Organizations, both for-profit and not-for-profit ones, often contemplate the need to take up new initiatives, develop new policies, bring about changes or create new capabilities to improve their current state of business-as-usual and create new benefits for the organization and stakeholders.
All such new initiatives will be taken up as new projects by the organizations. These projects are expected to create new business value or in some cases social value. Every new project or initiative will require fresh investments of efforts and money to be made. Organizations will need to make such decisions prudently by creating a clear justification.
Conducting a cost benefit analysis (CBA) or a Benefit-Cost analysis (as may be referred alternatively) is one of the most fundamental methods used to compare the financial cost to be incurred for such new initiatives and benefits to be generated from them.
To undertake new initiatives is an integral part of the evolution of mankind, at a personal level, at a social level or at a business level. On the social front, it may involve initiatives like developing new townships, new buildings, new schools, new hospitals, new monuments, new social infrastructures, and new offices. On the business front, it may involve developing new products, new services or new production capabilities.
There has always been a need to make sound and clear decisions. As the accountability of leaders on financial matters continues to rise, the need for doing a cost-benefit-analysis also becomes inevitable. CBA as a practice becomes part of policy matters in government projects in the US dating back in 1936, when Corps of Engineers started doing CBA for Federal Waterway Infrastructure projects.
A fundamental approach to do CBA includes estimating all the costs to be incurred in doing the project and carefully evaluating and estimating all the benefits to be garnered from the project. Benefits can include both quantifiable financial benefits and non-quantifiable benefits such improvement in quality of life, ease of living, ease of doing business etc.
We already discussed that every new project needs investments to be made with the expectation of returns from the investments. There are two main applications of conducting a CBA:
Estimating all costs to be incurred in doing a project is the first important part of CBA. It will involve carefully estimating and listing the required quantity, quality and duration of material, labor, equipment and facilities to be used for completing all the activities of project work. Then we can estimate the costs for each of the above categories of resources. There will also be a need to include cost for contingency, inflation, cost of financing (if needed) and cost of any other services (such as training, liaison etc.) which may be required to complete the project activities.
Cost estimation can be done with a considerable amount of accuracy level if all the activities of the project can be identified and all resource quantities can be estimated as stated above.
Estimating all benefits to be garnered is the second important part of CBA. Every project or investment done is expected to deliver benefits in future. Benefits can include financial benefits by means of increase in profit margins and increase in efficiency of doing things. Benefits can also include non-financial benefits such as increased comfort and ease of doing things, improved moral of people, increased satisfaction levels, more peace, social benefits etc. Financial benefits can be estimated with considerable amount of accuracy, while it will be somewhat challenging to estimate and quantify the non-financial benefits.
After careful and diligent estimation of costs and benefits as stated above, we need to compare the costs to be incurred with benefits to be garnered. If the benefits outweigh the costs considerably, such proposals will be taken up for further consideration by the organizations. Organizations may lay down clear guidelines regarding minimum expected difference between benefits to cost for the projects to be selected for implementation. Organizations may also lay down clear guidelines for evaluating the social benefits (mostly non-financial as explained above) for clear decision-making after doing a CBA.
To conduct cost benefit analysis, we need to estimate and enumerate all costs to be incurred and all benefits to be generated. Then one needs to compare the costs with benefits for arriving at suitable decisions and recommendation about whether the project is worthy of taking up or not.
There are two broad methods for doing cost benefit analysis:
We can take a simple example below to illustrate some of these methods.
These are very simple methods without considering the effects of interest and time period.The below illustration shows the costs incurred and benefits over a period of six years.
|Yr. 0||Yr. 1||Yr. 2||Yr. 3||Yr. 4||Yr. 5||Yr. 6||Discount rate at 10% (0.1)|
Example of CBA using Non-Discounted Method
Total Cost = 100000; Total Benefits = 150000
Using the above simple non-discounted methods we can see that this project looks good with benefits being more than the cost, with positive profits and lower payback period.
But these calculations are too simplistic, and do not account for the time-value of money based on interest rates, inflation.
In the above example, the costs are incurred in the present time, while the benefits will be received in future. These values of money are in different timelines and hence their values cannot be compared directly as it is. We need to bring down all the future values of benefits and costs to their corresponding present values and then we can do a comparison of present values of benefits and costs.
The below formula can be used to understand the relationship between present value (PV) and future value (FV) of money.
In the below example, the cost and benefits value mentioned are in specific period in time. We need to bring all costs as well as all benefits to their corresponding present values (PV) using the above equation and assuming an interest (discount) rate of 10% for ease of calculation.
|Yr. 0||Yr. 1||Yr. 2||Yr. 3||Yr. 4||Yr. 5||Yr. 6||Discount rate at 10% (0.1)|
Example of CBA using Discounted Method
Hence this project investment will lead to a profit after discounting the effect of interest and any other inflationary factors which are taken as 10%)
If NPV is > 0, then the project investments will lead to profit. NPV is one of the most practical methods for doing cost benefit analysis by considering the time-value of money.
As we discussed above, there are various methods for undertaking cost benefit analysis. Different financial parameters such as Benefit Cost Ratio (BCR), ROI, Payback Period, NPV, IRR etc. need to be calculated for arriving at decisions and making necessary recommendations on whether a specific project should be taken up or not.
Every organization is unique in their capabilities to invest and take risk. Organizations can define their specific guidelines or framework for project selection taking into account the above financial parameters, the risks involved in doing the project and most importantly specific nature of the investors. A framework for project selection will include all above factors.
Below are some basic guidelines which are used for decision making during cost benefit analysis (CBA)
Cost benefit analysis can be reasonably accurate if these are done by technical and financial experts. Experience and availability of real data about costs and benefits of similar projects from past can greatly enhance the accuracy of cost benefit analysis.
Since cost benefit analysis requires estimating costs and quantifying future benefits accurately, it requires solid maturity in terms of knowledge and availability of past data. In the absence of experience and data availability, CBA may fall short in its accuracy.
While doing cost and benefit analysis, it will be important to understand risks and uncertainties involved in doing the project. It will also be equally important to understand the uncertainties involved in realizing the benefits once the project is done. Cost benefits analysis need to consider the implications of uncertainties to make it realistic. It may require doing statistical simulations and modeling as well.
We saw that CBA became a formal and mandatory practice as early as 1930s in the US government departments, for numerically evaluating if the benefits will outweigh (and by how much) the costs of doing the project.
Organizations have become highly knowledgeable, experienced, and matured. Availability of past data coupled with ability to process the data using modern mathematical and statistical techniques and computerized tools exists in abundance within organizations.
In today’s world the need for doing CBA has become necessary. Businesses and governments are held more and more responsible and accountable to their citizens and investors for justifying their investment decisions. They can do this only by conducting a thorough cost benefit analysis.
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