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Cost-Benefit Analysis

Definition

Cost-benefit analysis is a decision-making tool that compares the costs of an action or project with its potential benefits. It helps individuals and businesses determine whether the benefits outweigh the costs, allowing them to make informed choices.

Analogy

Imagine you want to buy a new video game console. Before making a decision, you compare the cost of the console with the enjoyment and entertainment it will bring. If the benefits (fun, excitement) outweigh the costs (price), then it's worth buying.

Related terms

Opportunity Cost: The value of the next best alternative that is given up when making a choice. For example, if you choose to go to a concert instead of studying for an exam, your opportunity cost is potentially getting a lower grade on the exam.

Marginal Benefit: The additional benefit gained from consuming one more unit of a good or service. For instance, eating one slice of pizza may give you satisfaction, but each additional slice may provide less marginal benefit.

Sunk Costs: Costs that have already been incurred and cannot be recovered. An example would be purchasing tickets for a concert but then deciding not to attend. The money spent on those tickets becomes sunk costs because it cannot be refunded.

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Practice Questions (6)

Which of the following best defines cost-benefit analysis?
Suppose a business owner is considering investing in a new piece of equipment that costs $10,000. The estimated annual revenue generated from the equipment is $5,000. What can be concluded about the investment based on cost-benefit analysis?
A student is considering whether to spend an additional hour studying economics or watching a movie. The student values each hour of studying at $10 in terms of improved knowledge and future job prospects. The cost of watching the movie is $12 for a ticket. Based on the cost-benefit analysis, what should the student choose to do?
Mike is deciding between two vacation options. Vacation Option A costs $1,000 for a week but includes all meals and activities. Vacation Option B costs $800 for a week but doesn't include any meals or activities. Based on the cost-benefit analysis, which vacation option should Mike choose?
A company is considering implementing a new software system that would streamline its operations but requires a significant upfront investment. The expected benefits include increased efficiency and cost savings over time. Based on the cost-benefit analysis, what should the company consider?
Emma is deciding whether to buy a new car or continue using her current car, which is becoming less reliable. The new car costs $25,000 and offers better fuel efficiency and safety features. Emma estimates that she will save $500 per year on fuel costs and $200 per year on maintenance costs with the new car. Based on the cost-benefit analysis, what should Emma consider?