its name suggests, to use the technique simply add up the value of the benefits of a course of action, and subtract the costs associated with it.

Costs are either one-off, or may be ongoing. Benefits are most often received over time. We build this effect of time into our analysis by calculating a payback period. This is the time it takes for the benefits of a change to repay its costs. Many companies look for payback over a specified period of time – e.g. three years.

In its simple form, cost-benefit analysis is carried out using only financial costs and financial benefits. For example, a simple cost/benefit analysis of a road scheme would measure the cost of building the road, and subtract this from the economic benefit of improving transport links. It would not measure either the cost of environmental damage or the benefit of quicker and easier travel to work.

A more sophisticated approach to cost/benefit measurement models is to try to put a financial value on intangible costs and benefits. This can be highly subjective – is, for example, a historic water meadow worth $25,000, or is it worth $500,000 because if its environmental importance? What is the value of stress-free travel to work in the morning?

These are all questions that people have to answer, and answers that people have to defend.

The version of cost/benefit analysis we explain here is necessarily simple. Where large sums of money are involved (for example, in financial market transactions), project evaluation can become an extremely complex and sophisticated art. The fundamentals of this are explained in Principles of Corporate Finance by Richard Brealey and Stewart Myers – this is something of an authority on the subject.

Example:

A sales director is deciding whether to implement a new computer-based contact management and sales processing system. His department has only a few computers, and his salespeople are not computer literate. He is aware that computerized sales forces are able to contact more customers and give a higher quality of reliability and service to those customers. They are more able to meet commitments, and can work more efficiently with fulfillment and delivery staff.

His financial cost/benefit analysis is shown below:

Costs:
New computer equipment:

·         10 network-ready PCs with supporting software @ $2,450 each

·         1 server @ $3,500

·         3 printers @ $1,200 each

·         Cabling & Installation @ $4,600

·         Sales Support Software @ $15,000

Training costs:

·         Computer introduction – 8 people @ $400 each

·         Keyboard skills – 8 people @ $400 each

·         Sales Support System – 12 people @ $700 each

Other costs:

·         Lost time: 40 man days @ $200 / day

·         Lost sales through disruption: estimate: $20,000

·         Lost sales through inefficiency during first months: estimate: $20,000

Total cost: $114,000

Benefits:

·         Tripling of mail shot capacity: estimate: $40,000 / year

·         Ability to sustain telesales campaigns: estimate: $20,000 / year

·         Improved efficiency and reliability of follow-up: estimate: $50,000 / year

·         Improved customer service and retention: estimate: $30,000 / year

·         Improved accuracy of customer information: estimate: $10,000 / year

·         More ability to manage sales effort: $30,000 / year

Total Benefit: $180,000/year

Payback time: $114,000 / $180,000 = 0.63 of a year = approx. 8 months

Tip:
The payback time is often known as the break even point. Sometimes this is is more important than the overall benefit a project can deliver, for example because the organization has had to borrow to fund a new piece of machinery. The break even point can be found graphically by plotting costs and income on a graph of output quantity against $. Break even occurs at the point the two lines cross.

Inevitably the estimates of the benefit given by the new system are quite subjective. Despite this, the Sales Director is very likely to introduce it, given the short payback time.

Key Points:

Cost/Benefit Analysis is a powerful, widely used and relatively easy tool for deciding whether to make a change.

To use the tool, firstly work out how much the change will cost to make. Then calculate the benefit you will from it.

Where costs or benefits are paid or received over time, work out the time it will take for the benefits to repay the costs.

Cost/Benefit Analysis can be carried out using only financial costs and financial benefits. You may, however, decide to include intangible items within the analysis. As you must estimate a value for these, this inevitably brings an element of subjectivity into the process.

How to Create a Sales Forecast

Developing your sales forecast isn’t as hard as most people think. Think of your sales forecast as an educated guess. Forecasting takes good working knowledge of your business, which is much more important than advanced degrees or complex mathematics. It is much more art than science.

Whether you have business training or not, don’t think you aren’t qualified to forecast. If you can run a business, then you can forecast its sales. Most people can guess their own business’ sales better than any expert device, statistical analysis, or mathematical routine. Experience counts more than any other factor.

