Cost Benefit Analysis

Cost-benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic approach to estimating the strengths and weaknesses of alternatives that satisfy transactions, activities or functional requirements for a business. 

From the perspective of an economist, it takes both a long-term and a wide view. It is long-term in the sense of examining the effects, implications and repercussions both in the short and long-term. It takes a wide view in the sense of examining the effects of the project on different peoples, industries and regions. It is a broad treatment, and has more in common with economics than with business and commerce. It draws on a range of sub disciplines within economics, such as resource economics and public finance, to create a coherent view of the project.

Cost-benefit analysis has a long history, particularly in France, where the engineer Dupuit published a paper in 1844 on the utility of public works, a groundbreaking contribution to the field of economics.

It provides the best approach for the adoption and practice in terms of benefits in labour, time and cost savings etc. (David, Ngulube and Dube, 2013).

Cost-benefit analysis is primarily an economic analysis. Although market prices are a starting point for the determination of the benefits and the costs, they imperfectly represent the interests of various parties and stakeholders in the project. Market prices may be distorted by political intervention, taxes, subsidies, incentives, lack of competition, price control and other factors. In an economic cost-benefit

analysis, prices are adjusted towards their efficiency prices, those that would be achieved in a perfect market as a result of the best allocation of resources due to supply and demand. This is in contrast with financial or commercial analysis, which considers the flow of cash at market price.

Costs

Category	Details	Cost in First Year
Lease	750 square feet available next door at $18 per square foot	$13,500
Leasehold improvements	Knock out walls and reconfigure office space	$15,000
Hire two more designers	Salary, including benefits Recruitment costs Orientation and training	$75,000 $11,250 $3,000
Two additional workstations	Furniture and hardware Software licenses	$6,000 $1,000
Construction downtime	Two weeks at approximately $7,500 revenue per week	$15,000
Total		$139,750

Benefits

Benefit	Benefit Within 12 Months
50 percent revenue increase	$195,000
Paying in-house designers $15 an hour, versus $50 an hour outsourcing (100 hours per month, on average: savings equals $3,500 a month)	$42,000
10 percent improved productivity per designer ($7,500 + $3,750 = $11,250 revenue per week with a 10 percent increase = $1,125/week)	$58,500
Improved customer service and retention as a result of 100 percent in-house design	$10,000
Total	$305,500

He calculates the payback time as shown below:

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

Inevitably, the estimates of the benefit are subjective, and there is a degree of uncertainty associated with the anticipated revenue increase. Despite 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.

Flaws of Cost-Benefit Analysis

Cost-Benefit Analysis struggles as an approach where a project has cash flows that come in over a number of periods of time, particularly where returns vary from period to period. In these cases, use Net Present Value (NPV) and Internal Rate of Return (IRR) calculations together to evaluate the project, rather than using Cost-Benefit Analysis. (These also have the advantage of bringing "time value of money" into the calculation.)

Also, the revenue that will be generated by a project can be very hard to predict, and the value that people place on intangible benefits can be very subjective. This can often make the assessment of possible revenues unreliable (this is a flaw in many approaches to financial evaluation). So, how realistic and objective are the benefit values used?

Useful link: 

Hanbook of CBA 2006

Evaluating a project based on free cash flow

The evaluation of a project is concerned with determining the merits of the project. This evaluation is an assessment of the soundness of the business, of whether the project is economically favourable. Some of the factors that are important to assess are the following: that there is a strategic fit of the project within the company’s current business; that there are opportunities for the products of the project in the

market; that the project is economically viable; and that the project is technically feasible. 

The outcome of the evaluation should be an assessment not only of the intrinsic value of the project proposal but also the suitability of the project within the context of the company. The economic viability of the project is assessed on its free cash flows. The free cash flow is the amount of money that the business generates or consumes. If it generates money, it has a positive free cash flow. Money generated by the business is available to the owners of the business. It can be distributed to the owners as dividends or it can be re-invested in the business. If the business consumes money, the free cash flow is negative. This represents a shortfall in cash, and the managers need to make up this shortfall either by getting money from the owners or by getting it from lenders who loan the money to the company.

The free cash flows are used to calculate measures of the economic attractiveness of the project. These measures can be used as decision criteria to determine whether a project should be recommended for approval. There are a number of measures of the economic attractiveness. Some of these are the payback period, the return on investment, the net present value and the internal rate of return.

One useful way of analysing the free cash flow is to determine the cumulative free cash flow, which is the sum of the free cash flows for all the prior years. The cumulative free cash flow represents the total cash position of the project at that point. Initially, a typical project shows a negative cash position due to the construction and set-up costs. As the project begins to generate and accumulate cash, the cumulative cash position will gradually become more positive. The time taken for the cumulative free cash flow to reach zero is known as the payback period.

The payback period is amongst the oldest of the criteria used for the analysis of the investment decisions. It has the advantage that it is measured in units of time, which are intuitively understood. However, there is no prescription for what a good payback period is. In addition, the money that is promised in the future is less valuable than cash that is actually in hand now.

Another useful method of analysis of the project’s financials is the return on investment. The return on investment is a measure of the project’s ability to generate funds for its investors.

Basic Inputs for Project Financials

There are five basic inputs to the project financials. Each component is discussed

separately as follows:

1. Revenue. The revenue is the money that flows to the project because of the project’s activities. Consider the following simple example. The project aims to sell 100,000 items per year at $1.50 per item. The total revenue is $150,000 per year. The projections of revenue may be based on marketing data and forecasts or on contractual agreements.

2. Costs. These are the operating and overhead costs of the project. Operating costs are those costs that are incurred in the direct manufacture of the items. They include the costs of purchasing the raw materials, the energy, and the labour required for manufacturing the company’s products. These costs vary with the amount of production; as a result, they are sometimes called variable costs. Overhead costs are those that are not operating costs, such as those arising from administration and from selling and marketing. Overhead costs generally do not vary with the amount of production. If this is the case, they are also referred to as fixed costs.

3. Taxes and royalties. The taxes are the charges made by the government, such as income tax and capital gains tax. Royalties may be charged by the government for the use of a natural resource, such as in mining or oil production.

4. Capital expenditure. The sum of money required to develop and install a manufacturing facility is the capital expenditure. The capital expenditure is also referred to as the fixed capital in order to distinguish it from working capital.

5.Working capital.Working capital is the net amount of money required for stock, debtors and creditors.

These inputs are used to calculate the cash flow and the free cash flow. The cash flow in a year is equal to the revenues less the costs less the taxes and royalties. The free cash flow is the cash flow less the capital expenditure and the working capital requirement.