Q 372. Organizations usually take up projects or implement solutions which have a favorable cost benefit analysis. Explain cost benefit analysis in financial terms and its associated tools. Are there any situations where organizations give an exception and still take up projects that do not have favorable cost benefit analysis? Provide examples.

 

 

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Cost-benefit analysis refers to comparing the projected benefits versus the costs connected with a project/initiative decision to determine whether it makes sense from a business perspective.

 

If the projected benefits outweigh the costs, then it could be ascertained that the decision is a good one to make. However, if the costs outweigh the benefits, the company may want to rethink the decision or project.

 

Process : the following process is generally used in CBA :

 

1. Establish a Framework for Your Analysis : Identification of goals and objectives we are trying to address and the metric we shall be using to measure and compare the benefits and costs. 

 

2. Identify Your Costs and Benefits : Compiling a comprehensive list of all the costs and benefits associated with the project or decision.

The costs may include : 

• Direct costs like labour, manufacturing expenses, inventory, raw materials etc
• Indirect costs like electricity, overhead costs, rent etc.
• Intangible costs like effect on customers, employees, delivery times or goodwill.
• Opportunity costs 
• Cost of potential risks such as regulatory and environmental impacts.

Benefits may include : 

• Tangible benefits like Revenue and sales increases
• Intangible benefits like improved employee and customer satisfaction, safety.
• Market share gained (competitive advantage)

3. Assign a Dollar Amount or Value to Each Cost and Benefit : Easy for Direct costs/benefits...but more challenging for Intangible costs and benefits

 

4. Tally the Total Value of Benefits and Costs and take the decision

 

Exceptions / Limitations of Cost-Benefit Analysis

For projects which are very large and/or have a long-term time horizon, a cost-benefit analysis might not work as it is unable to consider financial concerns such as changing Cash Flows, Inflation and the present value of money.

 

Other capital budgeting analysis methods, including net present value (NPV) and IRR, could be mores suitable. Present Value models state that an amount of money or cash in the present day is worth more than receiving the amount in the future since today's money could be invested and earn income.

Cost-Benefit Analysis is commonly known as CBA. Alfred Marshall, British economist popularized CBA.

It is one of the Key Financial Measures and a Management tool to determine if approval should be given for the project go-ahead. Project CBA is a comparison to determine if a project will be (or was) worthwhile. The analysis is normally performed prior to implementation of project plans and is based on time-weighted estimates of costs and predicted value of benefits. The actual data is analyzed from an accounting perspective after the project is completed to quantify the financial impact of the project.

 

Sequence of performing Cost-Benefit analysis:

1.       Identify the project benefits

2.       Express the benefit in dollar amounts, timing and duration

3.       Identify the project cost factors including materials, labor and resources

4.       Estimate cost factors in terms of dollar amounts and expenditure period

5.       Calculate the net project gain (loss)

6.       Decide if the project should be implemented (prior to starting), or if the project was beneficial (after completion).

 

If the project is not beneficial using this analysis, but it is management’s desire to implement the project, what changes the benefits and costs are possible to improve the cost-benefit calculations. This is “Exception to CBA”.

Few examples of exception to CBA:

1.       Projects undertaken and investments to satisfy regulatory requirement.

2.       Risk Mitigation actions might not always yield +ve returns, but yet implemented

 

Some of the Key associated tools are-

Return on Assets (ROA)

           ROA= Net Income/ Total Assets

Where net income for a project is the expected earnings and total assets is the value of assets applied to the project.

Return on Investment (ROI)

             ROI- Net Income/ Investment

Where net income for a project is the expected earnings and investment is the value of the investment in the project

There are several methods used to evaluate project based on the $ or cash amounts and time periods. Three common methods are-

·       Net Present Value (NPV) Method

·       Internal Rate of Return (IRR) Method

·       Pay Back Period Method

 

Cost benefit analysis is basically benefits from any initiative ( Process improvement , Automation ,etc) subtracting the associated development & maintenance cost.

Example CBA = Total Benefits ( 1 Lakh) – development cost ( 20K) = 80K Actual benefit.

