The accidental benefits of cost-benefit analysis
Updated: October 19, 2005
By Marty Chakoian
Here's the view of the world most of my clients share: Costs are getting fatter, profit margins are getting skinnier, and stakeholders are getting more and more skeptical of bold new initiatives that will "save money," "increase market share," or, worst of all, "transform the business."
Yet some projects—large and small—are needed. Markets, products, and customer expectations are constantly changing; to stand still is to fall behind. Companies must carefully choose among competing demands such as increased manufacturing capacity, business intelligence systems, facility expansion, or the development of new products and markets. Even with limited resources, the choices can seem endless.
So how do organizations decide which projects to invest in and which to forego? When do you put the chips on the table, and when should you fold?
Not surprisingly, most businesses today perform some sort of formal, structured analysis on the costs and likely outcomes before gambling on a new project. I have worked with clients on business cases for projects ranging from major software system upgrades and data warehouse implementations to business process improvements. Meta Group (now part of Gartner Group) notes that by 2006, more than 60 percent of companies will use portfolio management models for making information technology (IT) investment decisions.1
Most public and private sector organizations find that following a formal evaluation process pays off in better investment decisions and reduced risk. (For a brief overview of cost-benefit analysis, see "Creating a cost/benefit analysis.")
Seattle Public Utilities, which provides water, wastewater, and solid waste services to 600,000 Seattle area residents, is one such organization. The utility recently implemented a highly structured process for reviewing all proposed projects of more than $250,000. The result, says director Chuck Clarke, has been better, more visible decision-making that helps to drive down costs. "We've cut our operating budget by nine percent and our capital budget by 18 percent," he says.
A financial services analyst for another firm, a large financial services company, notes additional positive results at her company. "I think our formal process has had a significant impact in building behavior toward working on things that have a justification. It is driving change by rewarding people who generate high-impact business cases," she says. That's the intended result. But some of the accidental consequences are even more interesting.
1Al Passori, "Making Decisions the ROIght Way." Meta Group, 23 February 2005 http://www.metagroup.com/us/displayArticle.do?oid=51610
Built-in uncertainties and unexpected consequences
Even proponents acknowledge that there are inherent weaknesses in any predictive analysis: No matter how structured and mathematical it gets, every prediction is based on assumptions. As Sandra Winters has written in Darwin magazine, any attempt to calculate a return on investment for a new initiative or project is "an estimate….a house built on best guesses."2 Want to change the outcome? Change the assumptions.
"There are inevitably some cases where if you make different assumptions, it may switch the alternatives," says Clarke. "So we look at those and ask, does this make a difference in the choice that we’re making?" That assessment of confidence in the assumptions becomes a factor in the decision-making process.
But I've seen organizations go too far in trying to strengthen their cost-benefit calculations, demanding more and more data to "shore up" the assumptions. Sometimes I start by helping these clients quantify the potential costs of a bad decision and then ask whether they are spending more to avoid a risk than it deserves. Clarke says it well: "I don't want to get to the point of spending more money on the cost-benefit analysis than the project is worth."
In other words, good process contributes to good decisions in a balanced, thoughtful way.
And there are three other consequences of even greater value. I call them the "accidental benefits":
| • | Exposure of choices |
| • | Improved communications |
| • | Enterprise-wide collaboration and risk-sharing |
2Sandra Winters, "The Tao of ROI." Darwin, June, 2004 http://www.darwinmag.com/read/060104/taoroi.html
Comparing investment options
As I've noted, a stand-alone cost-benefit analysis has its limitations. The uncertainties of estimated cost data and the greater uncertainties of estimated benefits often do not yield a simple yes/no decision.
But most real decisions aren't binary. Companies typically face an array of options for how to invest their resources. So a series of cost-benefit analyses, applied consistently with consistent assumptions across those options, can be a great help in exposing and comparing choices—including the very real choice of doing nothing.
As Clarke observes, "You tend to make the same assumptions through the range of alternatives, so that takes some of the uncertainty out. We try to think about it in terms of value returned to the rate-payer. Then you can easily compare five or six different alternatives and make decisions about which one returns the greatest value."
And the financial services analyst adds, "I've coached people who were really struggling with options. And I tell them, just do a cost benefit for both options, and then decide. It's a great decision-making tool." By comparing options against a level background of cost and benefit calculations, companies like hers are much more likely to choose the set of alternatives that best moves them toward their business objectives.
Communicating business decisions
As organizations grow and change, it's easy for employees to question decisions. In response to a new computer replacement program that I implemented, one of my own users once asked me, "What idiot came up with that idea?" Of course, I had to tell him that I did. Had I shared the business case with everyone early on, he still might have disapproved of this particular decision, but at least he would have understood the underlying reasons for it.
In fact, a business case can be a very powerful tool for communicating across an organization: explaining why certain decisions have been made; what it will take (the costs) to implement those decisions; and what the enterprise can expect to achieve as a result (the benefits).
"All of our cost/benefit templates, when they are filled out, go on our internal Web site," the finance services analyst notes. "We have more information about the nature of our spending than we did in our past. It's now visible, it's transparent, for all the projects that have happened, all the projects that are in flight, and all the projects still in the pipeline."
And because the data is in a standard format, people know where to look for information, how to interpret it, and even what assumptions underlie the data. "Having a standard template allows a broader range of executives to pick up a template and in five minutes understand the benefits," she says, "so there is a huge ability to engage a broader range of people throughout the company in these decisions. That's a win."
Collaborating and sharing risk
But perhaps the most interesting result of doing a formal cost-benefit analysis is that it can provide a safe platform for employees across the organization to collaborate and share in new ways—leading to a willingness to make bolder suggestions.
"The farther you get away from the director of an organization," says Clarke, "the more risk-averse employees get and the more conservative the decisions come. But if you have a good cost/benefit process—not just the analysis but the decision-making process so that the whole organization is sharing in the result—then the responsibility for risk is also shared across the whole organization."
He offers the example of looking at steel, instead of concrete, bridges for some roadways in the utility's watershed—an option that was contrary to unwritten "standards" but which turned out to have less environmental impact and a quarter of the construction costs.
"All of the sudden, employees feel empowered not only to be involved in the decision-making but to look at different kinds of decisions that accept more risk because now they're sharing it with the managers. I found that to be one of the most important lessons to come out of the work we're doing; and it has changed a lot the nature of the decisions we're making because of it."
Quality in, quality out
As organizations increasingly rely on structured cost-benefit analyses to inform their decisions, they also recognize the need to capture and refine the data. They know what they estimated for the cost of a project; but what were the actual costs? How did the results match the projections on the spreadsheet? "It's very easy," the financial services analyst observes, "to generate a business case with benefits if you don't have to come back around and show those benefits after the project is finished."
By capturing that data in a serious, methodical way, decision-makers improve the effectiveness of their process—not to second guess decisions that have already been made but to strengthen the information base for future decisions.
The growing power and sophistication of data capture, storage, collaboration, and analysis tools—such as Microsoft SQL Server, SharePoint Portal Server, and Excel—provide companies with increasing confidence in the validity of the data they are using to make business-critical decisions.
These tools will help to improve both the quality and efficiency of the cost-benefit process itself. And that’s important to people such as Chuck Clarke, whose core mission is public service. By using a structured decision-making process, "We're saving money, sure. But the critical thing is that we’re providing better customer service."
And that's no accident.
Marty Chakoian is an analyst with Semeron Corporation, where he provides assistance in business and technology practices to utilities, government, and private sector organizations. He is a former chief technology officer for the City of Seattle and director of information technology for Seattle Public Utilities.
