Cost-Benefit Analysis

Cost-Benefit Analysis Definition

The cost-benefit analysis compares the costs and benefits of a project and then makes a decision on whether or not to proceed with the project. The project’s costs and benefits are measured in monetary terms after adjusting for the time value of money, thus providing a true picture of the costs and benefits. Net Present Value and Benefit-Cost Ratio are the two most common methods of doing a cost-benefit analysis. The NPV model chooses the project with the highest NPV. The benefit-cost ratio model chooses the project with the highest benefit-cost ratio.

Cost-Benefit-Analysis

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How to do Cost Benefit Analysis?

When doing the 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 NPVNPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more 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 for going ahead.

It is represented by the following equation:

NPV = ∑ Present Value of Total Future Benefits – ∑ Present Value of Total Future Costs

#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.

BCR =Present Value of Total Future Benefits / ∑ Present Value of Total Future Costs

The greater the value above 1, the greater are the benefits associated with the alternative considered. If using the Benefit-Cost RatioBenefit-Cost RatioThe benefit-cost ratio measures the monetary or qualitative correlation of a project's or investment's cost with the benefits a company or individual will acquire from it. It is computed by dividing the present value of the project's expected benefits from the present value of the project's cost.read more, the analyst has to choose the project with the greatest Benefit-Cost Ratio.

Let’s take a quick look at the cost-benefit analysis suggesting a comparison between the two:

Project Alternative 1Project Alternative 2
  • Present value of Costs = $80 million
  • Benefits = $150 million
  • NPV = $150 million – $80m = $70m
  • BCR = 100 mn /70 mn  = 1.88
  • Present value of Costs = $9 million
  • Present value of Benefits = $20 million
  • NPV =$20 million – $9 million = $11 million
  • BCR = 20 mn /9 mn = 2.22

From this cost-benefit analysis, 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 two would be preferred as a BCR of 2.22 is greater than the BCR of 1.88.

In cost-benefit analysis, the overall result may be determined by considering the costs involved in option one, which are much greater, or 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.

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 a few of us know the other key elements that go into the analysis. The steps to create a meaningful model are:

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 instead of 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 essential to costs and benefits are classified in the following manner to ensure that you understand the effects of each cost and benefit.
    Direct CostsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more (Intended Costs/Benefits)
    Indirect CostsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc.read more (Unintended Costs/Benefits),
    – Tangible (Easy To Measure And Quantify)/
    – Intangible (Hard To Identify And Measure), And
    – Real (Anything That Contributes To The Bottom LineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more 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 crucial element. Mapping needs to be done when the costs and benefits will occur and how much they will pan out over a phase. It solves two major issues. Firstly, a defined timeline enables businesses to align themselves with 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.

    It implies converting future costs and benefits into present value. It is also known as discounting the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more or benefits by a suitable discount rate. Every business tends to have a different discount rate.

  6. Calculate net present values.

    It 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. It 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. E.g., 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 significant extent.
  • Addressing uncertainties precisely – Business decisions are clouded by uncertainties. It 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 the benefits or costs is 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.

Importance of Cost-Benefit analysis

Limitations

Like every other quantitative tool, Cost-benefit Analysis also has certain limitations: A good CBA model is the one which circumvents these hurdles most effectively: Few of the limitations are:

This article has been a guide to what is the cost-benefit analysis. Here we discuss how to do cost-benefit analysis along with examples, importance & limitations. You can also have referred to the following recommended articles to learn more about Corporate Finance –

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