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What is Cost-Benefit Analysis
Which car should I buy? Which job should I choose out of the two? Which location should I purchase the house? These are questions that greet us at the crucial junctures of our life. The process of arriving at answers to these questions calls for strong decision-making skills. Companies, whether multi-national or small enterprises are also gripped by a lot of situations that require decision making. Most companies use a see-saw like an approach, known as Cost-benefit analysis models to arrive at these decisions. This tool puts all benefits on one side of the plank and the associated costs on the other. The side that weighs the higher wins the argument.
When we talk about costs and benefits we mean the pros and cons that can be quantified. The purpose of the Cost-Benefit analysis models is to ascertain the accuracy of any investment decision and provide a foundation for comparing it with similar proposals. Firstly, the merits and demerits of the investment proposal are quantified in monetary terms and then adjusted for their time-value to obtain figures for conducting an accurate cost-benefit analysis. While identifying and categorizing the costs, many economists also include Opportunity cost. This refers to the loss incurred while sacrificing the next best alternative.
Uses of Cost-Benefit analysis
- Determining the feasibility of an opportunity: Nobody wants to incur losses in business. When a huge sum of money is invested in a project or initiative, it should at least break even or recover the cost. To determine whether the project is in the positive zone, the costs and benefits are identified and discounted to present value to ascertain the viability.
- To provide a basis for comparing projects: With so many investment choices around, there has to be a basis for choosing the best alternative. Cost-benefit analysis is one the most apt to tools to pick through the available options. When the one out the two options seem more beneficial, the choice is simple. However, a problem arises when there are more than two alternatives to evaluate. The Cost-Benefit Analysis model helps businesses to rank the projects according to their order of merit and go for the most viable one.
- Evaluating Opportunity Cost: We know that the resources at our disposal are finite but investment opportunities are many. Cost-benefit analysis is a useful tool for comparing and selecting the best option. However, while choosing the most viable project, it is also imperative to be aware of the Opportunity Cost or the cost of the next best alternative foregone. It helps businesses to identify the benefits that could have arisen if the other option was chosen.
- Performing Sensitivity Analysis for the various real-life scenarios: Situations are not the same always and exact outcome cannot be predicted. The discount rate can be tested over a range. Sensitivity analysis can be instrumental in improving the credibility of a Cost-benefit analysis and is mainly used where there is ambiguity over the discount rate. The investigator may change the discount rate and the horizon value to test the sensitivity of the Cost-Benefit Analysis model.
Steps of Cost-Benefit Analysis
We all know it’s quite simple to make an investment decision when the benefits overshadow the costs, but only few of us know the other key elements that go into the analysis. The steps to create a meaningful Cost-Benefit Analysis model are:
#1 – Define the framework for the analysis.
Identify the state of affairs before and after the policy change or investment on a particular project. Analyze the cost of this status quo. We need to first measure the profit of taking up this investment option as opposed to doing nothing or being on ground zero. Sometimes the status quo is the most lucrative place to be in.
#2 – Identity and classify costs and benefits.
It is important to costs and benefits are classified in the following manner so as to ensure that you understand the effects of each cost and benefit.
- Direct Costs (Intended Costs/Benefits)
- Indirect Costs (Unintended Costs/Benefits),
- Tangible (Easy To Measure And Quantify)/
- Intangible (Hard To Identify And Measure), And
- Real (Anything That Contributes To The Bottom Line Net-Benefits)/Transfer (Money Changing Hands)
#3 – Drawing a timeline for expected costs and revenue.
When it comes to decision making, timing is the most important element. Mapping needs to be done when the costs and benefits will occur and how much they will pan out over a phase. This solves two major issues. Firstly, a defined timeline enables businesses to align themselves to the expectations of all interested parties. Secondly, understanding the timeline allows them to plan for the impact that the cost and revenue will have on the operations. This empowers businesses to better manage things and take steps ahead of any contingencies.
#4 – Monetize costs and benefits.
We must ensure to place all costs and all benefits in the same monetary unit.
#5 – Discount costs and benefits to obtain present values.
This implies converting future costs and benefits into present value. This is also known as discounting the cash flows or benefits by a suitable discount rate. Every business tends to have a different discount rate.
#6 – Compute net present values.
This is done by subtracting costs from benefits. The investment proposition is considered efficient if a positive result is obtained. However, there are other factors to be considered as well.
Principles of Cost-Benefit Analysis
- Discounting the costs and benefits – The benefits and costs of a project have to be expressed in terms of equivalent money of a particular time. This is not just due to the effect of inflation but because a dollar available now can be invested and it earns interest for five years and would eventually be worth more than a dollar in five years.
- Defining a particular study area – The impact of a project should be defined for a particular study area. Eg: A city, region, state, nation or the world. It’s possible that the effects of a project may “net out” over one study area but not over a smaller one.
- The specification of the study area may be subjective but it can impact the analysis to a major extent
- Addressing uncertainties precisely – Business decisions are clouded by uncertainties. A Cost-Benefit Analysis must disclose areas of uncertainty and discretely describe how each uncertainty, assumption or ambiguity has been addressed.
- Double counting of cost and benefits must be avoided – Sometimes though each of benefits or costs are seen as a distinct feature, they might be producing the same economic value, resulting in the dual counting of elements. Hence these need to be avoided
Discounting Costs and Benefits: A key factor in the Cost-benefit analysis
Costs and benefits of projects analyzed are usually realized over a large time span and not in the short-term. While the costs and benefits remain the same, the value of money changes over time mainly due to inflationary trends. The value of a cost or benefit in the future may not be in tune with the actual worth of that cost or benefit in the present period. Therefore, it is essential to discount the future values of costs and benefits happening over time to the present values.
