Cost Benefit Principle
The cost benefit principle states that the cost of providing the information in the financial statements should not exceed the benefits that the users get from reading those statements.
It is obvious that every company incurs a huge cost of gathering and organizing financial statements. Typically, companies spend millions of dollars each year to ensure that their financial statements are meaningful to the users.
It is therefore not possible for the companies to include every bit of information about themselves as there is a financial cost attached to doing this. Some information might be irrelevant for the external user to obtain such as the amount a company spends on giving the public a tour of the headquarters. Other information could be too costly to attain.
The cost benefit principle is basically a commonsense rule. Management can ask itself questions like, “Does it really make sense to provide the users of our financial statements with this information?”, “Do the costs outweigh the benefits?”, and “Does the user need this information enough to spend this money on it?”.
These questions will help management to decide between the cost and benefit tradeoff associated with this decision.
Cost of Information
Financial information is expensive to produce. This has two perspectives to it:
- Level of detail: The financial controller of a company should not spend too much time gathering and organizing immaterial adjustments to the financial statements. This also means not including too much detail in the footnotes which is of no interest to the user.
- Type of information: The regulators and standard setting bodies set the type of information they require from the company reports so that companies do not go overboard in collecting excessive amounts of information that might not be useful at all to the user.
An additional consideration that the company needs to take into account while deciding on what information to include in its reports is the time required to do so. If the company takes too much time to report its earnings each quarter because of the need to prepare more information, it will lead to a lower utility for the users of the financial statements, since the information is no longer timely.
Examples of the Cost Benefit Principle
There are many situations where a company might need to use the cost benefit principle.
A business has just acquired another entity and some of its open derivative positions as well. An extensive and costly exercise worth $100,000 would be required to model the extent of gains and losses arising from those contracts.
As per the cost benefit principle, the company should choose not to provide this information at this point and instead wait for the derivatives to close out or resolve themselves.
The financial controller of a company gets to know that an employee has been involved in a low-level petty cash theft from the company for many years; the estimated amount of which is $5,000. The audit required to pin down the exact amount would cost $20,000.
The controller applies the cost benefit principle and chooses to skip the audit process since the cost outweighs the benefit.
Company XYZ issues its financial reports in March for its previous period. The statements highlight an error in the previous year’s statement of around $200,000. The precious amount of error would cost $60 mil to pin down exactly. This will mean a huge financial cost for the company for which there is little or no benefit.
As per the cost benefit principle, the company should just disclose the estimated amount in its reports as this would put them in a safe position; since they are still admitting to the potential error without taking on a huge cost to do so.
Cost Benefit Principle in Other Fields
The cost benefit principle has a prominent place in the field of economics as well. The theory in economics states that action should only be taken by an individual or a company if the marginal benefits drawn from the action are at least equal to or more than the marginal costs of the action.
This highlights the opportunity cost and the tradeoff. It is a fundamental tool that economists use to study how “rational choices” are made by individuals.
Suppose Tom goes to the nearest store to buy a video game. There, he finds out that the video game costs $100. Tom remembers that there is another store which is like a 30-minutes away from this one and it was selling the same video game for $80. According to the cost benefit principle, tom should only go to the second store only if the cost of the two-way journey is less than $20. Suppose the cost of the two-way journey is $5, this will mean that the economic surplus (which is the marginal benefit minus marginal cost) will be $15.
Therefore, as per the cost benefit principle, if Tom is a rational individual, he would choose to go to the second store and buy his video game from there. The net benefit (or economic surplus) that he is left with is $15.
Cost Benefit Principle Conclusion
The cost benefit principle does exactly what its name suggests which is to highlight the benefits a receiver gets for incurring the cost of a given activity. Some of the key points to remember relating to this concept are:
- An individual/firm should act only if the benefits are more than the costs.
- Critics of the cost benefit principle object that people do not compute the costs and decisions when taking a decision.
- Some costs and benefits might not be easily quantifiable. In this case, the decision taker should use estimations.
1. What is the cost benefit principle?
The cost benefit principle is a fundamental concept in economics that suggests action should only be taken if the benefits derived from it are greater than the costs. This highlights the trade-offs involved in any decision making process.
2. Why is the cost benefit principle important?
The cost benefit principle is important because it helps an individual or a company to make a rational decision. This principle takes into account the costs and benefits of any given action and compares them to see if the net benefit is positive.
It also highlights the opportunity cost of any given decision.
3. What is an example of a cost benefit principle?
An example of the cost benefit principle can be seen when an individual is deciding whether to purchase a video game.
If the cost of the game is $100 and there is another store which is selling it for $80, the individual should only buy the game if the cost of travelling to the other store is less than $20. This would mean that the individual would be making a profit of $15 on the purchase.
4. How do you use the cost benefit principle?
The cost benefit principle can be used in a number of different ways. In the context of economics, it is used to study how rational choices are made by individuals. For example, it can be used to decide whether to purchase a certain good or service.
It can also be used to calculate the net benefit of a particular decision. This is done by taking into account the costs and benefits of the decision and subtracting the costs from the benefits.
In the context of business, it can be used to decide whether or not to undertake a certain action. For example, a company might decide to undertake a new project if the benefits outweigh the costs.
5. Who uses the cost benefit principle?
The cost benefit principle is used by individuals, firms, and governments. It is a fundamental concept in economics and helps to make rational decisions.