COST BENEFIT ANALYSIS

Cost-benefit analysis (CBA) is a tool used to evaluate investment projects by comparing the costs
of the project to its expected benefits. The purpose of CBA is to determine whether the benefits of
a project outweigh its costs, and if so, by how much.

Cost-Benefit Analysis is a valuable tool for evaluating the economic feasibility of projects by
systematically comparing their costs and benefits. Despite its limitations, it provides a structured
approach to decision-making that incorporates both quantitative and qualitative factors.

Cost-benefit analysis is a useful tool for evaluating investment projects. By carefully identifying
the costs and benefits of the project, quantifying them, and performing sensitivity analysis, you
can gain a better understanding of the project's overall impact and make more informed investment
decisions. Overall, cost-benefit analysis is a valuable tool for evaluating investment projects. By
carefully identifying and quantifying the costs and benefits of the project, and considering both
quantitative and qualitative factors, you can make more informed investment decisions and
maximize the value of your resources.

Advantages of cost-benefit analysis:

1. Objective evaluation: Cost-benefit analysis provides an objective evaluation of investment
projects, allowing decision-makers to compare different options based on their economic
feasibility.
2. Comprehensive analysis: CBA considers both the costs and benefits of investment projects,
enabling decision-makers to evaluate the project's overall economic impact.
3. Considers time value of money: CBA incorporates the time value of money by discounting
future costs and benefits to their present values.
4. Sensitivity analysis: CBA allows for sensitivity analysis to be conducted, enabling
decision-makers to evaluate the impact of changes in key assumptions on the project's
economic feasibility.
5. Improved resource allocation: By identifying the investment option that provides the
greatest economic value, CBA helps decision-makers to allocate resources efficiently.
Disadvantages of cost-benefit analysis:
1. Difficulties in quantifying all costs and benefits: It may be difficult to quantify all costs
and benefits of an investment project, particularly non-monetary benefits such as improved
quality of life or reduced environmental impacts.
2. Relies on assumptions: CBA relies on assumptions about the future costs and benefits of
the investment project, which may be subject to uncertainty.
 3. May not consider all factors: CBA may not consider all factors that are relevant to the
decision-making process, such as social and environmental impacts, ethical considerations,
or political factors.
4. Discount rate may be arbitrary: The choice of discount rate used in CBA may be arbitrary
and may not reflect the true opportunity cost of capital or the expected rate of return on
investment.
5. May be time-consuming and costly: Conducting a comprehensive cost-benefit analysis can
be time-consuming and costly, particularly for large and complex investment projects.

Identifying Costs and Benefits

Costs:
Direct Costs: Construction expenses, operating costs, maintenance.
Indirect Costs: Increased noise during construction, displacement of businesses.
Benefits:
Direct Benefits: Reduced vehicle operating costs, time savings for commuters.
Indirect Benefits: Improved air quality, reduced traffic accidents.

Key points to consider when conducting a cost-benefit analysis for investment projects:
1. Identify the costs: The first step in a CBA is to identify all of the costs associated with the
project. This includes both direct and indirect costs, such as construction costs, labor costs,
maintenance costs, and any other expenses related to the project.
2. Identify the benefits: Once you have identified the costs, the next step is to identify the
benefits of the project. This includes both tangible and intangible benefits, such as
increased revenue, improved efficiency, reduced environmental impact, and improved
community relations.
3. Quantify the costs and benefits: In order to compare the costs and benefits of the project,
you need to put a dollar value on each item. This can be challenging for intangible benefits,
but it is important to do so in order to get an accurate picture of the project's overall impact.
4. Determine the project timeline: The timeline of the project will have an impact on both the
costs and benefits. You will need to consider factors such as construction time, operational
time, and the expected lifespan of the project.
5. Calculate the net present value (NPV): The net present value is the difference between the
present value of the project's benefits and the present value of its costs. This calculation
takes into account the time value of money, which means that future benefits and costs are
discounted to their present value.
NPV = NPV (Benefits) – (Initial cost + NPV(Costs))
 6. Calculate the Benefit to Cost Ratio:
Ratio of the present value of benefits to the present value of costs. A BCR greater than 1
indicates that benefits exceed cost.

BCR = NPV (Benefits)

NPV (Costs)

7. Consider qualitative factors: While CBA is primarily a quantitative analysis, it is important

to consider qualitative factors as well. For example, you may want to consider the impact
of the project on the local community, its potential for innovation or growth, and its
alignment with the company's values and goals.
8. Compare alternatives: When evaluating investment projects, it is often helpful to compare
them to alternative projects or investments. This can help you determine which project is
the best use of your resources and which will have the highest return on investment.
8. Communicate results: Once you have completed your CBA, it is important to communicate
the results to stakeholders, including investors, management, and employees. This can help
build support for the project and ensure that everyone is aligned around its goals and
expected outcomes.

Example 1

Assume a company is considering installing solar panels on a commercial building that will cost
$50,000. The project is expected to generate $10,000 in energy savings per year for the next 10
years. The company estimates that the panels will require $2,000 per year in maintenance costs.
The discount rate is 8%.

Step 1: Identify the costs and benefits

Costs:
• Installation costs: N50,000,000
• Annual maintenance costs: N2,000,000
Benefits:
• Energy savings per year: N10,000,000
Step 2: Quantify the costs and benefits
• The installation costs are already in dollar form.
• The annual maintenance costs can be discounted to their present value using the formula:
PV = C/(1+r)^t,
where PV is the present value,
C is the future cost,
r is the discount rate, and t is the number of years.

For example, the present value of the maintenance costs in year 1 is 1,851,851.85
(2,000,000/(1+0.08)^1).

You will do same for each year from 1 to 10

• The energy savings per year can also be discounted to its present value using the same
formula. For example,

the present value of the energy savings in year 1 is N9,259,259.26 (N10,000, 000/(1+0.08)^1).

Step 3: Calculate the net present value (NPV)

The NPV is calculated as the present value of the benefits minus the present value of the costs. In
this case, the NPV is:
NPV = summation of (PV of benefits for each of the year) – (summation of (PV of costs) + Initial
costs)
If NPV is positive, the project is expected to generate a positive return and is worth pursuing.

Step 4: Calculate the benefit-cost ratio (BCR)

The BCR is the ratio of the present value of the benefits to the present value of the costs. In this
case, the BCR is:
BCR = (PV of benefits) / ((PV of costs) + Initial cost)
A BCR greater than 1 indicates that the benefits outweigh the costs, so the project is expected to
generate a positive return and is worth pursuing.

Overall, these examples demonstrate the process of conducting a cost-benefit analysis for
investment projects. By identifying the costs and benefits, quantifying them in present value terms,
and calculating the NPV, IRR, and BCR, companies can make informed decisions about whether
to pursue a particular investment opportunity. However, it is important to keep in mind that cost-
benefit analysis relies on a number of assumptions and estimates, and the results may not always
accurately reflect the true costs and benefits of a project.

Exercise
Building a new manufacturing plant Assume a company is considering building a new
manufacturing plant that will cost $10 million. The project is expected to generate $5 million in
additional revenue per year for the next 10 years. The company estimates that the plant will require
$500,000 per year in maintenance costs. The discount rate is 10%. Establish your NPV, CBR and
justify the acceptance or rejection of the project.

oyeyipoo@gmail.com at 11:59pm 28th May 2024….