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Author : Admin Category : General March 26, 2022

A cost-benefit analysis is a process businesses use to analyze decisions. The business or analyst sums the benefits of a situation or action and then subtracts the costs associated with taking that action. For example, you are appointed as a CEO of XYZ company and you have to decide whether you build an E-commerce solution or not. On what basis you would like to decide in such a situation. Based on cost-benefit analysis, you would decide how much cost is required to build a solution. Secondly, you will check the benefits you would fetch from making the solution. If the cost is more, and the benefit is less, then drop the decision. However, if the cost is less, and the benefit is more, then adopt the decision.

Formula of Cost-Benefit Ratio

It is important to estimate the value of cost and its benefits so that estimation is taken.

Cost- Benefit Ratio = ∑ Present Value of Future Benefits / ∑ Present Value of Future Costs.

Steps for calculation

  • First of all, find out the present value of estimated benefits.
  • Secondly, find out the present value of estimated costs.
  • Find out the discounted rate based on the opportunity cost or market information that is present.
  • Enter the data and information as input into the formula.
  • Finally, calculate the cost-benefit ratio.

Example

Suppose the present value of expected benefits= $2000.

The present value of expected costs= $1000

Discounted rate= 4% of 0.04

Number of periods= 6

BCR= ($2,000 / (1 + 0.04)1) + ($2,000 / (1 + 0.04)2) + ($1, 00 / (1 + 0.04)6) / $1000

BCR= 11.54

Process of Cost-Benefit Analysis

  • Direct costs would be direct labor involved in manufacturing, inventory, raw materials and manufacturing expenses.
  • Indirect costs might include electricity, overhead costs from management, rent and utilities.
  • Intangible costs such as customer impact of pursuing a new business strategy, project or construction of a manufacturing plant, delivery delay of products and employee impact.
  • Opportunity costs such as alternative investments or buying a plan versus building one.
  • Cost of potential risks such as regulatory risks, competition, and environmental impacts.

 

Steps to perform cost-benefit analysis

  1. Understand the cost according to the current situation: - This step is important to measure the costs to initiate the work of a project. For instance, a person should always make efforts to achieve something because if one is not putting in the effort, then the competitor would go ahead and your business will end with more expenses than your investments.
  2. Determine the cost: - Estimate the cost analysis which is related to the project. For example, an approximate analysis should be made regarding upfront costs, intangible costs, tangible costs, potential risks that would carry cost and unexpected costs. All the costs should be related to any of the departments like marketing, finance, sales, human resource and management.
  3. Determine the benefits: - Estimate the benefits which are related to the project. The estimated benefits could be: -
  • What are the estimated benefits that can be generated by investing in a project?
  • What is the expected return on investment? ROI can be measured from revenue, efficiency or market share.
  1. Measure costs and benefits in the monetary form: - It is important to measure the costs and benefits in quantitative form. Separation of cost of a project into different denominations is not valid on the basis of country or region. There is one important thing that is essential which includes the number of employees who are required to complete the project. In addition to it, know that it is important to recruit new employees in the project and how many days are required to train them properly. However, it is not easy to monetize the benefits.
  2.  Create a timeline for cost and benefit analysis: - It means to find out the problem that has to be solved within the time period and look for the points for all the members to use their brains to find out the result. To solve this issue, work according to clear or smart goals and objectives.
  3. Compare costs and benefits: - Lastly, it is important to measure the overall cost with the benefits. It is important to use the same currency while calculating the figures. Most important concept which is required to be taken into consideration: - Inflation and the Payback Period.

Benefits of Cost-Benefit Analysis

  1. Helps in decision making: - Cost-benefit analysis helps in making the best decision out of the options available which are generally difficult to decide in nature. With the help of cost-benefit analysis, a decision can be taken easily.
  2. Outline the hidden cost and benefit: - With the help of cost-benefit analysis, all the direct and indirect hidden costs are easily depicted.
  3. Evaluation of best option: - With the help of cost-benefit analysis, all the data and information is received to evaluate the decision with proper evidence.

Limitations of Cost-Benefit Analysis

  1. Human perspective is not allowed: - In cost-benefit analysis; human factor is not taken into an account for calculation, since the organization doesn’t deal with a human perspective.
  2. Only considers accurate data: - In cost-benefit analysis, it only considers the accurate data, otherwise, the result will be invalid or inaccurate.
  3. Used for short-term and midterm projects: - It is only useful for short-term and midterm projects because, in a long-term project, inflation or deflation may occur. And it doesn’t carry forward the changed values.

Hence, it is all about cost-benefit analysis, its process, importance, advantages and disadvantages with formula and example.

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