Cost Benefit Analysis

Cost–Benefit Analysis is an analytical tool in the hands of a management of a company in taking a decision of undertaking a project or discarding the project. It investigates the cost to be incurred in the probable project and investment to be made. A project may be either the expansion of the existing business, or setting up of a new company or introduction of new project or project that would be beneficial to the employees and enhances their strength and ability in working towards the goal of the corporation. Whatever may be the project, the company should earn much more than the costs it incurred. The basic objective of any company to undertake a new project is to increase the profit earned and wealth of the owners. The techniques used in the analysis of cost – benefit are NPV, IRR, and Pay – back period and Return on Investment (ROI). Every individual, whether he/she be a producer, consumer or employee working in an organization, uses this technique knowingly or unknowingly for attaining the highest benefit. Everyone acts sensibly to make a rational choice that is getting highest benefit at the lowest cost.

Cost-Benefit Analysis in Consumer’s Decision Making

Consumer’s behavior is rational in nature. They weigh many pros and cons before deciding to buy a product. While trying to get the quality product at the lowest cost, they also consider the opportunity costs of the product. If the product is having high opportunity cost, the consumer may not opt for the product. The product may give the highest satisfaction but may be very expensive. The consumer may be rational to opt for such product that gives the greatest benefit relative to the cost.

Cost-Benefit Analysis Approach for Decision Making by Producers

Producers may behave rationally in deciding the production. If the management speculates to choose a new product line, it will analyze the costs to be incurred and the benefits to be attained. The amount of investment to be made, the periodical cash flows, and period within which to take back the investment made initially, the return on investment and the internal rate of return. If the new product line assures the good net present value within a short span of time, the management may consider it worthy. Sometimes, the new product line may need only some extra variable costs without involving new fixed costs. The management of the business entity may go in for the project if it is having satisfactory contribution margin. The extra variable cost includes raw material costs, extra labor costs and the cost of component parts. The revenues should be higher than the cost incurred.

Cost-Benefit Analysis Approach for Hiring New Employees

Selecting a right person for the right job is a difficult task that requires certain amount of investment on human resources. The cost of recruitment involves advertisement, time cost of internal recruiter, time cost of assistant recruiter for reviewing the resumes, and the time cost of the person who conducts the interviews, pre-employment tests. Apart from the cost of recruitment, the cost of training, the cost of placement, salary and other benefits require considerable investment on human resource. The probable benefits should be more than the cost incurred on human resources.

History of cost benefit analysis

French engineer, Jules Dupuit, developed this technique in the year 1848. Later on, the cost benefit technique gained popularity at the instance of the congress passing the Federal Navigation Act. The aim of the act was to control the floods of waterways and their tributaries. The engineers of the corporation set up for the purpose of controlling the floods analyzed the costs and their corresponding benefits methodically and adopted only those projects whose benefits exceeded the costs. Thus the analysis of public investment was developed.

Principles of Cost Benefit analysis

Common unit of measurement:

The desirability of the project whether to adopt it or reject, must be expressed in terms of money. Money is a common measurement of value. The benefits and costs of all projects should be expressed in terms of money value. This monetary value should include the inflation. Inflation reduces the real value of money over the period. Therefore, it is necessary to calculate the present value of the future benefits of the investments made today. The present value of the future earnings is the discounted value of such earnings. The present discounted value of future earnings should be more than investment made.

Choices and Trade-off in Decision Making

Choosing between the trade off and equivalencies is a challenging task in the cost-benefit strategy.

Benefits and market choices

Consumers prefer to buy a particular product till the point where the marginal cost equals marginal benefit. Since the marginal cost of a unit is equal to it’s price, the consumer will continue to increase consumption till the point where the marginal benefit is equal to the price of the commodity. The demand schedule provides required information about the marginal value of the increasing consumption.

Accepting or Rejecting Investment Decisions based on Cost Benefit Analysis

Sometimes the firms have to undertake investment projects that will only provide benefits in future but will entail considerable costs in the current period. Calculations of Net Present Value, an analytical tool in the cost – benefit strategy, helps in deciding whether to undertake such long-term investment decisions or not. The investment of the project is compared with periodical cash flows over certain periods. Price rise due to inflation decreases the real value of the expected future cash flow. To compare present marginal costs with future cash flows, discounting technique needs to be employed. The future cash inflows should be converted into discounted cash flows. The investment upon the project should be deducted from the total discounted cash flows over the periods. This would give the net present value of the project. If the net present value is positive, the management can accept the decision to undertake the project and reject it if the NPV is negative.

Example of Cost Benefit Analysis based on Net Present Value Calculations

An investment of $10,000 (having scrap value of $500) yields the following returns:

Years Yields
1 $4000
2 $4,000
3 $3,000
4 $3,000
5 $2,000

The cost of capital is 10%. Is the investment in the project desirable?

Year Cash Inflows PV factor @10% [1/(1+r)^n] Present value in $
1 $4,000 0.909 3,636
2 $4,000 0.826 3,304
3 $3,000 0.751 2,253
4 $3,000 0.683 2,049
5 $2,500 0.621 1,552
(including the scrap value)
Present value of future cash inflows 12,794
Less: Initial investment -10,000
Net present value 2,794

The net present value is positive, and therefore the investment is desirable.

Constraints to cost benefit Analysis

The physical constraints: Certain benefits are immeasurable in terms of money value. For example, it is not possible to measure the life saved in terms of money value when the authorities takes action in the prevention of road accidents. The benefit of saving a life is not measurable and compared with the cost incurred.

Legal constraints: Legal constraints may be either domestic or international. Law relating to property, foreign exchange, and constitutional limits are some of the legal constraints that play against the strategy of cost–benefit analysis.

Administrative constraints: This constraint refers to the availability of skilled technical person who suits the particular job requirement. It is very difficult to get a suitable person for the job. This is the biggest hurdle in carrying out the project successfully.

Political constraints: This political constraint plays a vital role in fulfilling the project successfully. It is very difficult to calculate the cost and its corresponding benefits accurately in the prevailing cumbersome political mechanism and in the midst of strong competing interest groups.

Financial or budget constraints: A project would be successful only when the tasks are fulfilled as per the plan. The sudden change like increase of interest rate, or failure of the getting necessary loan, may increase the cost and reduce the benefits of the project.

Conclusion on using Cost-Benefit Analysis

The costs incurred and the benefits arrived should be measured in terms of money value. The future cash flows should consider the inflationary tendency that reduces the real money value. For this purpose NPV, method is adopted.

Consumers would purchase commodity wherein their marginal benefit equals the marginal cost.

Producers rely on opportunity costs in the production at lowest price. The internal rate of return should be greater than the cost of capital. The positive net benefit should be more than one.

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List of References and Books for further reading on Cost-Benefit Analysis

Managerial Economics: Applications, Strategy and Tactics by McGuigan, Moyer and Harris

Economics for Business – Third Edition by John Slow man and Mark Sutcliffe