Operations Research

COST-BENEFIT ANALYSIS

Desmond Ighravwe (PhD)

Table of Contents
1. Introduction
• Background
• Pros and Cons
• Purposes of Cost-benefit Analysis

2 Fundamentals of Cost-Benefit Analysis

• Types of Costs
• Types of Benefits
• Cost benefit analysis steps

3 Cost-Benefit Analysis Formula

• Net Present Value
• Benefit-Cost Ratio

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1. INTRODUCTION

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 Background
Cost-benefit analysis (CBA) is a technique used to compare the total costs of a
programme/project with its benefits, using a common metric (most commonly monetary
units).

As a technique, it is used most often at the start of a programme or project when

different options or courses of action are being appraised and compared, as an option
for choosing the best approach.

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 Background

• The cost-benefit analyst sums the potential rewards expected from a situation or action and then

subtracts the total costs associated with taking that action.

• The cost-benefit analysis compares the costs and benefits of a project and then makes a decision on

whether or not to proceed with the project.

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 Pros & Cons
PROS CONS

Requires data-driven analysis Difficult to predict all variables

Makes decisions simpler Incorrect data can skew results

Useful starting point in determining a project’s Better suited to short- and mid-length projects
feasibility

Considers the time value of money Removes the human element

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Purposes of Cost-benefit Analysis

• To determine if the project business case is feasible by figuring out if its benefits

outweigh costs.

• To offer a baseline for comparing projects by determining which project’s benefits are

greater than its costs.

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Examples of when to use a cost-benefit analysis
• Developing a new business strategy

• Making resource allocation or purchase decisions

• Deciding whether to pursue a new project

• Comparing investment opportunities

• Measuring the potential impact or desirability of new company policies

• Assessing proposed changes to your company structure or processes

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2. FUNDAMENTALS OF COST BENEFITS

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 Types of Costs
• Direct costs: Are purchases that a business makes that directly relate to the creation of its goods and
services. These costs can include material purchases, employee salaries and equipment or tool
rentals.

• Indirect costs: Are other expenses that help keep the business or company operating, including
insurance, facility rentals and utility costs.

• Intangible costs: Are costs that companies can't easily quantify. These costs can include customer
satisfaction, employee morale or overall productivity.

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• Potential risks: Are any challenges or issues that a company might face during a project or after

the project's completion. These can include other direct or indirect costs, such as spending

more than the company expected, and intangible costs, such as loss of business or profit.

• Opportunity costs: Are the loss of potential benefits or profit from making one decision over

another. For example, if a company decides to sell some property, they might be missing out on

potential profit from renting the property on a monthly basis.

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 Types of Benefits

• Direct: Increased revenue and sales generated from a new product

• Indirect: Increased customer interest in your business or brand

• Intangible: Improved employee morale

• Competitive: Being a first-mover within an industry.

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 Cost-benefit analysis steps
• Identify Project Scope: Understand the situation, determine goals, and build a framework for
scope.
• List All of the Direct and Indirect Costs and Benefits Associated With the Project: A complete
list of costs should include short and long-term costs of labor, inventory, materials, supplies,
overhead, services, training, and fees.
• Sum It Up: Add up all of the figures using accurate estimates and historical data to support a
best guess at numbers if they are not obvious.
• Evaluate the CBA: Review the outcomes as a group and consider how the project will affect
users and the company.
• Make a Recommendation and Implement: Summarize findings and present the details to
management for their review, approval, and a final decision to move forward.

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3. COST-BENEFIT ANALYSIS FORMULA

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 Net present value (NPV)

• The difference between the present value of cash inflows and the present value of

cash outflows over a period of time.

• In simpler terms, net present value is a more dynamic way to measure net cost-

benefit, because it includes how your net cost-benefit will change over a period of

time.

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 Net Present Value
Step 1: Find out the future benefits.
Step 2: Find out the present and future costs.
Step 3: Calculate the present value of future costs and benefits. . The present value factor is 1/(1+r)^n.
Here r is the rate of discounting, and n is the number of years.
The formula for calculating present value is:
Present Value of Future Benefits = Future Benefits * Present Value Factor
Present Value of Future Costs = Future Costs * Present Value Factor
Step 4: Calculate the Net Present Value using the formula:
NPV = ∑ Present Value of Future Benefits – ∑ Present Value of Future Costs
• Step 5: If the Net Present Value (NPV) is positive, the project should be undertaken
If the NPV is negative, the project should not be undertaken

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Example 1
The present value of the future benefits of a project is N6,00,000. The present value of the
costs is N4,00,000. Calculate the Net Present Value (NPV) of the project and determine
whether the project should be executed.

