Cost-benefit analysis: Meaning, process, and examples
Prudent managers proceed with an investment decision after conducting a thorough _cost-benefit analysis _of all the alternatives available.
A cost-benefit analysis enables firms to compare several projects based on their net monetary benefits, prompting them to invest in the project yielding the highest cost-benefit.
A cost-benefit analysis is a process used by firms to project the potential net rewards of undertaking a project. It involves the estimation of the benefits of an investment that have been reduced for its associated costs after accounting for the time value of money.
The main purpose of doing a cost-benefit analysis is to determine which projects should be undertaken. A higher cash inflow projection will indicate that investing in the project will yield a favourable outcome.
There is no standardised process for undertaking a cost-benefit analysis in project management. But generally, the following steps can be followed for performing a cost-benefit analysis:
The first step in conducting a cost-benefit analysis is to take stock of the current situation and identify how it can be improved with a new project. For instance, do you need to spend on marketing to drive new sales in existing markets, or do you want to expand into new markets for higher sales?
To do this, create a framework that clearly defines the goals, costs, limitations, timeline, and performance parameters associated with the project. At this planning stage, you should additionally consider whether you have adequate resources and staff to conduct a cost-benefit analysis.
After defining the scope of your project, calculate the costs of undertaking the project, classifying them further into fixed and variable costs. Some of the costs to identify are:
- Direct costs, such as labour costs, raw material pricing, inventory costs, and manufacturing overheads.
- Indirect costs, including renting, utilities, administration, and management expenses.
- Intangible costs, i.e., non-financial expenses with a significant business impact in the form of customer reaction, employee morale, and brand reputation.
- Opportunity costs, or the costs of not undertaking alternative investment opportunities.
- Potential costs stemming from changes in peer competition or regulation.
The next step in a cost-benefit analysis is to identify the benefits of undertaking the project, including the intangible benefits of higher employee morale and any competitive advantages.
However, it is best to keep these estimates conservative as projections involve several assumptions about market conditions, consumer demand, and the state of the economy.
Given the project’s duration, firms must determine reasonable discount rates, which can then be applied to costs and benefits to estimate their present values. Sensitivity analysis can also be used to analyse the impact of different discount rates on these cash flow projections.
Follow up by computing the net present values by subtracting the present value of cash outflows (costs) from cash inflows (benefits). At this stage, some firms also use a cost-benefit ratio to get a better picture of the project’s dynamics.
Finally, summarise all the projections of the project’s costs and benefits. If the estimates yield net benefits, i.e., cash inflows exceed cash outflows, then undertaking the project investment will usually make for a sensible decision. But such decisions may be limited by resource constraints or higher risks.
A cost-benefit analysis is primarily conducted via the Net Present Value (NPV) and the Benefit-Cost Ratio (BCR) methods. We outline them below.
The NPV model calculates the difference between the present value of cash inflows (benefits) and cash outflows (costs). As long as the NPV > 0, the project is suitable for investment. But when faced with capital restrictions, companies can opt for the project with the highest NPV.
The cost-benefit analysis formula in the case of the NPV method is as follows:
NPV = ∑ PV of benefits (cash inflows) – ∑ PV of costs (cash outflows)
The benefit-cost ratio model computes the relative benefits and costs of a project. It is the ratio of the PV of benefits to the related costs, with a value exceeding 1 denoting net rewards. When deciding between different investment options, this method favours the project with the highest BCR.
The formula for cost-benefit analysis under BCR is: BCR = ∑ PV of Benefits (cash inflows) / ∑ PV of costs (cash outflows)
Example 1: A firm wishes to evaluate whether it makes sense to purchase equipment for £50,000. It estimates annual cost savings of £20,000 over five years. Assuming a 5% discount rate, this investment’s cost-benefit analysis will be as follows:
NPV = PV of costs (initial investment) – the sum of PV of benefits (cost savings) NPV = -£50,000 + (£20,000 / (1+0.05) ^1) + (£20,000 / (1+0.05) ^2) + (£20,000 / (1+0.05) ^3) + (£20,000 / (1+0.05) ^4) + (£20,000 / (1+0.05) ^5) NPV = £6,477.43
Since the NPV is positive, the firm can go ahead with the investment as it is likely to be profitable.
Example 2: A company needs to make a decision between two projects using the following cost-benefit analysis template:
|Project A||Project B|
|PV of costs||£70,000||£50,000|
|PV of benefits||£150,000||£120,000|
|NPV||£150,000 - £70,000 = £80,000||£120,000 - £50,000 = £70,000|
|BCR||£150,000 / £80,000 = 1.875||£120,000 / £50,000 = 2.4|
Here, both projects yield net benefits, with project A showcasing a higher NPV. However, using the BCR method, project B signals superior results, with 2.4 being higher than 1.875 for project A.
Firms conduct a cost-benefit analysis to determine the feasibility, soundness, and justiciability of their new investments. By forecasting cash flows and adjusting the projected net benefits for time value through this analysis, companies evaluate whether an investment will be profitable for their businesses.