Saturday, October 27, 2018

Cost Benefit or Benefit Cost Analysis (Basic Review)

The Cost-Benefit Analysis, which is also known as Benefit-Cost Analysis. Cost benefit analysis in itself is a vast subject.
Usually, these kinds of analyses are performed by high-level stakeholders; e.g. top management, or an organization’s board members.
They sit together and analyze which project is more profitable to them and aligned with the organization’s objective, and then pick the best project.
Once the project is chosen, they start the process of developing the project charter.
Cost benefit or benefit cost analysis is a benefit measurement method, and it is a systematic approach to calculate the cost to produce the product, service, or result and then compare it with the cost of the benefits to be received. It also provides us the current worth of future earnings and helps to compare the different projects.
Cost benefit analysis provides valuable information about:
  • Profit to be earned
  • Time value of the profit
  • Basis to compare the projects.

Profit to Be Earned

Cost benefit analysis adds all costs to be invested, and then it identifies all benefits and converts them into monetary form. Afterwards, all invested costs are subtracted from the monetary value of all benefits to get the result.
If the result is positive, then you may proceed further; otherwise, you will simply abandon the idea.
For example, let’s say you work in a large publishing house where book binding work is performed by manual operations. Therefore, you decide to propose your management to purchase a book binding machine to increase the output and improve the efficiency of the book binding department.
However, before submitting your proposal to the management, you will go for a fact-finding mission. You will list the cost of the investment and the benefits received by this investment and monetize them, such as:
  • Cost of the machines.
  • Cost of maintenance.
  • Cost of electricity used by these machines.
  • How many bindings you can perform with the machine vs how many you were performing with manual binding per day?
  • How much will manpower be reduced?
  • Cost of better quality product.
Now, you will add the cost of machines, maintenance, and electricity etc. Once you are done, you add the cost of benefits; e.g. how much extra bookbinding can be done with these machines, and cost of reduced manpower, etc.
You will then perform the cost benefit analysis. You subtract the cost of investment from the cost of benefits and show this figure to the management to convince them about your proposal.

Time Value of the Profit

In cost benefit analysis, you calculate how much money you are going to spend on it, and how much profit you will earn from this investment. Not only this, but also you have to find the current value of the profit that you will earn after a certain period of time because inflation erodes the value of money. Profit earned after several years will not have the same value as today. Therefore, an inflation factor must be taken into the consideration while doing the calculation.
For example, let us say if the inflation rate is 5% yearly then the thing you buy today for 100 USD, you will be able to get the same thing after one year for 105 USD.

Calculating the Current Worth

Let’s say that you are going to invest 100,000 USD on a project, and after one year you earn a 10,000 USD profit.
Then, considering a yearly inflation of 5%, what will be the current value of this money?
Formula to find the Current Value is
FV = CV(1+r/100)^n
Where,
FV = Future Value
CV = Current Value
r = Inflation
n = time period.
Here,
FV = 10,000 USD
r = 5
n =1
Putting all these values in the formula,
10,000 = CV(1+0.05)^1
CV = 10000/1.05
CV = 9,523.80
Therefore, the current value of your profit is 9,523.80 USD

Basis to Compare the Projects

If you have multiple projects and you have to select any one project, then you can perform cost benefit analysis on all projects and compare the profit in its current value. You will choose the project which will give you the highest profit.
Cost Benefit analysis helps especially when the projects are very costly and the duration is very long. In this case, on first look, the profit may appear to be high; however, applying the cost benefit analysis can bring a shocking result.
Cost benefit analysis helps you to decide which project should be selected from all the available options.

Summary

  • Cost benefit analysis compares the cost invested to the benefits.
  • It also compares the future earnings with today’s dollar value.
  • It helps in selecting the most profitable project.
  • Usually, top management is involved in cost benefit analysis.
  • Cost benefit analysis is performed before the project charter is developed.

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