 

Cost benefit analysis in financial terms means revenue earned or cost saving as a results of the decision, initiative pursued on projects.  

Below are the some of the associated tools for estimation which will help in cost benefit analysis. 

• Benefit-cost ratio (BCR) :- It shows relationship between the relative costs and benefits of a proposed project
• Regression modelling :- It shows relationship with one dependent variable (X) with series of independent variables (Y)
• Expert Judgement :- Taking expert people judgement as they will have prior knowledge on similar kind of projects and they can suggest valuable insight based on their experience.
• Analogous Estimation :- Analogous estimation uses the technique of estimating project with prior similar project completed in the organization using  the parameters scope, budget, duration, size, weight and complexity.
• Parametric Estimation :- This technique uses the algorithm to calculate the cost of current project using historical data of other project variables.
• Bottom-Up Estimation :- Bottom up estimation technique starts collecting data from lower level and it rolled up to higher level.
• Three-Point Estimation :- In this technique various scenarios of risk is also considered i.e mostly to complete, optimistic ,pessimistic.
• Reserve Analysis :- In this technique some fund is allocated as contingency reserve to deal with uncertainty of the project.
• Cost of Quality:-  In this technique we do estimation of cost of both conformance and non-conformance expenses.
• Project Management Software :- Here we can use the tools such as software application, spreadsheet, simulation and statistical tool.
• Vendor Analysis :- Here we try to compare cost from various vendor to arrive at optimal cost.
• Group Decision Making Techniques :- Here we involved group of technical people who are going to execute the projects.

 Yes in some situation organization give an exception and still take up projects that do not have favourable cost benefit analysis.

Example :-

• Give go ahead to run addition employee benefit programs ,adding budget to run employee engagement activity, force leave programs to reduce stress in the system these will not give direct financial benefit but will have notional benefit like less attrition , employee satisfaction score increasing.
• Giving go ahead to run audit programs , people safety ,deploy addition security & firewall in system.

 

 

Cost-benefit analysis (CBA) is a simple tool used to compare the total investment on a programme/project with its benefits.  For any project/programme to be successful or even picked up for implementation requires budgetary support.  Not every project sees the light of the day and in large organization or team there are lot of identified projects to enable where the budgets will be spent for implementation.  This is critical to know what will be the overall spend on a project.  And it’s not just the cost which matters even though there is budget available, but we will not start project randomly.  Very important is to know what is the benefit from the project.  Benefit is not just hard dollar save or FTE in case of service industry but nontangible outcomes or improvement in a business metric which drives overall goal of the organization example CSAT improvement.

 

Every programme or project before implementation, the sponsor wants to see the ROI for which the Cost Benefit Analysis becomes very important to take the decision.  It is very important to note what all comes under Cost, Benefit and overall duration to calculate ROI.

 

Cost: Costs should include all the spends on the project.  Cost can be further divided under broad 2 heads:

·       Capital Expenditure

·      Operational Expenditure

 

Benefits are the outcomes from a project which are essential to pick it up for implementation.  Different types of benefits in a project:

·       Hard Cash Saving

·       Capacity Creation / Cost Avoidance

·       Stakeholder impact

·       Reduction of Risk Exposure

·       CSAT Improvement

 

 

Once all the cost and benefits are computed, they are compared, and this analysis is done to decide whether to proceed with project or reprioritize it.

If benefits outweigh the total cost. During this, it's important to consider the payback time, to ascertain how long will it take to reach the break-even point or what is the duration any solution will be deployed or contract period.

 

For simple examples, where the same benefits are received each period, you can calculate the payback period by dividing the projected total cost of the project by the projected total revenues:

Total cost / total benefit = length of time benefit will be yields.

Below if cost benefit analysis grid to prioritize the project.  Different projects are placed in 2*2 grid to be picked up for implementation based on ROI.

