Cost Benefit Analysis

The cost benefit analysis is a basic analysis framework that involves weighing up the costs and benefits of one course of action against another

Cost Benefit Analysis

IN YOUR consulting case interview you will most likely be required to make a recommendation on a hypothetical business problem. Understanding how to use the cost benefit analysis could come in handy.

The cost benefit analysis

One of the most basic analysis frameworks you can use to solve a business problem is the “cost-benefit analysis”. This method is fairly self-explanatory. It involves weighing up the total expected costs and benefits of one course of action against another. Having done this, you will be able to formulate a more well-thought-out solution to the business problem.

For example, consider the following business problem (Project Gold Mine). Your client says to you, “Currently we run a single gold mine (Mine A) and are trying to decide whether we should expand Mine A or build a second mine (Mine B). Which project should we undertake?” In this problem there are three possible recommendations: (1) expand Mine A, (2) build Mine B, or (3) do nothing (i.e. maintain the status quo). To make a recommendation, you will need to consider the benefits and costs of each course of action.

Evaluating the benefits

In considering the benefits, you will mainly want to think about revenue (Revenue=quantity x price); more on this in a later post.

Counting the cost

As far as I’m aware, there are four types of costs that you need to pay attention to: sunk costs, fixed costs, variable costs, and opportunity costs. I will consider them in turn.

1. Sunk costs

Sunk costs are expenditures that have already been made and cannot be recovered. As such, sunk costs should not be factored into your decision-making process. For example, in Project Gold Mine the original cost of building Mine A is a sunk cost. This money has already been spent and cannot be recovered, it is therefore a sunk cost, and should not be factored into the decision-making process.

2. Fixed costs

Fixed costs are costs that do not vary with the quantity of output produced. In the Project Gold Mine example, fixed costs might include things like rent, land taxes, utilities and other overheads.

It is important to understand that fixed costs are fixed only in the short term. In the short term, the cost of labour may be a fixed cost if the mining company cannot vary the number of employees due to contract obligations. In the long run, these contracts can be renegotiated. In the long run, nearly all costs are variable, even things like rent, because the mining company could move its operations overseas to a country where operating costs are lower.

3. Variable costs

Variable costs are costs that vary with the quantity of output produced. In the Project Gold Mine example, the main variable costs would be the cost of extracting the ore from the ground, and the cost of transportation.

When making decisions in the short run, variable costs are the only costs that should be considered because, in the short term, a company cannot change its fixed costs.

4. Opportunity costs

The opportunity cost of an item is what must be given up to obtain that item.

In the Project Gold Mine example, failing to consider opportunity costs could lead to the wrong decision being made. Consider the following hypothetical:

If the mining company expands Mine A the profit is $1 million, and if it builds Mine B the profit is $2 million. Which project should it undertake? Building Mine B is the more profitable of the two projects; however, the company also needs to consider the opportunity cost of building Mine B. In this hypothetical example, the profit obtained from not undertaking either project is $3 million. So, although building Mine B is the most profitable project, doing nothing is even more profitable.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Researching consulting firms: what do you need to ask?

THIS article looks at some of the questions that you should consider asking in your consulting case interview. After reading this article and one of my previous articles on researching for your consulting case interview, make sure to access the practice case interview questions.

Questions, everyone’s asking them

Preparing a resume, and building a personal story, is one of the first and most important steps in applying for a job. This kind of preparation helps you answer your interviewers questions, “Who are you? And, why should we hire you?”

The reason your interviewer will ask so many questions is because they are trying to get to know you, and to decide whether they want to hire you. Consulting firms invest a lot of time and money in their employees. So, hiring the wrong person is a costly mistake.

Consulting firms will ask a lot of questions, and so should you. You can only begin your career once, so you want to start out on the right foot. Some of the reasons why you need to research your potential future employer are outlined in the article “Researching consulting firms: what do you need to know?”.

Whatever you are looking for in a consulting job, asking questions is the best way to go about finding the firm that is right for you. For example, asking questions will help you find the firm that:

  • interests you,
  • inspires you,
  • suits your lifestyle and family needs,
  • will help you achieve your current goals, or
  • will give you the skills and experience you need to move on to the next big thing.