Break your sales down into manageable parts, and then forecast the parts. Guess your sales by line of sales, month by month, then add up the sales lines and add up the months.

The illustration below gives you an example of a simple sales forecast that includes simple price and cost forecasts which are used to calculate projected sales and direct cost of sales and estimate total dollar value for each category of sales.

Use text to explain the forecast and related plans and background
Although the charts and tables are great, you still need to explain them. A complete business plan should normally include some detailed text discussion of your sales forecast, sales strategy, sales programs, and related information. Ideally, you use the text, tables, and charts in your plan to provide some visual variety and ease of use. Put the tables and charts near the text covering the related topics.

In my standard business plan text outline, the discussion of sales goes into the chapter on Strategy and Implementation. You can change that to fit whichever logic and structure you use. In practical terms, you’ll probably prepare these text topics as separate items, to be gathered into the plan as it is finished.

Sales strategy
Somewhere near the sales forecast you should describe your sales strategy. Sales strategies deal with how and when to close sales prospects, how to compensate sales people, how to optimize order processing and database management, and how to maneuver price, delivery, and conditions.

How do you sell? Do you sell through retail, wholesale, discount, mail order, phone order? Do you maintain a sales force? How are sales people trained, and how are they compensated? Don’t confuse sales strategy with your marketing strategy, which goes elsewhere. Sales should close the deals that marketing opens.

To help differentiate between marketing strategy and sales strategy, think of marketing as the broader effort of generating sales leads on a large scale, and sales as the efforts to bring those sales leads into the system as individual sales transactions. Marketing might affect image and awareness and propensity to buy, while sales involves getting the order.

Forecast details
Your business plan text should summarize and highlight the numbers you have entered in the Sales Forecast table. Make sure you discuss important assumptions in enough detail, and that you explain the background sufficiently. Try to anticipate the questions your readers will ask. Include whatever information you think will be relevant, that your readers will need.

Sales programs
Details are critical to implementation. Use this topic to list the specific information related to sales programs in your milestones table, with the specific persons responsible, deadlines, and budgets. How is this strategy to be implemented? Do you have concrete and specific plans? How will implementation be measured?

Business plans are about results, and generating results depends in part on how specific you are in the plan. For anything related to sales that is supposed to happen, include it here and list the person responsible, dates required, and budgets. All of that will make your business plan more real.

How many years?
I believe a business plan should normally project sales by month for the next 12 months, and annual sales for the following two years. This doesn’t mean businesses shouldn’t plan for a longer term than just three years, not by any means. It does mean, however, that the detail of monthly forecasts doesn’t pay off beyond a year, except in special cases. It also means that any detail in the yearly forecasts probably doesn’t make sense beyond three years. It does mean, of course, that you still plan your business for five, 10, and even 15-year time frames; just don’t do it within the detailed context of business plan financials.

How to Write a Financial Statement Analysis

A financial statement analysis is a comprehensive examination of the financial statements of a business. Financial statement analyses are often used for investment research in the context of scrutinizing the health of a target company. There are five discrete steps required to write the most common form of financial statement analysis. Accurate numeric calculation is the key to a successful analysis.

Instructions

1.  

o    1

Get the financial statements for your target business. The financial statements of publicly traded companies are available for free through the Securities and Exchange Commission's EDGAR database (see Resources). For privately held companies, financial statements are very difficult to obtain. These companies are under no obligation to report or even prepare financial statements. Publicly traded companies must file financial statements at set intervals. For this reason, financial statement analyses are usually conducted on publicly traded companies.

o    2

Obtain the financial statements for businesses that operate in the same industry as your target business. For publicly traded companies, use the SIC codes from the SEC's EDGAR database to identify companies in the same industry. The most common form of financial statement analysis involves comparing a target company against a benchmark developed from the financial statements of competitors. The more company financial statements you have available, the better your benchmark.

o    3

Compare each line item on the financial statement of your chosen company against the identical item on a competitor's financial statement. For example, look at the current assets section of the balance sheets to compare the accounts receivable of the two companies. If your target company has a much larger accounts receivable balance than its competitor in the same industry, this suggests you should investigate this particular financial statement item further.