 

 

Example: Implementation of Automation Project for a service industry client

 

Cost:

 

Development effort (one time cost)	USD 45,000
IT Enablement Cost (one time cost)	INR 15,000
Recurring Annual  Infrastructure Cost License	INR   60,000
Total Cost (1st year)	INR 120,000

 

Benefit

 

FTE save per annum due to Automation                9 FTEs

Cost of 1 FTE                                                        USD 15,000

Total savings per annum                                   USD 1,35,000

 

In the given example, project will be break even in first year itself and advisable to go ahead with this project.

But while selecting a project benefit accumulation and recurring cost is equally important.  In many a cases benefits are carried forward to every year till the product/service is useful and in some cases it might be one time utility hence the cost benefit is to be seen for the shorter period only.

 

 

 

Irrespective of a negative Cost Benefit we still go ahead and do certain projects which are strategic in nature and may not have direct hard cash savings but can have soft benefits which might be critical for organisation to pursue for its strategy.

For example implementing a reconciliation platform like BlackLine it may not yield significant FTE benefit or hard dollar save as the work is getting done in excel also serves the purpose but the controllership it brings to the process brings confidence in a controller to go ahead with the project.  Even though CBA is negative but still the project will be prioritized for implementation due to non-tangible benefits it yields.

Cost-benefit analysis is the method used to measure the benefits of a decision minus the costs associated with taking that action or decision. In 1772, Benjamin Franklin wrote of its use. But the concept of CBA (Cost Benefit Analysis) dates to Jules Dupuit, a French engineer, who put forward the process in an article in 1848. This concept become quite popular in 1940-1950s in US and was vastly used in U.S. Flood Control Act to prove that benefits of flood-control projects largely exceed their costs. A Cost Benefit Analysis involves measurable financial values such as revenue earned or costs saved as a result of the decision to pursue a project. Also intangible benefits are considered into the cost benefit analysis like customer satisfaction, Employee Satisfaction etc.

In today’s competitive world, its very important to conduct the Cost Benefit Analysis and take the decisions as per that. It helps in identifying the projects which are generating the higher benefits (revenue / sales) than the cost incurred on them and will be beneficial for the company from the financial standpoint. Also sometime opportunity cost (Opportunity costs are alternative benefits that could have been realized when choosing another alternative over the selected one) is also included in this analysis.

 

How Cost Benefit Analysis is Conducted?

Step1 : List down the direct costs involved in the project like Raw Material, Labor, Manufacturing Expenses, Machinery Cost etc.

Step2 : List down the indirect costs like electricity, overhead costs from management, rent, utilities etc.

Step 3 : List down the intangible costs too like impact on customer satisfaction, employee satisfaction, or delivery timelines etc.

Step 4 : List down opportunity costs associated with decision as well like purchasing a new machine vs taking the same on rent.

Step 5 : List down the potential risks as well regulatory risks, competition, and environmental impacts etc. as well.

Step 6 : List down the benefits e.g. Revenue / Sales etc.

Step 7 : List down the intangible benefits as well like impact on customers, employees, or faster delivery etc.

Step 8 : List down the competitive advantage gained as result of this decision like Market Share.

Step 8 : Do the sensitivity Analysis and consider the risks and uncertainties in projections.

Step 9 : Take the decision

 

Example : Lets say Company ABC Plans to Start a New Production Plant with details as below. Lets see if they shall set up the new plant or not basis the cost and benefits listed below.

 

Costs and Benefits Involved :

Cost Heads	Cost Amount (INR)	Benefits Type	Benefits Amount (INR)
Land Cost	1000000	Revenue	4000000
Raw Materials	200000	Scrap	1000000
Machinery	1000000	Client Satisfaction	100000
Labour	1000000
Electricity, Water etc.	100000
Inventory	100000
Manufacturing Expenses	100000
Total Costs	3500000	Total Benefits	5100000

 

So If we see in example above, total costs are 3500000 INR and Total Benefits out of it are 5100000 INR and hence there are benefits of (5100000-3500000) = 1600000 INR and hence company can take the decision to setup the new plant.