Some questions to ask

Here is a list of 7 questions that you might want to ask. You could ask these questions in your interview, or try to answer them for yourself by doing some pre-interview research:

  1. What kind of consulting projects does the firm normally work on? For example, does the firm deal with high level strategy? Does the firm work primarily with particular industries?
  2. Do associates work on more than one project at the same time? The answer to this question will help you understand whether the firm will give you depth or breadth of experience. For example, McKinsey and Booz Allen Hamilton normally assign their associates to a single project at a time, providing associates with depth of experience.
  3. Do project teams include both consultants and full-time client members? Try to get an idea of how much client contact you can expect to have.
  4. What is the size of a typical project team? Some consulting firms use a lowly leveraged structure. That is, one partner will work on a project team with one or two other consultants. This kind of firm will give you more exposure to clients and more interaction with the partner.
  5. What is the travel model? Think about how much travel you want to do. Booz Allen Hamilton, and McKinsey typically keep their consultants on client site four days a week.
  6. Does the consulting firm have offices worldwide? If so, there may be opportunities to work overseas.
  7. At what level do consultants begin to specialize by industry, function, or geographic expertise? That is, for how long will you be able to remain a generalist before specialising in a particular practice area or industry group.

Career choice: consulting versus investment banking

IF YOU”RE in your final or penultimate year of your degree, and you’re interested in pursuing a career in the commercial field, you will probably have started thinking about which career path you want to take. Consulting is an attractive career prospect, but you may also be considering investment banking.

There are many similarities between the two careers. Both career paths will give you an attractive salary, require long hours of work, and involve doing work that is client focused.

There are also some significant differences between consulting and investment banking. This table highlights some of the most obvious differences. If you can think of any differences that I have overlooked, I’d be interested to hear from you.

Management consulting

Investment banking

Short
description

Consulting firms assist companies and governments by providing expert advice and by facilitating the examination of particular problems.

For more information, read the article: What is management consulting?

Investment banks help companies raise money so that these companies can use that money to grow their businesses.

Investment banks sell securities (stocks or bonds) to public investors in order to generate these funds.

Investment banks might also help a company to merge its assets with that of another company, manage and invest the money of wealthy individuals or institutions, or buy and sell securities to make money for itself.

Advantages

High pay: Consultants can make over US$60,000 in their first year (The Vault Guide to Consulting).

More reasonable hours: The hours in investment banking (especially at the junior levels) can be very long. 100 hours per week is a realistic possibility. This equates to working between 15 and 18 hours a day, with frequent all-nighters.

More predictable hours: Investment banking is deal driven. Deals can close or change at the last minute, making it hard to predict workload.

Numbers focussed: Consulting requires a lot of quantitative analysis.

More travel: If you enjoy travel and being put up in expensive hotels, this is an upside.

Very high pay: Investment banking pays graduates more than consulting firms do. Bankers can make over US$150,000 plus bonuses in their first year (The Vault Guide to Consulting).

High profile work: When the deal goes public, the work that your team has done will be reported on in The Wall Street Journal or The Australian Financial Review. This can be very exciting.

Deal driven: Investment banking is deal-driven. This makes it a perfect line of work if you do well working off adrenalin and think you will get a thrill out of chasing and closing a deal.

Very numbers focussed: Banking typically requires more quantitative analysis (that is, looking at the numbers).

Less travel: If you don’t like constant travelling and living out of hotel rooms, this is an upside.

Researching consulting firms: what do you need to know?

THIS article looks at why, how and what to research for your consulting case interview. To get started with your interview preparations, take a look at my list of consulting case interview practice questions.

Preparing for an interview with a consulting firm can be a difficult task. Having obtained an interview, you will need to do some thorough research of the firm. But why, I hear you ask, do I need to spend so much time researching when I have been successful in gaining an interview? And, where should I start? These are very valid questions and hopefully this article will help get you thinking the right way about researching consulting firms.

This article is broken up into four sections:

  1. Why should you research?
  2. How should you research?
  3. What should you research?
  4. Making the most of your research

1. Why should you research?

The objective is to get a job offer. This point sounds obvious, and it is, however it can be easy to take your eyes off the prize. After having spent days preparing resumes and cover letters for your multiple consulting firm applications, getting invited for an interview can feel like a success. Being invited for an interview is only the first step in the recruitment process. You need to do your homework if you want to increase your chances of being successful in the interview process. Neglecting to do your research can be the difference between a job offer and a rejection letter.

It is important to show a genuine interest. Being knowledgeable about the consulting industry and the firm for which you are applying shows that you have a genuine interest in working in this field. It is important to remember that, regardless of your university grades, the firm will need to train you from the ground up once you start. A consulting firm does not want to spend tens of thousands of dollars on training a young graduate who isn’t keen to be there.

Take control of your professional career. Researching a consulting firm doesn’t just help you do well in the consulting interviews; it also helps you decide whether the firm you are applying for is where you want to be. In more general terms, your research will also help you decide whether you are really interested in pursuing a career as a consultant.