You should be able to identify items of significant difference or items of surprising similarity for use in additional analysis. It is crucial to compare similar companies on a line-by-line basis in writing a financial statement analysis, to identify small differences in terminology or item placement.

o    4

Conduct detailed ratio analysis for accounts of interest. Continuing the previous example, if your target company has an extraordinarily high accounts receivable balance, you should construct an accounts receivable turnover ratio by dividing the accounts receivable balance into sales. Compare the accounts receivable turnover ratio of your target company with its competitor. Any significant difference is grounds for written investigation and interpretation.

Ratios are used to normalize line-item differences for companies of different sizes. It is generally useful to normalize these differences by dividing by sales or total assets.

o    5

Use items that have significantly different ratios and balances in a text description of your target company. For the example, write a paragraph detailing the dollar value and ratio difference in the accounts receivable balances between the companies.

Next, explain why you believe this difference exists. Note that your explanation is generally a matter of subjective interpretation, but the dollar and ratio differences are matters of objective fact. However, if the numeric calculations are accurate, your interpretation will be grounded by factual observation and thus form the key component of your financial statement analysis.

How to Write a Final Audit Report

The purpose of an audit report is to evaluate a project a company is implementing or trying out. Projects can include new software systems, a new customer service approach or a new marketing campaign to attract customers. A final audit report is the last report in the auditing and implementation process to determine whether or not the project in question needs adjustments prior to implementation. The final audit report has the same sections and discussions as a regular audit report, as it needs to address the concerns brought up in earlier audit reports for the project in question.

Instructions

o    1

Compose a front page for the final audit report. Ensure that it has the title "Final Audit Report" and write the name of the project being discussed in the report. You should also include the name of the department and the person who is responsible for the auditing process. On the second page, start an index page, which should be updated as the report progresses.

o    2

Write an executive summary for the final audit report outlining the key points of the report. Write this section last, but place it after the index page. You should focus on the key points leading up to the final decision by highlighting the objectives of the audit project, final tests and results.

o    3

Compose a background section for the final audit report. The background section should focus on the purpose of the initial project, the information presented in previous audit reports and what changes have been made leading up to the final audit report. This should provide new readers with all of the background information leading up to this final report.

o    4

Compose a list of the objectives of the final audit report. The objective of a final audit report should focus on finding out what needs to be changed in order for the project to be completed. The objectives should be in the last stages of implementation, rather than focus on starting new projects.

o    5

Outline any new methods used in the final stages of the auditing process. Explain these new methods in detail and the justification of why these new methods were used, so readers understand how these methods feed off older results. If the methods are the same as the ones used in previous audit reports, then mention that fact.

o    6

Write the final results of the auditing process. The results should indicate whether the project in question is a success or something that is better left for a later date. For example, if the results of the various tests showed that not everyone was pleased with the new software system, it may not be the best idea to implement it until the concerns have been addressed. The final results should provide an answer, rather than raise questions for the reader.

o    7

Write a conclusion for the final audit report. The conclusion should indicate the final answer or approach of the project. If the project is a success, the conclusion should indicate the next step or implementation procedure. If the audit project is not a success, the conclusion should address the reasons why the project did not succeed and what can be changed so the project can be a success after adjustments have been made.

How to Write a Financial Analysis Report

Accurately and honestly communicating your company's strengths and weaknesses will help convince investors to throw their money behind your business. A financial analysis report is a document that will be of great interest to investors since it contains a detailed assessment of your company's financial health. Write a financial analysis report comparing costs and benefits, translating these concepts into real dollar amounts. Rather than glossing over economic challenges, openly admit threats to the company's well-being without fear of chasing stakeholders away. Professional market-watchers who are likely to invest understand that costs and income often depend on variables such as global markets. A transparent and objective assessment of your company's finances will serve as a reliable source, enticing investors to take a deeper look.

