COST BENEFIT ANALYSIS

A process that estimates the benefits and costs of an investment (asset or project)

Why use this technique:

to determine the viability of a project (if it’s a good investent)
to copare one project investment with the other

TYPES OF COST BENEFIT ANALYSIS

1. Benefit Cost Ratio (BCR)

2. Net Present Value
3. Incremental Cost Benefit Ratio
4. Payback Period

NB: Now you can see that cost benefit analysis is the mother to beneit-cost ratio.

In the AAT exams that I wrote I came across the 1st and 2nd type of cost benefit analysis. I will
be explaining the two. Hope we understand each other along the way. Good Luck!

1. Benefit Cost Ratio

The ratio of project benefits versus project costs

The results: what the project outcome will tell you towards making a decision

BCR < 1 Investment option generates losses. Project should not be undertaken
BCR = 1 Investment option is neither profitable nor lossy. Undertake project but further
analysis should be considered.
BCR > 1 Investment option is profitable.

Example #1

Sports International limited is planning to expand its business, and for that, it will require
four new employees in the organization. For analyzing whether the expansion is beneficial
or not, the management of the company decides to use the cost-benefit analysis. The
following are the information available related to benefits and costs related to expansion:

Within the time frame of one year, it is expected that if the company hires four employees
for the expansion, then the revenue of the company will increase by 50 %, i.e., the
revenue benefit will be around $ 250,000.
Also, due to the new hiring, the company value of the business will increase, which would
result in additional revenue of $ 30,000.
The salary of the new employees is estimated to be $ 160,000.
The additional cost of hiring is estimated to be $ 15,000.
The cost of additional hardware and software required will come at around $ 25,000
Analyze the expansion using Cost-benefit analysis.

Solution

Total benefit from the project = Increase in revenue from expansion

Total benefit from the project = $ 250,000 + $ 30,000 = $ 280,000
Total Cost from expansion = Salary of new employees + Cost of hiring + Cost of additional
hardware and software
Total Cost from expansion = $ 160,000 + $15,000 + $25,000
Total Cost from expansion = $ 200,000

Now the benefit-cost ratio will be calculated for the expansion.

Benefits
Increase in Revenue 250,000.00
Increase in Additional Revenue 30,000.00
Total Benefits 280,000.00

Costs
Salary of new employees 160,000.00
Cost of hiring 15,000.00
Cost of Additional Hard&Software 25,000.00
200,000.00

Benefit cost ratio 280 000 / 200 000 = 1.40

Conclusion or Recomendation

The benefit cost ratio is greater than one which means the expansion of the business
should proceed but with caution and further analysis.

NB:
make sure you pick pointers fro the company background and the questions
scenario to support your answer. Go deeper and use relevant info
When you mention that further analysis should be undertaken make sure
you explain what analysis should be used.
Example #2

Constru Ltd is a real estate developer. It is planning to make the investment for which it
came across different investment options. The following are the information available
related to benefits and costs related to various investment options:

Option 1
Build 200 flats out of which 100 flats will be given on the rent for 10 years at the rent of
$ 2,000 per year. After 10 years, the rented 100 flats would be sold out at the price of
$100 000
On the cost side, the cost of construction would come to $ 110,000 per flat, which can be sold
at $150,000 each. Apart from the construction cost, the cost of sales and staff would come to
$ 700,000 per year. The financing cost of the project would be $1,500,000, and the project
would last for two years.

Option 2
Build 100 flats out of which 20 flats will be given on the rent for 5 years at the rent of $ 3,000
per year. After 5 years, the rented 20 flats would be sold out at the price of $ 120,000
On the cost side, the cost of construction would come to $ 150,000 per flat, which can be sold
at $200,000 each. Apart from the construction cost, the cost of sales and staff would come
to $ 450,000 per year. The financing cost of the project would be $4,000,000, and the project
would last for one year.

Analyze the investment options using Cost-benefit analysis.

Option 1 Option 2
Calculations Totals Calculations Totals
Benefits

Income from rental 100 x 10 x 2000 2,000,000.00

Income from sales 100 x 150 000 1,500,000.00

Income from sales
after rent period 100 x 100 000 10,000,000.00 YOU ARE TO COmPLETE
27,000,000.00
OPTION 2!
Costs
Construction cost 200 x 110 000 22,000,000.00

Sales and staff cost 2 x 700 000 1,400,000.00

Financing cost 2 x 150 000 3,000,000.00

26,400,000.00

Benefit cost Ratio 27 000 000 / 26 400 000 = 1.02 Benefit cost ratio for option 2 = 1.04
2. NET PRESENT VALUE

It considers the difference between the total discounted benefits and the total
discounted costs which gives the NPV.

Results
If NPV is negative and internal rate of return (IRR) is below the discount rate
Do not proceed with project
If NPV is zero and IRR is equal to the discount rate. Undertake project but further
analysis should be considered and close monitoring.
If NPV is greater than zero and IRR is greater than the discount rate.
Investment option is profitable.

Example #1

The CFO of Housing Star Inc. gives the following information related to a project. Costs of
$1,80,000 are to be incurred upfront at the start of 2019, which is the date of evaluation of
the project. Use a discounting rate of 4% to determine whether to go ahead with the project
based on the Net Present Value (NPV) method.

Year Benefits Forumula for the PV factor is

2019 30,000.00 ^ = to the power of NB: the value after
2020 50,000.00 4% = 0.04 this sign (^) is
2021 70,000.00 1/(1+0.4)^1 substituted by the
2022 80,000.00 1/(1+0.4)^2 years.

Year Cash inflows PV factor Amount

(cash inflow x PV factor)
1 30,000.00 0.9615 28,846.15
2 50,000.00 0.9246 46,227.81
3 70,000.00 0.8890 62,229.75
4 80,000.00 0.8548 68,384.34
Present value of inflows 205,688.04
Outflows 180,000.00
NPV 25,688.04

Conclusion or Recommendation
The NPV is greater than zero which means the project should be implemented because it is
profitable

NB:
make sure you pick pointers fro the company background and the questions
scenario to support your answer. Go deeper and use relevant info
When you mention that further analysis should be undertaken make sure
you explain what analysis should be used.