What is Cost Benefit Principle?
The term “cost benefit principle” refers to the theory that encourages the evaluation of whether the marginal cost of retrieving any financial information is outweighed by the incremental benefit expected from that information. This principle is a reiteration of the fact that no financial information comes for free. Every year companies spend millions of dollars to gather and organize financial information in order to build them into financial statements.
In an ideal scenario, the stakeholders – investors and creditors, would prefer to know every piece of information about a company in which they have invested. However, such a large volume of information entails a significant amount of financial cost. In such a case, the information seeker needs to assess the marginal benefit of the information and the corresponding marginal cost. If the inquirer believes that the benefit outweighs the cost, then he/ she should pursue the information, otherwise it wise to ignore the information. Basically, the cost benefit principle is a manifestation of the rule of common sense.
Examples of Cost Benefit Principle
Now, let us look at some of the common examples of cost benefit principle:
Let us take the example of a company that has recently acquired another entity. Just after the acquisition, the acquiring company realized that the acquiree is involved in a derivative transaction and there is some amount of ambiguity about the final outcome of the same. The exact outcome (possible gains or losses) of the derivative transaction can be determined by using the extensive modeling techniques. However, the cost of building the model could possibly run into several thousand. In such a scenario, the company might decide against the modeling exercise as it would be more cost beneficial to wait a few months for the outcome of the transaction.
Let us take the example of a company that is in the process of publishing its financial annual report. It has been brought to the company’s notice that there is an error in the financial statements. However, the exact value of the error is not available and a reasonable estimate states that the error is to expected be around $50,000. Although the company can employ auditors to investigate the matter, it would cost around $500,000 to exactly determine the value. As per cost benefit principle, the company is not mandated to unearth the exact error value and a reasonable estimate of the error is also acceptable, given that cost of investigation would eventually overshadow the actual cost of the error.
Let us take the example of a company that has recently realized that one of its executives has been stealing petty cash from the cash register for the last one year. However, in the absence of material evidence, it is very difficult to ascertain the extent of the theft. An external auditor suggested that he can help in investigating the matter and determine the exact of theft, but he would charge $8,000. The company’s accountant believes that the amount of the theft would be a few hundred dollars. In such a scenario, it would be more cost beneficial not to go for the external investigation.
Let us take the example of an insurance agent who filed his income tax returns few days. During an audit process, the tax authority highlighted the fact the agent has erroneously quoted a higher income on the tax return. The auditor planned to hire an external consultant to probe the issue. However, the external would charge around $10,000, which is relatively higher than the expected benefits (around $4,000). Therefore, it would be wise not to hire the consultant as per the cost benefit principle.
Some of the advantages of cost benefit principle are as follows:
- The expected benefits are fairly clear
- It is used in an objective comparison of two or more alternatives.
- It predominantly used by senior management as a tool for making a decision.
Some of the disadvantages of cost benefit principle are as follows:
- It is based on the basic assumption that each person will behave rationally, which is not always the case.
- It is very difficult to arrive at the marginal costs and as such the degree of subjectivity is very high.
- Inaccurate identification of marginal costs and benefits can result in erroneous decisions.
Important of Cost Benefit Principle
The underlying issue for cost benefit principle can be categorized under the following two heads:
- Level of Detail Required: The cost of retrieving escalates with the level of information digging. Exhaustive research means higher cost, which eventually results in rejection.
- Type of Information Required: The type of information requirement also influences the cost of information. Any standard information doesn’t need much effort and hence costs less, while customized information means a massive amount of work and a such higher cost.
Further, while using the cost benefit principle one should be mindful of the following critical points:
- Action should only be taken if its marginal benefit is at least as much as the marginal costs, if not more.
- While making a decision most people don’t prefer to compute the benefits and the associated costs.
This is a guide to Cost Benefit Principle. Here we also discuss what is cost benefit principle along with advantages, disadvantages, importance and practical examples. You may also have a look at the following articles to learn more –