Instructions

o    1

Begin the report with an "Executive Summary" of key findings from the financial analysis. State the time period the study focused on. Identify the firm requesting the report.

o    2

Prepare an introduction that emphasizes the report's objectives. Define financial terms necessary to understanding those objectives. For example, a reporting objective might be to measure a firm's cost-benefit ratio. That would require the report also define terms like "project costs" that help to clarify the main points.

o    3

Move on to a section titled "Resources." Write a general description of the data analyzed and where it came from. Examples of resources include income statements, balance sheets, inventory ratios, operating costs and warehouse statistics.

o    4

Describe resources further under the heading "Method of Collecting Data." State whether data was provided by different sources, such as government agencies or departments within the company. Explain each source's method for reporting data. Discuss how the analysis accounted for these distinct reporting methods.

o    5

Call the next section "Significant Financial Events." Enumerate events that occurred during the time period studied and that altered results. For example, unrealized gains on stock sales during the past year might explain the company's unexpected rise in revenue. Then, identify offsets to that rise in income.

o    6

Continue with a section titled "Detailed Results." Provide a comprehensive analysis of investment returns, income statements, balance sheets and productivity ratios. Comment on each of these factors and provide support for your statements with tables and graphs.

o    7

Compare results from different quarters in a section called "Analysis of Variance." For example, contrast fourth quarter sales to average sales.

o    8

Create an appendix for "Financial Revenues." Define how that term was used to prepare the report. Tabulate the revenues over the time period of the analysis. For example, the report might chronicle plywood sales for all contracts in a given year. Distinguish between the amount of plywood actually sold in the year and the amount provided for in contracts signed that year.

o    9

Finish the report with an appendix for "Observations." Discuss any problems encountered in analyzing the data, then explain how the research method handled the problems. Conclude with a statement that projects future performance based on past results.

Set the Right Price for Your Service

Don't go too high or too low, or customers won't buy what you're offering.

Without a doubt, one of the hardest parts of starting a consulting or professional practice is the art (there is no science) of pricing your services, the subject of this week's e-mail: "I've just left corporate America and am starting my own consulting business. There's a fair amount of competition in my area, but I'll be working out of my home with low overhead, and I'm thinking of offering really low prices to my customers, like 50 percent of what my competition charges, in the hopes that once I become more established in my practice I'll be able to raise them. Do you think this is a viable strategy?"

When you start any business, there's always a certain amount of insecurity (OK, terror) about just how good you really are. You lie awake at nights asking "Will people actually part with their hard-earned money to buy what I have to offer?" It's very tempting to sell yourself short and offer your services at rates significantly below the market in an effort to get business--any business--in your front door.

But let me ask you a question. Let's say you were thinking of hiring me as a consultant, and I told you my rate was $10 an hour. You have spoken to other consultants who quoted you $200 to $300 an hour for the same services. Tell me the truth: Would you be jumping up and down for joy, thinking that you have been offered the deal of your life? If you are like most people, you would be very suspicious of my offer. You would be thinking either:

• This deal is too good to be true--I'd better check this guy out thoroughly; or
• This guy is so naive or desperate for business that if I bargain hard with him, I'll probably end up getting the services I need for nothing.

Either way, I am not going to get what I want out of this relationship.

There's another drawback to low-ball pricing. Let's say your competition is charging an average of $200 an hour. You price yourself at $100 an hour, and you get tons of business. Now you want to raise your fees to $125 an hour. How do you think your clients will react to that, once they have become accustomed to paying $100 an hour? Believe it or not, even though at $125 an hour your clients are still getting a tremendous deal, they probably will yell and scream that you are raising your fees by 25 percent in a difficult economy. Try it, and see what happens.

It's a lot easier to overprice your services and offer discounts to your clients--that way, the clients perceive that they are getting a deal, and you are still getting a market rate for your services--than it is to underprice your services in the hopes of increasing them later once the clients are "hooked" on your way of doing things.

This doesn't mean that you should price higher than your competition, in the hopes people will perceive you as the "gold standard" of your profession. Some people do think that high prices equal superior quality, but they usually aren't the clients you want to attract. Remember, you are an unknown quantity at this point.

What I would do, if I were in your shoes, is find out exactly what your competition charges, and price yourself at 80 to 90 percent of what they charge. Then, if you sense a customer wants an even lower price, you can offer a one-time, "new client" discount, or perhaps a flat fee, on the first job you do for them. This will send the desired signal that you are eager for their business and are flexible in your pricing, while also communicating that sooner or later the client will be asked to pay something close to market rates.

There is always the risk that you will overprice your services at some point. Just keep in mind two important truths. If you do not charge what you are worth:

1. You are guaranteed to burn out quickly; and
2. You will resent your customers for not providing you with a decent living and start treating them like dirt--a sure formula for failure.