 

Limitations of Cost Benefit Analysis :

i)  There are number of forecasts built into the process, and if any of the forecasts are inaccurate, the results may be called into question. E.g. Cost of Machines, Land, Expected Revenue etc.

ii)  Cost Benefit Analysis works well for short term to mid term projects with low to medium complexity but it fails for long term and complex kind of projects as there is always some elements of uncertainty in the long run e.g. costs may go up, interest rates may change and technology may become obsolete.

iii) Cost Benefit Analysis of concept does not take into account the NPV concept (Net Present Value) and IRR (It is the rate of return at which the net present value of a project becomes zero or rate at which your investment is expected to generate the money, higher the IRR, more attractive is the investment because of higher rate of return) of money while calculating the Benefits as Costs would be incurred in near future but the benefits will be realized in long run or say 2-3 down the line OR even if it is taken into account the assumptions may not be correct because of inflation, time value of money / interest rate fluctuations. One of the benefits of using net present value  (NPV) for deciding on a project is that it uses an alternative rate of return that could be earned if the project had never been done. That return is discounted from the results. Or we can say, a project needs to earn at least more than the rate of return that could be earned elsewhere or the discount rate. So to avoid the same NPV shall be taken into consideration :

NPV = F / [ (1 + r)^n ] where, PV is Present Value, F is Future payment (Cash Flow), r = Internal Rate of Return and n = the number of periods in the future is based on future cash flows.

iv) There is always subjectivity involved in Quantifying the Intangible costs and benefits and may not be totally true and accurate.

v) Sometime Cost Benefit analysis done is taken forward as the budget of the project and which may not be actually true and hence the stakeholders are pressed hard to meet these numbers like cost / sales etc.

vi) Wherever the assumptions / forecasts are involved, person doing the analysis has the tendency to assign more weights or values to factors / elements which he wants to go with basis his instincts and hence it may cause bias in the results.

vii) The supposed clarity in determining and listing costs and benefits can prove harmful as the actual outcome is dependent on several variables that you can only know with time.

 

Can organizations take decisions in favor of unfavorable Cost Benefit Analysis ?

 

Yes, organizations sometimes may take decisions in favor of the projects where Cost Benefit Analysis is not in favor of them. Some Examples are as listed below :

1. Corporates are going for its own vaccination drives for the safety and health of its employees. If we see here there are lot of costs involved in setting up the system, softwares, vaccination, facilities etc. with no direct immediate benefits for the company but companies do so for the benefits and wellness of their employees.

2. An organization taking a project to plant 10000 trees to make the environment better.  If we see here there are no direct benefits to company but they do so for their responsibility towards society or nature.

3. An Organization taking a project to install the safety devices  / equipment. If we see here, there will be cost involved to company but still they do so for the safety of their staff.

4. Twitter to appoint additional staff in India to comply with the Government Regulations - Though this may not be required or beneficial from company standpoint but they have to do so (Cost) to adhere to government rules and regulations. 

5. Organisation providing free transport, food, gifts etc. to employees to their employees to increase their employee satisfaction though these results in cost to the company.

Edited June 11, 20214 yr by RahulGarg
Additional points added.

Cost Benefit Analysis is one of the Key actions performed by the Project team/Finance team before moving ahead in any Project decision. This analysis helps Business to decide whether the decision they are going to take will benefit them or not. 

 

For doing the Cost Benefit analysis various sub elements of Cost and benefits will be considered and

likewise from Return point of view.  

 

Cost Examples:

·       Direct Cost

·       Indirect Cost

·       Intangible cost

·       Opportunity cost

·       Cost of Potential Risks

 

Benefit Examples:

·       Direct Benefits

·       Indirect benefits

·       Notional benefits etc.

 

There are 4 steps process in Cost Benefit Analysis:

·       Identify the Cost and Benefit Associated with the Project

·       Assign monitory value to the cost

·       Assign monitory value to the benefit

·       Finally compare the value of the Cost with the value of the Benefits. If the Value of the Benefit is more than value of the Cost, then Project can be taken up.