The formula used to calculate the present value of a future cost or benefit in monetary terms is:
PV = present value
F = future value of cost or benefit in monetary terms
r = the rate of discount
n = no. of periods under consideration (e.g. years)
The key to accurate discounting is ascertaining the discount rate. An incorrect value for the discount rate could easily result in an erroneous estimate of the present value of a future cost or benefit and could render the entire Cost-Benefit Analysis model as inaccurate and ineffective. If still used it might lead to lopsided business decisions.
Cost-Benefit Analysis Models & Examples
When conducting a Cost-Benefit Analysis there are two main methods of arriving at the overall results. These are Net Present Value (NPV) and the Benefit Cost Ratio (BCR).
#1 – Net Present Value Model
The Net Present Value (NPV) of a project refers to the difference between the present value of the benefits and the present value of the costs. If NPV > 0, then it follows that the project has economic justification to go ahead.
It is represented by the following equation:
#2 – Benefit-Cost Ratio
On the other hand, the Benefit-Cost provides value by calculating the ratio of the sum of the present value of the benefits associated with a project against the sum of the present value of the costs associated with a project.
The greater the value above 1, the greater are the benefits associated with the alternative considered. If using the Benefit Cost Ratio, the analyst has to choose the project with the greatest Benefit-Cost Ratio.
Let’s take a quick look at the cost-benefit analysis example suggesting a comparison between the two:
|Project Alternative 1||Project Alternative 2|
From this cost-benefit analysis example, it can be seen that while both investment proposal provides a net positive outcome. However, the NPV and BCR methods of obtaining results provide slightly varied outcomes. Using NPV suggests investment option 1 provides a better outcome as the NPV of $70 million is greater than the NPV of option 2 ($ 5 million). On the other hand, applying the BCR method, option 2 would be preferred as a BCR of 2.22 is greater than the BCR of 1.88.
In this cost-benefit analysis example, the overall result may be determined by considering the costs involved in option 1 which are much greater or may be determined by considering the overall much greater benefits (in monetary terms) obtained by choosing alternative 1. Hence what we can see is that the results of Cost-Benefit Analysis are not close-ended. Presenting both forms of analysis by different methods may be most appropriate as the authorities can weigh the decision based on all perspectives.
Like every other quantitative tool, Cost-benefit Analysis also has certain limitations: A good CBA model is the one which circumvents these hurdles in the most effective way: Few of the limitations are:
- Inaccuracies in quantifying costs and benefits – A cost-benefit analysis requires that all costs and benefits be identified and appropriately quantified. However, certain errors in cost-benefit analysis such as accidentally omitting certain costs and benefits due to the inability to make a forecast may result in difficult causative relationships, thereby giving an inaccurate model. Moreover, the ambiguities over assigning monetary values further lead to inefficient decision-making.
- Element of subjectivity – All costs and benefits cannot be quantified easily. There are certainly other elements involved which call for subjectivity. The monetary value of benefits such as employee satisfaction, client satisfaction or costs such reduction of trust etc is difficult to be ascertained. But since the standard Cost-Benefit Analysis model calls for quantification, businesses might quantify these factors and there is the limited scope of accuracy involved. Decision makers might get emotionally carried away and this again results in skewed and biased analysis.
- Cost-Benefit Analysis might be mistaken for a project budget – The elements of a cost-benefit analysis involve estimation and deemed quantification, however, there are possibilities that at some level the Cost-Benefit Analysis model may be mistaken for a project budget. Forecasting budget is a more precise function and Cost-benefit analysis can only be a precursor to it. Using it as a budget may lead to a potentially risky outcome for the project under consideration.
- Ascertaining the discount rate – A major concern in the usage of discounting is the value pertains to the discount rate chosen. The standard method of discounting to present value is based on the timing of costs and benefits. This method of discounting s assumes that all costs and benefits occur at the end of each year (or maybe this timing is used for the ease of calculation). However, it certain scenarios the timing of costs and benefits needs to be considered more thoroughly and in a distinguished manner. Let’s say if a cost is incurred halfway through the year or in the last quarter of the year, discounting it at the end of the year could skew the results to some extent. Thus the timing of discounting the costs and benefits needs to be adjusted depending on the life span of the project.
Performing a cost-benefit analysis is crucial for a business to make profitable decisions. It is vital that the costs and benefits should be precisely defined with minimal involvement of subjectivity. The identification and quantification have to be in depth because superficiality can be detrimental for the business. Cost-benefit Analysis is not just restricted to finding out whether the proposition or a particular project is feasible or not. It also helps us to ascertain the viability quotients of each project.
The result of a Cost-benefit analysis model should be viewed as a holistic process rather than just an end result. While presenting the final result of a Cost-Benefit Analysis model, the analyst should explain authorities about the entire progression. Each step and the rationale behind it is equally important. Thus Cost-Benefit Analysis models not only helps businesses to ascertain the viability but also make the most apt decisions.
This has been a guide to what is the cost-benefit analysis. Here we discuss its uses, examples, steps of cost-benefit analysis, cost-benefit analysis models like NPV and BCR and its limitations. You can also have referred to the following recommended articles to learn more about Corporate Finance –
- Cost-Benefit Principle
- Opportunity Cost Formula – Examples
- Drawing Accounting Example
- Key Differences Direct Cost vs Indirect Cost
- Economic Value Added (EVA) | Formula | Calculation | Top Examples
- Time Value of Money | Top Real Life Examples | Formula
- NPV vs XNPV | Top Differences with Excel Examples
- Corporate Finance Career Path