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). Cost benefit analysis is a decision-making tool widely used in economics. It is applicable to many industries such as IT, software development, construction, education, healthcare, and information technology. The main purpose of tracking the Cost Benefit analysis steps is to calculate the ratio of benefits over costs. It is a simple technique that can be used for financial decisions. Simply put a Cost Benefit Analysis is conducted 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 discuss how net present value is related to cost benefit analysis.
What is CBA?
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 is a decision-making tool in economics that takes into consideration the net present value of costs and benefits. But as discussed above, it is applicable to many industries and cases. For example, you can use it while deciding to purchase a real estate property or undertake a new project. But, what is the purpose of making a CBA for an investment?
Basically, Cost Benefit Analysis serves two purposes ;
- To verify that an investment’s (or a project’s) benefits are more than its costs.
- To select an investment (or a project) by comparing their benefits over cost 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. Note that CBA is used for both long term and short term decisions.
Cost Benefit Analysis and Net Present Value
Before to analyze a cost benefit analysis example, let’s discuss how net present value is related to cost benefit analysis. Whether you are planning to undertake a large project or buying a desktop computer for office works, you need to weigh the expected costs against benefits to take the right decision. Therefore, you must compare both costs and benefits on equal terms. That’s why you need the net present value calculations.
In finance, the time value of money concept holds that 1 USD today has greater value than 1 USD in the future. Therefore, while making a CBA, you need to bear in mind the time value of money. Using a discount rate adjusts the future cash flows to the present day. However, to provide simplicity, we will use the discount rate as “1” in our example.
A Simple Cost Benefit Analysis Example and Calculation Steps
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
In this cost benefit analysis example, 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 simple 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 tool in economics that is used 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 with 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 and discussed calculation steps. We hope that it is useful to understand and use the CBA for future decisions.
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