Cost Benefit Analysis Example (CBA Example)
Cost Benefit Analysis (also known as Benefit Cost Analysis) is a mathematical approach to compare the costs and expected benefits of two or more projects (or options). These projects may be IT, software development, construction, education, healthcare, and information technology. The purpose of applying Cost Benefit analysis is to calculate the ratio of benefit over costs. It is a simple technique that can be used for financial decisions. Simply put a Cost Benefit Analysis is made to identify how well, or how poorly, a project will be concluded.
In this article, we will analyze a simple Cost Benefit Analysis Example and review the options.
Cost Benefit Analysis
A French economist and engineer Jules Dupit introduced the concept of CBA in his article in 1848. After this date, a famous economist Alfred Marshall formalized this approach. The U.S. Army Corps of Engineers used Cost Benefit Analysis for federal waterway infrastructure.
Cost Benefit Analysis takes into consideration the net present value of costs and benefits.
Basically, Cost Benefit Analysis serves two purposes ;
- To verify that an investment’s (or a project’s) benefits are more than it’s costs.
- To select an investment (or a project) by comparing their benefits over costs ratios.
In order to make a comparison between the positive and negative aspects of the alternatives, a common unit is required. Money is the common unit used for comparison of alternatives. In a CBA calculation, costs and benefits are represented as monetary values. Time value of money is an important concept in CBA. While performing a CBA calculation future costs and benefits are converted into present value by using a discount rate.
A Simple Cost Benefit Analysis Example
Let’s assume that a board chairman of a construction company claims his team to make a comparison between two potential real estate development projects to be constructed. He also reminds them that the company’s financial health is getting poor so he has to select one of them.
The team works and lists below the potential incomes and costs of each project.
Note: In order to simplify the cost benefit analysis example, we will not make a net present value calculation for each cost and income.
– 500 housing units will be constructed.
– 400 of them will be sold and 100 of them will be rented for 20 years.
– Rental Price of each unit is 4,000 USD per year
– Rented 100 units will be sold 70,000 USD after 20 years.
– Construction Cost of each unit is 100,000 USD.
– The sale price of each unit is 120,000 USD.
– The project needs a luxury sales office with a price of 2,000,000 USD.
– The sales personnel cost is 300,000 USD per year.
– The project duration is 3 years.
– Project financing cost is 3,000,000 USD per year
– 400 housing units will be constructed.
– 350 of them will be sold and 50 of them will be rented for 15 years.
– Rented 50 units will be sold 80,000 USD after 15 years.
– Rental Price of each unit is 4,500 USD per year
– Construction Cost of each unit is 90,000 USD.
– The sale price of each unit is 135,000 USD.
– The project needs a luxury sales office with a price of 3,000,000 USD.
– The sales personnel cost is 250,000 USD per year.
– The project duration is 2 years.
– Project financing cost is 2,500,000 USD per year
Comparing the Project Parameters
Now we will calculate the amount of money to be spent and the amount of money to be earned from each project.
All the project parameters are summarized in the table below :
Project cost calculations are summarized in the table below :
Project benefit calculations are summarized in the table below :
Costs and Benefits Comparison
In this cost benefit analysis example, there are too many parameters affecting the board’s decision. Financing costs per year, units for sale, units for rent, total units to be constructed are some of them that make decision making difficult.
The above table summarizes the benefits, costs, and profits of each project. Although the incomes of Project 1 is more than Project 2, the costs of Project 2 is less than the costs of Project 1.
It is obvious that Project 2 is more profitable than Project 1. If the board chairman selects Project 2, the company will earn more profit by spending less money.
This simple example shows that Cost Benefit Analysis is a useful calculation while comparing multiple projects.
This simple example shows how to make a cost benefit analysis for two projects. It is important to bear in mind the intangible benefits such as customer satisfaction, environment, employee satisfaction, or health and safety, historical importance while making cost benefit or benefit cost analysis.
Because benefits do not only consist of revenues obtained from business actions but also consist of intangible factors. In order to make a correct cost benefit analysis, the current worth of future earnings must be calculated by the help of financial techniques such as net present value.
Sometimes it may be difficult to compare the options that have very close values. At this stage, intangible factors affect the final decision.
Generally, these kinds of analyses are done by high-level stakeholders, top management, and board members. After the selection of the project, they start the process of developing the project charter.
In this article, we review a simple cost benefit analysis example. We hope that it is useful to understand and use the Cost Benefit Analysis for future decisions.