 

Key Financial measures of Cost Benefit Analysis, Few examples:

 

·       ROI: Return on Investment:  

This Financial measure compare the Cost (Investment) with the Benefit (Profit) and arrive the impact in a Percentage.

Example: if cost incurred is $10K and if the benefit generated is 15K then ROI 150%, in this case it is wise to go ahead with Investment decision.

 

·       NPV – Net Present Value

NPV is the difference between the Present value of the Cash Outflow with that of the Present value of the future Cash inflows over a period. NPV focus on Time value of the Money. For example. An investor would like to receive $100 today rather than receiving the receiving $105 after 6 months. CBA helps to calculate the Present Investment and Future Revenue and the difference is highly significant then we can go ahead with Project decision.

 

Exceptions if the Cost Benefit Analysis outcome is Negative:

 

Yes, there may be instances where Business may need to go ahead with a Project even though there is no Profit or not much return on Investment. Few examples could be Projects related to enhancing the Customer satisfaction, Employee satisfaction, gaining more Market Share or in case of Regulatory compliance. Some of these projects may see a negative CBA in short term however indirectly it is building the Reputation and Brand for the Company.

Cost Benefit Analysis is a powerful financial management and decision making tool. It provides a systematic approach to measure the benefits of a decision or taking action minus the costs associated with taking that action. 

 

Applications of Cost Benefit Analysis :

1. It involves measurable financial metrics like revenue earned, costs saved etc. as a result of the decision to pursue a project.  
2. This monetary evaluation method helps to identify effective and favorable options and  helps to take informed decisions.
3. This technique also values intangible aspects in benefits and costs or effects from a decision such as employee satisfaction and customer experience.
4. The results of the analysis are often expressed as a payback period which means that this is the time it takes for benefits to repay costs. Mostly, people who use it look for payback in less than a specific period for example three years.
5. This technique can be used in a wide variety of situations like hiring decisions, evaluating a new project or initiative, or ascertaining the feasibility of a capital purchase.

Tools or methods used in Cost Benefit Analysis :

When carrying out the analysis, there are two main methods to arrive at the overall results. These are

1. Net Present Value Model (NPV) : The NPV of a project refers to the delta between the present value of the benefits and the present value of its costs. If we observe NPV > 0, then it follows that the project has economic justification to proceed ahead. 
2.  Benefit Cost Ratio: Benefit-Cost provides value by calculating the ratio of the total of the present value of the benefits associated with a project against the total of the present value of the costs related with a project. Higher the value above 1, higher are the benefits associated with the alternative considered. When using the Benefit-Cost Ratio, the analyst has to select the project with the greatest Benefit-Cost Ratio.
3. Other tools & methods that can be used are regression modeling, valuation and forecasting techniques.

There is a possibility to increase the reliability of the assumptions in a cost-benefit analysis by incorporating a sensitivity analysis and adding the discount rate.

 

Let us take an example of the cost-benefit analysis suggesting a comparison between the two choices:

Illustration 1 -

Dynamic Graphic Works has been operating for just over a year, and sales are exceeding targets. Presently, 2 designers are working full time, and the owner is evaluating increasing capacity to meet demand. This would involve leasing more space along with hiring two additional new designers. The owner decides to complete a Cost-Benefit Analysis to explore the choices.

 

Key Considerations :

1. Presently, the owner of the company has more work than he can cope with, and he is outsourcing to other design firms at a cost of $50/hour. The company outsources 100 hours of work on an average basis each month.
2. He anticipates that revenue will grow by 50% with increased capacity.
3. Per person production will grow by 10% with more working space.
4. The analysis horizon is one year: that is, he expects benefits to accrue within the year.

 

Cost :

 

Benefits :

 

Lets calculate the payback time as given below:

$139,750 / $305,500 = 0.46 of a year, or approx. 5.5 months

 

Undoubtedly, the estimates of the benefit are subjective and there is a degree of uncertainty involved with the expected revenue increase. Regardless of this, the owner of Custom Graphic Works decides to go ahead with the expansion and hiring, given the extent to which the benefits outweigh the costs within the first year.