Keep the stress levels down. Being well informed can help to lower your stress levels and present at the interview in a more relaxed and confident manner. For example, if you have done your homework before hand, questions like “Why do you want to work here?” and “What is it about our firm that interests you?” should not faze you in the slightest.

2. How should you research?

Read the firm website. The amount of information that firms provide on their websites will no doubt vary but, at the very least, this is a good starting point for your research. All big consulting firms will have a website. Making yourself familiar with the firm website should provide you with all of the basic information that you are looking for. The website will often provide you with information on the firm’s history, the firm’s vision and values, firm culture, clients, areas of expertise, office locations, recent news, and the names of important employees.

Talk to people. The best source of information about a consulting firm is from people who have had direct contact with the firm in some way. Talking with current and former employees, friends who have gone through the interview process and to company recruiters can be an invaluable source of knowledge.

Read widely. In general, the more you know about consulting the better. Some good publications include Vault Career Guide to Consulting, and Vault Guide to the Case Interview.

Stay abreast of the news.The internet makes this job a lot easier that it would have been ten years ago. Staying abreast of the news will allow you to put the firm’s work into a broader context and help you to understand the nature of the firm’s work, and who the firm’s main clients and competitors are.

3. What should you research?

Know the company basics. The basics include:

  • firm history,
  • firm vision and values,
  • culture,
  • current practice areas and industry specialisations,
  • areas of expertise,
  • recent news involving the company,
  • key factors that distinguish the company from its competitors,
  • the names of major clients,
  • the names of important employees, and
  • office locations.

Know the core competencies or skill set that the firm is looking for in potential candidates.

Understand how the firm interviews. Do they ask case questions? Does the firm put an emphasis on asking questions with a numerical component? Are there multiple interview rounds? Does the firm use interview panels, or is each interview conducted in a one-on-one format?

Read the firm’s annual report if it is publicly available.

4. Making the most of your research

Research is not an end in itself. Use your research to help you structure your thoughts, to provide substance to your discussions with the interviewer, and to ask intelligent questions.

Weakness in the economy? An insight from two taxi driver economists

THIS article is intended to be pretty light-hearted. It provides an insight into the strengths of the current Australian economy after talking with two aspiring amateur economist taxi drivers.

Taxi driver 1

I was chatting with the taxi driver on the way home from work last week, and he was complaining to me that, despite talk of a “resources boom” and a resilient Australian economy, he felt that the economy is weak because he has been experiencing a significant reduction in business over the last little while.

My taxi driver turned out to be quite an economist and inspired this article and my last one, Economic recession 2008: measuring the strength of the economy.

Australia has been negatively affected by the sub-prime mortgage crisis in a similar way to most other countries. At the same time, however, Australia is benefiting from a resources boom. High commodity prices and strong demand for raw materials from countries like China has seen large amounts of money flow into Australia.

As my taxi driver made me realise, however, it’s all very well to be told about a “resources boom” and a record Federal Government surpluses, if the tell tale signs are painting a different picture. A company might appreciate that the economy is weakening when its inventory levels start to rise above expected levels. The government might appreciate that the economy is weakening when tax revenues start to decline or grow more slowly. But how does the common man, how do you and I, appreciate that the economy is weakening?

Obviously, if your wage isn’t rising and the price of things like food and oil rise, then you will have less money to spend on other things. However, this tells you nothing about the strength of the economy over all.

Here is a list of four tell tale signs, from day to day life, that might indicate the economy is weakening (some of these ideas are borrowed from a discussion on James Valentine’s program on 702 ABC radio last week):

  1. The length of the cab rank: The theory goes like this. When the economy weakens and people are put under financial strain, they cut spending. Expenditure on necessary things like food and accommodation are the last things that people cut out of their budget. The first thing that people do away with is entertainment. If people are not attending concerts and not staying out late, then they are not using taxis, and consequently there will be an oversupply of taxis. So, when the cab ranks become inexplicably longer than normal, or taxis become easier to catch on a Friday night, it might be a sign that the economy is weakening.
  2. The length of the queues in Aldi: For those of you who are unaware, Aldi is a discount supermarket chain that is slowly but surely taking the world by storm. In Sydney at least, Aldi stores are not always so conveniently located. Increased queues in Aldi might indicate that people are tightening their budgets due to weaker economic conditions.
  3. The length of Tuesday petrol queue: In Sydney, the cheapest day for petrol is, for some unexplained reason, Tuesday.
  4. The number of new Aston Martins on the road: Flashy sports cars are a luxury good, when the economy weakens there is less disposable income available and you would expect to see less new luxury cars on the streets.

