The Solution to Every Decision

Here’s a Quiz For You

What do these decisions have in common?

  • Is it wise for me to invest in new equipment for my business?
  • Should I respond to the irate customer’s email or just let it go?
  • Is the best route turning left, turning right or going straight?
  • Should I have beef or chicken for dinner tonight?
  • Should I wear the blue shirt or the green shirt today?

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Give up?

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The answer is that each decision’s solution will be based on the costs and benefits as perceived by the decisionmaker. The decision will be driven by a cost benefit analysis.

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(OK. I’ll come clean. It’s a trick question. Why? Because the solution to every decision is based on a cost benefit analysis.)

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What is Cost Benefit Analysis?

Simply put, cost benefit analysis is evaluating the costs required to carry out a particular decision with respect to the benefits derived from that decision. It’s not a difficult concept. (But as with all simple concepts we can apply great complexity, so if you’re interested in the complex description, check out the Wikipedia page here.)

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Cost benefit analysis consists of three simple steps:

  1. Calculate the expected costs over some time frame
  2. Calculate the expected benefits over the same time frame
  3. Compare them to each other

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Obviously the great majority of decisions are made using a unconscious cost benefit analysis, but there are times when consciously evaluating the costs and benefits may be helpful. One of those times is when you are planning how to mitigate your risks and exploit your opportunities.

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Cost Benefit Analysis and Risk Management Connected How?

Cost benefit analysis (CBA) is a great tool for evaluating mitigation alternatives during step three of the risk management process – plan for your risks. We’ve all heard the saying “There’s more than one way to skin a cat.” It was uttered by a very wise, albeit somewhat troubled (or very hungry) individual. There are always alternatives. There are always decisions to be made. Cost benefit analysis provides the method for making the best decision.

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Tips for Effective CBA

Analyzing costs and benefits is not difficult. In fact we all do it many times each day. There is a key to doing “effective” CBA, however – considering the “hidden” costs and benefits. Let’s look at a simple example…

Fred (of Fred’s Coffee Shop, introduced here) has identified fire risk as a key risk for his business. Working with his insurance broker, Fred has identified several different alternatives that will reduce his risk. A key part of every solution is insurance, but he could also purchase extra fire extinguishers, install a monitored fire detection system or install a sprinkler system. Fred recognizes that each alternative has a very obvious cost – installation cost. But Fred also realizes that there are hidden costs and benefits involved.

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Fred learned from his insurance broker that each of his alternatives will have some ongoing expenses. The fire extinguishers will require employee training and need to be inspected every year. The monitoring system will have a monthly service charge. Even the sprinkler system will require regular inspections and testing. Fred makes a point to capture the hidden costs.

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Fred’s insurance broker also told him that the insurance company will give Fred a discount on the insurance premium if he installs a fire detection system and an even bigger discount if he installs sprinklers. Fred adds these discounts to the “benefits” list so he can have a true picture of his net cost for each alternative.

In the example Fred could have done the cost benefit analysis and made a decision without the hidden costs and benefits information, but the decision may not have been the best solution. Some of the hidden costs and benefits could be substantial.

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It’s also important to remember to include qualitative costs and benefits in your analysis. Your alternative might have benefits like increasing employee morale or just plain making you more comfortable. Don’t forget to include that information in the analysis – it’s important.

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Do you see how including hidden and qualitative costs and benefits could make an apparently obvious decision not so obvious?

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We all do cost benefit analysis every day of our lives. It is an extremely effective way to make a good decision IF all of the costs and benefits are included in the analysis. Keep the formal CBA in your risk management toolbox. Once you start using it and getting comfortable with it, you’ll find that you come back to the technique over and over again.

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How are you doing? Starting to get the idea about how to manage risk in your small business? Give me an example of when you’ve consciously done a cost benefit analysis. It doesn’t have to be business related. Feedback, please!

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p.s. Check out the complete listing of “How To Manage Business Risk” for small business risk management tips, tricks and details.

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