A cost-benefit analysis is an approach that businesses use to analyze which decisions to consider and which one to let go of.
The cost-benefit analyst subtracts the total costs associated with taking that action from the potential rewards expected from a situation or action. 

 

The main key pointers are:
•    A cost-benefit analysis is the method used to measure the benefits of a decision.
•    A cost-benefit analysis has measurable financial metrics such as revenue earned or costs saved base on the result of the decision to pursue a project.
•    A cost-benefit analysis also includes intangible benefits such as employee morale and customer satisfaction.

 

The methods involved in cost-benefit analysis (CBA) is:
•    Benefit-cost ratio (BCR)
•    Regression modeling
•    Forecasting techniques

 

Benefit-cost ratio (BCR):
•    A benefit-cost ratio (BCR) is used in a cost-benefit analysis that summarizes the overall relationship between the costs and benefits of an upcoming project.
•    BCR can be expressed in financial terms or qualitative terms. 
•    The project is expected to deliver a positive net present value to an organization and its investors if a project has a BCR greater than 1.0.

Regression modeling:
•    Regression is a statistical method that is used in finance that attempts to determine the strength and character of the relationship between one dependent variable (denoted by Y) and a series of other variables (particularly known as independent variables).
•    Regression helps financial managers and investors to value assets and understand the direct relationships between variables, such as asset prices and the stocks dealing in those commodities.

 

Forecasting techniques:
•    Forecasting is a method that uses historical data as inputs to make informed estimates that are predictive in estimating the direction of future trends.
•    Businesses make forecasting to determine how to allocate the budgets or plan for anticipated expenses in the future. 
•    This is typically based on the demand for the goods and services offered which can be termed as Demand & supply.
 

Cost Benefit Analysis:

 

Cost Benefit Analysis also known as (CBA) is the technique used to measure the benefits of the given project and associated cost involved for the project to complete

 

It is good to measure and articulate these benefits and costs in financial metrics (Example: Revenue Earned & Cost saved due the project implementation)

 

Cost Benefit Analysis as a Tool and some standard approach:

 

1.       List down all the cost associated with the project and estimated benefits, think of a situation where in you have to pull in budget for unexpected costs and plan accordingly

 

2.       Cost can be anything; human efforts, technology & physical resources. For example: Imagine a situation where you planned for some new technology implementation and there is a change management process for the team which will have direct impact on their productivity. Try to gauge how much it is impacting and translate it to cost. So in simple terms assign a monetary value to the costs involved

 

3.       Benefits are sometimes difficult to predict. Since not all benefits are translated into numbers. We have something called soft savings which is also very important to measure

 

4.       Finally compare cost and benefits. Use this phase of the CBA to determine if the benefits are positive or negative

 

Organization sometimes initiate the projects which are not favorable when compared to Cost and Benefit analysis. However will have to move the project since it may be an ask from key stakeholders

 

Example: Dashboard which is simple and was automated in Excel, Ask to enhance the same dashboard with some BI tool for colorful graphs which might not add value to the business.

Cost Benefit Analysis is a decision making tool . It has some very basic calculations on expenditure and benefits and a ratio is arrived at to infer if a project is good to do or not . Its also a risk assessment tool . Both costs and benefits are measure in monetary terms and not by any other metric

We can also extend the scope of analysis by calculating NPV and adjust the future cash flows and costs to present day  . After that we can do a sensitivity analysis and evaluate the results and give our inference as positive or negative

Some times opportunity cost is also linked while arriving at CBA results which is an interesting aspect

 

In many models, a cost-benefit analysis will also factor THE OPPORTUNITY COST  into the decision-making process. Opportunity costs are alternative benefits that could have been realized when choosing one alternative over another. In other words, the opportunity cost is the forgone or missed opportunity as a result of a choice or decision. Factoring in opportunity costs allows project managers to weigh the benefits from alternative courses of action and not merely the current path or choice being considered in the cost-benefit analysis.

By considering all options and the potential missed opportunities, the cost-benefit analysis is more thorough and allows for better decision-making.

