What is Cost-Benefit Analysis?
Cost-Benefit Analysis refers to a capital budgeting ratio wherein the estimated costs and benefits of a project are compared to determine its economic feasibility.
If the cumulative benefits of a potential project are anticipated to outweigh the incurred costs, a company is more likely to decide in favor of proceeding with undertaking the project.
However, if the projected costs outweigh the benefits, the likelihood of the company approving the project (or investment) is far lower, since it would be irrational to pursue an opportunity where the monetary benefits are offset by the losses.
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How Does Cost-Benefit Analysis Work?
The cost-benefit analysis (CBA), or “benefit-cost ratio” (B/C), is a decision-making tool relied upon by corporations to quantify the economic viability of a potential project or investment.
The cost-benefit analysis ratio measures the economic viability of a potential project by comparing the present value (PV) of the associated benefits to the present value (PV) of the associated costs.
Conceptually, the cost-benefit analysis ratio should exceed 1.0 for the project to be approved, since that implies the expected benefits outweigh the costs.
If the projected benefits outweigh the costs, the project could be worth pursuing, considering its potential to create positive economic value for the company, and vice versa.
Otherwise, the approval of a project where the aforementioned condition is not met (“net loss”) contradicts the risk-return trade-off theory, a fundamental principle in capital budgeting.
For the most part, the decision by a corporation to approve (or reject) a potential project abides by the following guidelines:
- Benefits > Costs → Approve Project
- Costs > Benefits → Reject Project
The practical utility of conducting a cost-benefit analysis is namely to ensure the project (or investment) opportunity is profitable, with the potential to contribute positive economic value on behalf of the corporation.
How to Calculate Cost-Benefit Analysis Ratio
Corporations should only undertake a project if the net proceeds received exceed the costs per economic theory, since that implies the project is economically feasible (and thus worthwhile to pursue).
Given the perceived net gain (or net loss) from pursuing the project, the anticipated monetary rewards can be compared to other opportunities to which to allocate capital, With that comparison, the goal would be to allocate more capital toward the one where the risk-reward profile is more favorable.
The implicit assumption that underpins the cost-benefit analysis is termed the “opportunity cost”, a fundamental economic concept that states each decision must consider the foregone value of alternative options with a comparable risk profile.
In other words, the time and resources of a company are scarce, so the decision for which projects to pursue must be the one deemed to be the most profitable relative to the alternative options available on the date of the given analysis.
The step-by-step process to calculate the cost-benefit analysis ratio is as follows:
- Step 1 → Quantify the Projected Monetary Benefits (Revenue)
- Step 2 → Quantify the Projected Monetary Costs (Expenses)
- Step 3 → Discount the Benefits and Costs to their Present Value (PV)
- Step 4 → Divide the Cumulative Present Value (PV) of Benefit by the Coinciding Cost
Cost-Benefit Analysis Formula
The cost-benefit analysis involves comparing the monetary benefits of a project to the costs.
The formula to calculate the cost-benefit analysis ratio divides the projected present value (PV) of benefit by the present value (PV) of cost attributable to a project.
The projected benefits and costs must consider the opportunity cost of capital (or discount rate), which requires discounting each cash flow to its present value (PV).
While there are a multitude of metrics that can be derived from performing a cost-benefit analysis – such as the net present value (NPV), payback period, and return on investment (ROI) – the CBA ratio is one of the more straightforward “back of the envelope” metrics used to analyze a potential project.
If the benefit-cost ratio exceeds 1.0, that is perceived positively by corporations, since the project is implied to be cost-effective and create positive economic value (i.e. monetary benefit > monetary cost).
However, the minimum requirement for the benefit-cost ratio to be greater than 1.0 is insufficient as a standalone metric – albeit, the metric provides a basis for comparing against other projects or investments.
Cost-Benefit Analysis Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Cost-Benefit Analysis Calculation Example
Suppose we’re tasked with calculating the cost-benefit analysis ratio of a project on behalf of a corporation.
In the initial period (Year 0), the total cost incurred to proceed with the investment is $20 million.
From Year 1 to Year 2, the project cost is anticipated to be $6 million and $4 million, with the cost fixed at $2 million for the remainder of the forecast period.
- Project Cost (Year 0) = ($20 million)
- Project Cost (Year 1) = ($6 million)
- Project Cost (Year 2) = ($4 million)
- Project Cost (Year 3) = ($2 million)
- Project Cost (Year 4) = ($2 million)
- Project Cost (Year 5) = ($2 million)
On the other hand, the project benefit – which refers to revenue here – is as follows.
- Project Benefit (Year 1) = $4 million
- Project Benefit (Year 2) = $8 million
- Project Benefit (Year 3) = $10 million
- Project Benefit (Year 4) = $12 million
- Project Benefit (Year 5) = $16 million
The discount rate – the minimum return for the corporation to accept the project (or “hurdle rate”) – is 5.0%, with the project expected to last five years in total.
- Project Discount Rate (%) = 5.0%
Since the cost and benefit are forecasted measures of the project’s cash flow, each metric must be discounted to the present date using the 5.0% discount rate.
The present value (PV) of each metric is determined by dividing each cash flow metric by one plus the discount rate, raised to the period number.
Once each metric is discounted, we’ll calculate the cumulative present value (PV) of the two cash flow streams to arrive at $34 million and $42 million for the cost and benefit, respectively.
- Present Value (PV) of Cost = ($34 million)
- Present Value (PV) of Benefit = $42 million
Note: If the monetary costs are input as negatives, a negative sign must be placed before the formula for the output to return a positive integer.
In closing, the cost-benefit analysis ratio comes out to 1.2, which we arrived at by dividing the present value (PV) of the anticipated benefits by the present value (PV) of the anticipated costs.
- Cost-Benefit Analysis Ratio = $42 million ÷ $34 million = 1.2
Therefore, the project is more likely to be approved by the corporation since the ratio exceeds 1.0 – but to reiterate from earlier, the insights obtained from the other capital budgeting metrics must also support the decision.
