What is cost-effectiveness analysis? Lessons for entrepreneurs

What is cost-effectiveness analysis? Lessons for entrepreneurs

Claudia Roca

Sep 16, 2022

Sep 16, 2022

Sep 16, 2022

What is cost-effectiveness analysis? Lessons for entrepreneurs
What is cost-effectiveness analysis? Lessons for entrepreneurs
What is cost-effectiveness analysis? Lessons for entrepreneurs

The financial success of your company depends on multiple factors such as a cost-effectiveness analysis, for example. 

Money management and investments are and always will be key, so it is time to pay attention to the cost-effectiveness analysis to get the most out of your products.

Imagine that you have a tool at your disposal that allows you to know to what extent your project will be cost-effective. The cost-effectiveness analysis will help you in this regard.

Forget about improvisation and the crisis that usually comes with it. Stay with us and ensure the viability of your corporation:

What is a cost-effectiveness analysis?

We can say that rhe cost-effectiveness analysis is a method that allows you to know how much money you will earn with an economic activity in a set period of time. 

In other words, shareholders analyze their own capital and the resources they have available to carry out the operation.

This tool allows you to determine whether your product or company will be cost-effective in the future, since it takes into account the number of items you need to sell to cover operating costs. 

The first step for any company is to ensure that its expenses can be covered by the sales of its products. With the cost-effectiveness analysis you'll be able to know the exact amount you'll need to sell.

Once you get it, you'll see how much easier everything will be.

How is a cost-effectiveness analysis calculated?

What we love about the cost-effectiveness analysis is that it's very simple to calculate, so you don't need to be a financial expert to do it.

Just follow the formula below: 

Fixed costs/product price-variable cost per unit. Let's take a closer look at each element:

1. Price

This is the value you have added to your product and that you consider necessary to ensure the sustainability of the business without affecting the target customer. 

2. Fixed costs

They're all the expenses that you necessarily have to execute to ensure the stability of the business. No matter how much you sell, the figure will always be the same. 

It includes elements such as salaries, debt payment, rent of the premises, among others.

3. Variable cost

Unlike the previous one, they increase or decrease according to the volume of sales you have in a given period of time. 

Some of them are: distribution costs, raw materials, among others.

Profits and profitability, are they the same thing?

It's very common that when we project the results of our company we confuse some terms that in the long run can affect the future of the project.

Profits and profitability is a very clear example, and although they are related, they have completely different definitions. 

Profit is a specific figure that is determined by the amount of income and expenses that the company has in a specific period of time and that is reflected in the balance sheet. 

Meanwhile, profitability differs because it's a much more relative figure, which is why it's measured in most cases as a percentage. 

In short, it's used to calculate the reach of profits according to the size of the company, so it determines the effectiveness of that strategy that we have applied in recent times.

5 Elements that make up a company's profitability

There are several elements that make up the profitability of any company. Take a look at some of them:

1. Sales

The first thing we think of when we have a company is sales. It's the closest thing to oxygen for a human being, you only realize it was there when it's gone.

Marketing allows you to obtain money that is used to cover operating costs and then obtain the profits you need to continue working. 

Sales depend on the customer, time and the demand that exists in the market. With a proper marketing strategy you will take advantage of the demand curve and your profitability will be much higher.

2. Expenses

We define expenses as all those expenditures that a corporation has to make to survive and can be divided into fixed or variable expenses, as you saw at the beginning of the article.

The important thing is to project each of the expenses in the next period in order to control all the company's expenditures. Finances in order are key to the success of any project.

3. Price

Setting the right price is essential to get the profits you want for each product sold. 

To determine the ideal value you must take into account the characteristics of your audience, sector and much more. You should also evaluate the strategies that the competition has applied to see how you can improve yours.

A product cannot be too expensive because no one will buy it or too cheap, since your company will not be sustainable over time. 

4. Permanence

One of the key points of any company is to establish the cost of permanence needed to survive in the medium term.

Do you know the best way to determine this? Through the return on equity, which is the amount of money you receive for each investment made by shareholders.

Focus on the return being higher than the opportunity cost and you will see how subsistence will be much more feasible in the future. 

5. Measuring profitability

The best way to measure profitability is through the income statement. Here you'll see the amount of money that has gone out and come in over the last time period, which will give you insight into the financial health of the project.

Do this ahead of time so you can make any necessary changes. 

cost effectiveness analysis

Importance of calculating profitability

There are many keys to the success of any business, but calculating profitability is undoubtedly one of them. 

Without it you won't know how much money you have earned or lost in the last fiscal year, so you won't be sure if the strategy applied is being effective. 

We suggest that you project the estimated profitability every few months and monitor it closely, as this way you will be able to measure the health of the company in all areas.

Don't forget, business is a numbers game, so you will have to master them to have a solid and stable company in the long run. 

And you already know how cost-effective your project is? Follow each of the tips we have given you to get closer to the results you set out to achieve.