What is cost benefit analysis? Any company when it is trying to get into an investment mode for any project/implementing any solution.. it always does feasibility study of whether the project or solution, post investment will be able to get better ROI (Return on Investment). If the ROI is positive and well within the expectations of the stakeholders, company goes ahead with the project. if the ROI is negative then the company drops the project.

 

Costs that are taken into account are: Direct + Indirect Costs, Opportunity costs, Risk related costs and Intangible costs (impact that may happen on internal stakeholders)

 

Benefits that a company might gain are: Increase in market share, intangible benefits, increased revenue and reduced costs

 

Some of the financial terms used in cost benefit analysis are: 1. Return on Investment, 2. Opportunity Costs, 3. Net Present Value, 4. Cost Benefit Ratio, 5. Internal Rate of Return (IRR), 6. Discounted Cash Flow, Payback Period, 7. Sensitivity Analysis

 

Examples of companies still going into cost benefit analysis which has a negative ROI are:

1. Initiative which is going to benefit or improve employee moral or satisfaction

2. Initiative which is going to help us improve our inherent quality and therefore better client satisfactions

3. Initiative which is going to help in CSR activities

4. Initiative which is going to kill the competition

1. Organizations usually take up projects or implement solutions that have a favorable cost-benefit analysis. Explain cost-benefit analysis in financial terms and its associated tools.

 

Cost-benefit analysis is a versatile methodology very often used by businesses, projects, and public policy decisions to estimate cost and benefits, thus arrive at the most cost-effective alternative available. Organizations have to make informed decisions on their investment, and how they plan to spend their working capital. As such, the cost-benefit analysis uses a data-driven approach to narrow down the decision-making process and focus on areas where there are clear outcomes.

 

The most common capital budgeting frameworks use a) Payback period, b) NPV (Net present value) c) IRR (internal rate of return)

 

Payback Period – Looks for the duration required to break even the original investments, i .e. will the project be able to pay for itself and in what time period. For e.g. a project is estimated to have an outlay of ~ $2mn, and expected to return $50,000 annually. The payback period for the project will be estimated at 4yrs to recover the initial outlay. The payback period is a good enabler when the cash flow forecasts from the project are available and no additional discounting is required. Discounting can be applied to PB methods to further improve the calculation and factor in the time value of money. Another limitation of the payback period has is that it ignores the windfall if at all the project generates after the PB and which may have significance in the decision-making process.

 

Internal rate of return (IRR) – IRR applies a discount rate which makes the net present value of the project zero. In other terms, the initial cash investment of the project will be equal to the future cash flow of that investment (cost incurred = Present value of future cash flow, thus NPV = 0) The IRR is usually compared with the organization's cost of capital, and if the IRR >= cost of capital, it is assumed to be a good investment to make. To further assess the cost of capital, WACC (weighted average cost of capital) is widely used. WACC assumes the cost of various capital sources for the organization, i.e. equity, debt, bonds etc. The key advantage of IRR as a decision-making tool, is that it provides a benchmark figure on which the project can be assessed and this based on the company’s capital structure, i.e. c cost of capital. 

 

Net Present Value - NPV is widely used and is one of the most accurate valuation approaches in capital budgeting. NPV discounts the net cash flow (after-tax cash flows), and compares it with WACC and thus allows the organization to make an informed decision if the project is profitable or not. NPV also helps to make a comparison of various projects and allows assessing if project A is profitable than project B and by how much. A positive or negative NPV is assessed by discounting the future cash flows at a certain discount rate, and a positive NPV indicates the project will be profitable. The discount rates are usually considered as WACC in most cases and

 

2. Are there any situations where organizations give an exception and still take up projects that do not have favorable cost-benefit analysis? Provide examples.