Taxi driver 2

I had another encounter last night with an aspiring amateur economist taxi driver on my way home from work (my taxi drivers are such a source of inspiration). Having discussed the economy with the other taxi driver last week, I was intrigued to find out whether this driver also thought that business was slow at the moment, and why he thought that might be.

He informed me that business had been a little slower than normal, but nothing out of the ordinary. Unlike my first taxi driver, he didn’t attribute this to a slowing economy. “The weather has been cloudy and wet lately, and people don’t like to go out in this weather. Winter is coming. This means that it gets dark earlier, it’s colder at night and less people are out in the city. There are also less tourists in the winter. I make more money when it is sunny.”

The conclusion

So, all things considered, perhaps these aspiring economist taxi drivers haven’t really been able to give me any insights on the current strength of the Australian economy. But at least they got me thinking.

Economic recession 2008: measuring the strength of the economy

It’s the economy, stupid

IT’S THE economy, stupid” is a well known phrase that was widely used during Bill Clinton‘s 1992 presidential campaign against George Bush senior. The phrase was coined by Clinton campaign strategist James Carville and refers to the notion that Clinton was a better choice because Bush had not adequately addressed the economy, which had recently headed into a recession. Clinton went on to win a decisive victory.

Having entered the second quarter of 2008, the American economy may be heading towards a recession once again.

What is a recession?

Broadly speaking, a recession is a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists have other more precise definitions of a recession, the easiest of which to understand is “two consecutive quarters of falling GDP”.

This definition was borrowed from the Economist A-Z, which is a really useful resource for understanding economic terms. I have added it to my list of useful links.

Strength of the US economy

A key contributor to the current weakness of the US economy is the sub-prime mortgage crisis. To indicate the magnitude of the losses suffered from the crisis, it is useful to note that the largest US bank, Citigroup Inc., has alone incurred more than US$45 billion of write-downs and credit losses since 30 June 2007.

In order to stimulate the American economy, the Federal Reserve has slashed the Federal Funds Rate by 2.75% between 18 September 2007 and 30 April 2008.

Gordon Brown, George Soros and Warren Buffett are all of the opinion that America, and the world at large, is currently facing its worst financial crisis since the 1930s. In particular, Warren Buffet was quoted by the LA Times on May 5 saying, “I would say that we’re in a recession, clearly”.

In the first three months of 2008, the US economy managed to achieve a modest annual growth rate of 0.6%. So, at least according to the precise Economists’ definition provided above, the US is not yet in a recession.

However, things are far from in the clear. Reuters reports that Scotia Capital senior currency strategist Camilla Sutton outlined that there are some very negative indicators for the strength of the US economy in the short term,

[T]he housing market has yet to bottom, consumer confidence is at multi-decade lows, employment growth has evaporated and high commodity prices are … exacerbating an already weak economic backdrop.

Bearing all of this in mind, concern about the short term strength of the US economy was sparked yesterday, May 6, when US crude oil prices hit a record high of US$120.36 a barrel. The rising price of oil (and food) is contributing to a higher US inflation rate. The US inflation rate, for the 12 months ending March 2008, was 4.0%. This compares with an inflation rate for the same period last year of 2.8%. Inflation is a procyclical coincident economic indicator because price levels tend to rise when the economy is booming. However, the rising price of oil is being driven by booming developing economies, in particular India and China, and not from growth in the US economy. Higher oil prices are also being driven by the uncertainty of oil supply resulting from political unrest in certain oil producing countries and interruptions in supply due to extreme weather conditions, leading to higher prices and slower growth in the US economy.

There is some cause for optimism however. According to the Times Online, recent economic data on the American economy (measuring things like jobs, GDP, business confidence, industrial orders and consumer spending) indicates that, although the US economy weakened abruptly in the final quarter of 2007 (October to December), the US economy is not nearly as weak as it has been at the start of previous recessions.

Strength of the world economy

According to the IMF, the growth prospects for the world economy in 2008 appear to be strong.

In the IMF’s World Economic Outlook, published in October 2007, the IMF indicates that global economic growth is predicted to be 4.75% in 2008. Interestingly, this prediction is made in light of the fact that financial market strains might trigger a more pronounced slowdown in the world economy.

Growth in developing countries appears to be the main driver for the expected strong global economic growth in 2008. In 2007, economic growth in China, Russia and India accounted for half of global economic growth. The IMF indicates that in 2008, the Chinese economy is expected to grow by 10% and the Indian economy by 8.4%. This is an extremely fast rate of economic growth, which would see the size of the Chinese economy double in less than 8 years.

If you enjoyed this article, you may want to read about The benefits of an economic recession and how to prepare for one, on the James Cox finance blog.