COST BENEFIT PRINCIPLE: Definition, Examples & How It Works

cost benefit principle

The cost-benefit principle can be defined as an Information system principle that requires the benefits from activity in an accounting system to offset the costs of the activity. The cost-benefit principle should be examined is as part of the decision process for all components of the principles of an accounting system. Let’s go in-depth on the cost-benefit principle and see some examples of how it works.

What is the Cost-Benefit Principle?

The cost-benefit principle or cost-benefit relationship asserts that the cost of supplying financial information in the financial statements must not outweigh the benefit of that information to the users. In other words, financial information is not free. Companies spend millions of dollars every year acquiring and organizing financial information to compile into financial statements.

Ideally, investors and creditors would like to know every piece information about a company as possible. Unfortunately, this level of disclosure would create a great financial strain on the organization. Some financial facts external consumers don’t obtain a substantial benefit from knowing such as how much money Apple spends offering the public tours of its headquarters. Other information would be considered too costly to collect like audit, prospective litigation, and competitor’s information.

Essentially, the cost-benefit principle is a common-sense concept. Management can question, “does it make sense to gather this financial information and include it in financial statement? Do the costs of acquiring this information outweigh the benefit to the users?” Essentially, do customers need this knowledge enough to spend this money receiving it? If the response is affirmative, the corporation can leave the information out of the financial statements.

The cost-benefit principle also applies to internal company procedures.

Explaining the Cost-Benefit Principle

When firms are implementing the cost-benefit principle, they examine if the benefits someone is obtaining from an activity are worth the cost of that action.

Businesses should not incur the cost of action if the benefit is not at least equivalent to that cost.

Generally, for firms, this comprises the cost of providing financial statements.

Large firms spend millions of dollars producing financial statements.

They do this to ensure that the financial statements they supply will be valuable to people who use them.

Companies adopting the cost-benefit principle examine whether or not the information they are offering financial statement users is worth the cost of that information.

Some information may not be useful to the users of the company’s financial statements.

Other information may be important but too pricey to be worth the cost.

If the benefit of the information the firm is providing in its financial statements is not worth the cost, then the company should not be releasing the information.

Understanding Cost Benefit Principle

The Cost-Benefit principle focuses on the benefits which the receiver should acquire from a specific action. You should take action only if benefits from taking action are at least as big as the increased costs.

For example, the controller of the company should not spend excessive effort on fine-tuning the financial statements with immaterial/irrelevant modifications. Additionally, material through footnotes should also be avoided since it can give a sense of too much window dressing or perhaps manipulation of facts.

Critics of this technique typically protest that people don’t assess costs and associated benefits when making a decision.

The fundamental point is that some financial information is too expensive to produce. This is a serious issue from two perspectives, which are noted below.

#1. Level of Detail Provided

The company controller should not spend an unreasonable amount of time fine-tuning the financial statements with insignificant modifications. This also means not offering an unreasonable amount of supporting information in the accompanying footnotes.

#2. Types of Information Required

The standard establishing entities need to judge the level of information they want enterprises to report in their financial statements so that the standards do not impose an unreasonable amount of work for these businesses.

A third consideration is that supplying greater information needs more time to create the financial statements. If an unreasonable length of time passes because of the requirement to produce extra information, it might be claimed that the utility of the resultant financial statements is lowered for readers, since the information is no longer timely.

Examples of the Cost-Benefit Principle

Example #1 — Forensic Accounting

Let us consider an instance from the subject of forensic accounting

Say an owner of a store finds out that their accountant has been fudging their books of accounts and pocketing the benefits. There is no way to figure out how much in the past is this theft being traced back to. From numerous sources, the store owner learns the theft is traced back to roughly two years. Thus, he hires the services of an accounting firm to research and generate a report with specifics of all incidents of theft.

The respective accounting firm reveals two full years of theft and also traces specific transactions which are dated to as long as five years. There is a realization for the owner that the accountant would be unable to reimburse the stolen quantity of money in the last five years. Still, if adequate evidence is accessible for two years, there can be the opportunity to retrieve the same.

Therefore, the owner understood that the cost of the accounting company

exposing the deception was not in proportion to the benefit. The owner will most likely not get back the stolen monies from the last two years, and so, the services of the firm may not be useful before that time frame.

Example #2 – Internal Process

We can investigate another examples of the Cost-Benefit Principle connected with the internal procedures of a firm:

Let’s imagine ABC Company produces their financial statements

in March for its preceding year. The statement indicates an inaccuracy in the past year’s statement estimated at roughly $250,000. The specific amount of mistakes is not known and would approximately cost $60 mm for identifying the figure. The cost-benefit principle asserts that ABC co. Need not to find the precise number, and approximation should be sufficient. In this scenario, a fair approximation shall be acceptable as the costs for precisely repairing the inaccuracy is very expensive than the benefits. As they are confessing to the fault, it does put them in a safe position.

Example #3

Let us take the example of a corporation that has lately recognized that one of its executives has been stealing petty cash from the cash register for the last year. However, in the absence of material proof, it is exceedingly difficult to assess the amount of the theft. An external auditor indicated that he can help in examining the situation and discover the precise of theft, but he would charge $8,000. The company’s accountant feels that the amount of the theft would be a few hundred dollars. In such a circumstance, it would be more cost-beneficial not to go for the external examination.

Example #4

Let us take the example of an insurance agent who filed his income tax returns a few days. During an audit procedure, the tax authority highlighted the fact the agent has erroneously reported a greater income on the tax return. The auditor planned to employ an external expert to explore the issue. However, the external would charge roughly $10,000, which is substantially greater than the predicted benefits (around $4,000). Therefore, it would be advisable not to hire an expert as per the cost-benefit principle.

Advantages

Some of the advantages of the cost-benefit principle are as follows:

  • The projected benefits are fairly evident
  • It is utilized in an objective comparison of two or more alternatives.
  • It is utilized by top management as a technique for making a choice.

Disadvantages

Some of the disadvantages of the cost-benefit principle are as follows:

  • It is founded on the underlying assumption that each person will behave logically, which is not always the case.
  • It is exceedingly difficult to get at the marginal costs and as such the degree of subjectivity is very high.
  • Inaccurate identification of marginal costs and benefits might result in erroneous decisions.

Important of Cost-Benefit Principle

The fundamental issue for the cost-benefit principle can be characterized under the following two heads:

  • Level of Detail Required: The cost of retrieving grows with the level of information digging. Exhaustive research entails increased cost, which eventually results in rejection.
  • Type of Information Required: The type of information requirement also determines the cost of information. Any conventional information doesn’t need much effort and hence costs less, whereas customized information means a large amount of work and a much bigger cost.

Further, while employing the cost-benefit principle one should be cognizant of the following key points:

Action should only be taken if its marginal benefit is at least as much as the marginal costs, if not greater. While making a decision most people don’t prefer to compute the benefits and the associated costs.

Cost Benefit Principle FAQs

What is the concept of cost benefit?

A cost-benefit analysis is a process of analyzing the predicted or estimated costs and benefits (or opportunities) connected with a project decision to evaluate whether it makes sense from a business standpoint.

What is the importance of cost-benefit analysis?

Cost-benefit assessments let firms weigh advantages and downsides in a data-driven fashion so they can make difficult decisions in a systematic manner. For a successful CBA, leaders need to identify and project the explicit and implicit costs and benefits of a proposed action or investment.

What are the two main parts of a cost-benefit analysis?

The name refers to the two components of cost-benefit analysis. Knowing the cost and calculating the benefit based on that cost is what it is all about.

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