 

There are multiple scenarios where the negative CBA projects are picked up. The challenge here is often not that the value of the investment is negative NPV/IRR, but that of the difficulty in quantifying the benefits. Keeping aside the decision-making process flaws, a negative CBA project may be undertaken in scenarios like

a) To comply with regulatory requirement

b) Undertaking the project, though with a negative CBA, but is of strategic importance

c) Undertaking the project with negative CBA, due to product innovation, however, PBB is not near term

 

For example, assume that an organization is planning to organize leadership training for its management staff and it requires a significant upfront cost. All the cost-benefit analyses return a negative result, due to the ambiguity in projecting positive cash flows from the investment made. However, the organization continues to go ahead with this, considering the opportunity cost of not training its employee for leadership roles and hiring externally for senior management roles. This disturbs the organization's culture, additionally, significant time is lost for the external hire to make sense of the business and operate the model of the organization. Assuming the larger opportunity cost of not having the leadership course, the organization believes it to be wise to invest in the training

A Cost Benefit Analysis (CBA) is an approach to estimate strength & weakness of alternatives which are used to determine options that provide the best approach to achieve benefits. This approach is commonly used in commercial transactions, business & policy decisions and project investments. This analysis includes the expected balance of benefits & costs considering any alternatives or proceeding with status quo.

Although implementing a cost benefit analysis is an informed estimate of the best suited alternative, a perfect appraisal of all present and future costs and benefits is difficult.

 

The CBA begins with compiling a comprehensive list of all associated costs & benefits related to the project or decision.

The various costs involved are:

• Direct costs (like inventory, raw material, manufacturing/ development costs)
• Indirect costs (like rent, electricity, management overheads)
• Opportunity costs (like alternative investments, buying a ready software or building/ developing new one)
• Potential risks (like regulatory risks, environmental factors etc)

 The benefits of CBA include:

• Increase in Sales & revenue with a new product or an increased production
• Intangible benefits such as Customer satisfaction, improvement in employee productivity, faster delivery etc.
• Increased market share or edge with competitors

The Analyst should consider all the monetary costs for cost benefit list ensuring not to underestimate or overestimate the benefits. The result of comparison between aggregate cost & benefits should be taken to determine the rational decisions of going ahead with a project or not. The business can review the project and see if any adjustments by increasing benefits or decrease in costs are required to make the project viable. 

 

Are there any situations where organizations give an exception and still take up projects that do not have favorable cost benefit analysis? Provide examples.

 

Yes, there can be projects where the Cost Benefit Analysis may not be considered due to criticality to business & the ones where benefits are beyond cost factors only.

For example - projects that involve less capital expenditures and are short term developments, need less time to complete, the CBA may not be sufficient to make a well informed decisions.

Even in cases for long term horizon, a cost benefit analysis could fail on account of important financial concerns like inflation, interest rates, varying cash flows or current currency value.

 

Cost benefit analysis is the process used to measure the benefits of a decision.

It involves measurable financial metrics like the result of your decision in project yield revenue or cost save.  CBA is a tool to determine which potential decision makes the most financial sense for the business. Based on the CBA tool business can decide whether to pursue a project.

 

Financial benefit-cost analysis includes the below 8 steps.

1.      Determine the annual revenue of the project

2.      Find the Project cost

3.      Calculate the project net benefits

4.      Determine the discount rate

5.      Find the average incremental cost

6.      Find the financial net present value

7.      Find the financial internal rate of return

8.      Analysis of Risk and sensitivity

 

Other cost also you need to account for

Indirect Cost – fixed cost

Intangible cost – any cost difficult to measure

Opportunity cost – lost benefit or opportunities

There are some tools like BCR Benefit Cost ratio may also computed to summarize the overall relationship between relative cost and proposed project benefit.  We have /regression modelling, Valuation and forecasting techniques are some of the tools used for Cost Benefit analysis.

 

There are some exception when the organization still taking projects even that do not have favorable cost benefit. The environmental projects, Customer satisfaction projects which Organization wants to pursue even that do not have favorable cost benefit but it maintains the company’s reputation and customer satisfaction.

 

There are two winners for today - Dhirendra Singh and Rahul Garg. Dhirendra's answer lists down multiple tools to do CBA while Rahul's answer also highlights some of its limitations.

Must read answers for the examples - Ajit Pathania and Archana Handa.