Particulars Amounts(N)

Present value of future benefits 600,000

Present value of future costs 400,000

Net present value (NPV) 200,000

Since the NPV is positive, the project should be executed.

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Example 2

Mr. James is considering a project. He wants to determine whether the project should be

executed. He decides that he would use the NPV model to determine whether the

company should be executing the project. The upfront cost of N1,00,000 would be

incurred. It is the given information relating to the benefits.

i. Use the discounting rate of 6% to calculate the NPV of the project.

ii. Determine whether the project is viable.

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Year Benefits (N)

1 50,000

2 30,000

3 60,000

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 Year Cash 𝟏 Amounts (N)
PV factor
𝟏+𝒊 𝒕
inflows/Outflows
0 -100,000 1 -100,000
1 50,000 0.9434 47,168.81
2 30,000 0.8900 26,699.89
3 60,000 0.8396 50,377.16

Where:

i = Discount rate
n = Number of periods
t = Period that the cash flow occurs

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 Present value of future benefits 124,246.86

Present value of future costs -100,000

Net present value 24,246.86

• Since the Net Present Value (NPV) is positive, the project should be executed.

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 Benefit-cost Ratio
Benefit-cost ratio (BCR) is a profitability indicator used in cost-benefit analysis to

determine the viability of cash flows generated from an asset or project.

BCR compares the present value of all benefits generated from a project/asset to the

present value of all costs.

• A BCR exceeding one indicates that the asset/project is expected to generate

incremental value.

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 Formula for the Benefit-Cost Ratio

𝑛 𝐶𝐹𝑡 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝑡=0 1+𝑖 𝑡
𝐵𝐶𝑅 = 𝑛 𝐶𝐹𝑡 𝐶𝑜𝑠𝑡𝑠
𝑡=0 1+𝑖 𝑡

Where:

CF = Cash flow
i = Discount rate
n = Number of periods
t = Period that the cash flow occurs

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BCR general interpretation

Case 1: BCR < 1

Case 2: BCR = 1

Case 3: BCR > 1

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Case 1: BCR < 1
The project is destroying value and should not be undertaken

 The net present value of the project is negative

 The internal rate of return (IRR) of the project is below the discount rate

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Case 2: BCR = 1

The project will neither create nor destroy value

 The net present value of the project is zero

 The internal rate of return (IRR) of the project is the same as the discount rate

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Case 3: BCR > 1

The project will generate incremental value

 The net present value of the project exceeds zero

 The internal rate of return (IRR) of the project is greater than the discount rate

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Example 3

Mr. James is in a dilemma. He has to decide whether to go for Project A or Project B. He

decides to choose the project based on the benefit-cost ratio model. The data for both

the projects is as under. Choose the project based on the benefit-cost ratio.

Particulars Project A Project B

Present value of Benefits 78,000 56,000

Present value of future 60,000 28,000

costs

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Particulars Project A

Present values of benefits 78,000

Present values of future cost 60,000

Benefit cost ratio 1.3

Particulars Project B
Present values of benefits 56,000
Present values of future cost 28,000
Benefit cost ratio 2

Since the benefit-cost ratio for Project B is higher, Project B should be chosen

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 Example 4
The cash flow projections for a project are provided below. The relevant discount rate is
10%. What is the benefit-cost ratio of the project?

Time t=0 t=1 t=2 t=3

Costs -N5,000 -N10,000 -N10,000 -N15,00

Benefits - - N50,000 N75,000

Net cash flow -N5,000 -N10,000 N40,000 N60,000

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 Time Discounted Costs Discounted Benefits
t=0 N5,000.00 0
t=1 −𝑁10,000 0
= 𝑁9,090.91
1 + 10% 1
t=2 −𝑁10,000 −𝑁50,000
2
= 𝑁8265.46
1 + 10% 1 + 10% 2
= 𝑁41,322.31
t=3 −𝑁15,000 −𝑁75,000
= 𝑁11,269.72
1 + 10% 3 1 + 10% 3
= 𝑁56,348.61
Total -N33,625.09 N97,670.92

The benefit-cost ratio would be calculated as N97,670.72 / N33,625.09 = 2.90

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The BCR of 2.90 in the preceding example can be interpreted as “For each N1 of cost in

the project, the expected naira benefits generated is N2.90.

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 THANK YOU

FOR LISTENING

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