1/27/21

SBEQ 4452 –
DEVELOPMENT
ECONOMICS
Fara Diva Mustapa (PhD, PQS, MRICS, MRISM)
Department of Quantity Surveying
Faculty of Built Environment & Surveying
UTM

COST BENEFIT ANALYSIS

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At the end of this topic, you should be able to:

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Understand the
importance of CBA

The information required

to calculate CBA

The formula to calculate

CBA

LECTURE OUTLINE
• What is CBA?
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• Why CBA is needed?

• How CBA is conducted?
• Basis for CBA?

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DEFINITION
▪ Cost–benefit analysis (CBA), sometimes called
benefit–cost analysis (BCA), is a systematic
approach to estimating the strengths a nd

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weaknesses of alterna tives that satisfy transactions,
activities or functional requirements for a business.
▪ It is a technique that is used to determine options
that provide the bes t approach for the adoption
and practice in terms of benefits in labor, time and
cost savings etc. (David, Ngulube and Dube, 2013).
▪ The CBA is also defined as a sys tematic process for
calculating and comparing benefits a nd costs of a
project, decision or government policy (hereafter,
"project").

PURPOSE OF CBA
▪ To determine if it is a sound
investment/decision (justification/feasibility),
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▪ To provide a basis for comparing projects. It

involves comparing the total expected cost of
each option against the total expected benefits,
to see whether the benefits outweigh the costs,
and by how much.

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THREE TYPES OF COST /

BENEFIT
DIRECT COST / BENEFIT –quantifiable into RM, directly relevant
to project implementation, e.g. capital/initial cost (professional

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fees), maintenance and operation costs, construction cost, land
cost

INDIRECT COST / BENEFIT –not easily quantifiable into RM,

e.g. saving in journey time, reduction in pollution, noise
abatement, accident reduction, tree cutting, cleaner river

INTANGIBLE (SOCIAL) COST / BENEFIT –involving non-

quantifiable elements, e.g. level of comfort, social well-being,
aesthetics, social dislocation, stress, sentimental value,
satisfaction, social interaction

CBA SALIENT POINTS

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HOW TO PERFORM CBA

Brainstorm Costs and Benefits

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Assign a Monetary Value to the Costs

Assign a Monetary Value to the Benefits

Compare Costs and Benefits

BRAINSTORM COSTS AND

BENEFITS
▪ First, take time to brainstorm all of the costs
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associated with the project, and make a list of these.

Then, do the same for all of the benefits of the
project. Can you think of any unexpected costs? And
are there benefits that you may not initially have
anticipated?
▪ When you come up with the costs and benefits,
think about the lifetime of the project. What are the
costs and benefits likely to be over time?

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ASSIGN A MONETARY VALUE

TO THE COSTS
▪ Costs include the costs of physical resources
needed, as well as the cost of the human effort
involved in all phases of a project. Costs are often

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relatively easy to estimate (compared with
revenues).
▪ It's important that you think about as many related
costs as you can. For example, what will any training
cost? Will there be a decrease in productivity while
people are learning a new system or technology,
and how much will this cost?
▪ Remember to think about costs that will continue to
be incurred once the project is finished. For
example, consider whether you will need additional
staff, if your team will need ongoing training, or if
you'll have increased overheads.

ASSIGN A MONETARY VALUE

TO THE BENEFITS
▪ This step is less straightforward than step two.
▪ Firstly, it's often very difficult to predict revenues
accurately, especially for new products. Secondly,
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along with the financial benefits that you anticipate,

there are often intangible, or soft, benefits that are
important outcomes of the project.
▪ For instance, what is the impact on the environment,
employee satisfaction, or health and safety? What is
the monetary value of that impact?
▪ As an example, is preserving an ancient monument
worth RM500,000, or is it worth RM5,000,000 because
of its historical importance? Or, what is the value of
stress-free travel to work in the morning? Here, it's
important to consult with other stakeholders and
decide how you'll value these intangible items.

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COMPARE COSTS AND

BENEFITS
▪ Finally, compare the value of your costs to the value of
your benefits, and use this analysis to decide your course
of action.

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▪ To do this, calculate your total costs and your total
benefits, and compare the two values to determine
whether your benefits outweigh your costs. At this stage
it's important to consider the payback time, to find out
how long it will take for you to reach the break even point
– the point in time at which the benefits have just repaid
the costs.

▪ 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 revenue (or benefits) = length of time

(payback period).

CBA IN THE PLANNING PROCESS Fara Diva Mus tapa QS@ U TM

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 COMPOUND INTEREST FACTOR

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EXAMPLE
▪ Custom Graphic Works has been operating for
just over a year, and sales are exceeding

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targets. Currently, two designers are working
full-time, and the owner is considering
increasing capacity to meet demand. (This
would involve leasing more space and hiring
two new designers.)
▪ He decides to complete a Cost-Benefit Analysis
to explore his choices.

ASSUMPTIONS
▪ Currently, 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
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RM50 an hour. The company outsources an

average of 100 hours of work each month.
▪ He estimates that revenue will increase by 50 %
with increased capacity.
▪ Per-person production will increase by 10 %
with more working space.
▪ The analysis horizon is one year: that is, he
expects benefits to accrue within the year.

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COSTS
Category Details Cost in First Year
Lease 750 square feet available next door at RM13,500
RM18 per square foot
Leasehold Knock out walls and recon figure office RM15,000

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improvements space
Hire two more Salary, including benefits RM75,000
designers
Recruitment costs RM11,250
Orientation and training RM3,000

Two additional Furniture and hardware RM6,000

workstations
Software licenses RM1,000

Construction Two weeks at approximately RM7,500 RM15,000

downtime revenue per week
Total RM139,750

BENEFITS
Benefit Benefit
Within
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12 Months
50 percent revenue increase RM195,000
Paying in-house designers RM15 an hour, versus RM42,000
RM50 an hour outsourcing (100 hours per
month, on average: savings equals RM3,500 a
month)
10 percent improved productivity per designer RM58,500
(RM7,500 + RM3,750 = RM11,250 revenue per
week with a 10 percent increase =
RM1,125/week)
Improved customer service and retention as a RM10,000
result of 100 percent in-house design
Total RM305,500

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SOLUTION BASED ON PAYBACK TIME

RM139,750 = 0.46 of a year, or approximately 5.5 months

RM305,500

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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
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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?

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KEY POINTS
▪ Cost-benefit analysis is a relatively straightforward tool
for deciding whether to pursue a project.
▪ To use the tool, first list all the anticipated costs
associated with the project, and then estimate the

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benefits that you'll receive from it.
▪ Where benefits are received over time, work out the
time it will take for the benefits to repay the costs.
▪ You can carry out a Cost-Benefit Analysis using only
financial costs and benefits. However, you may decide to
include intangible items within the analysis. As you must
estimate a value for these items, this inevitably brings
more subjectivity into the process.

CBA EXAMPLE
▪ A commercial director is deciding whether or not to
invest in a new computer-based customer service
system. The sales department currently has only a
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handful of computers, and the customer service

operatives are not especially computer literate, but
he can see the potential value of being able to reach
a significantly larger number of customers and
provide more efficient customer services, and feels
that the new system would enable this to happen.
▪ The director carries out a cost benefit analysis, with
the results shown below. It can be seen from these
figures that (providing the estimates are accurate, of
course) the system would pay for itself within the
first year of operation - within the first eight months,
in fact.

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DISCOUNTED CASH FLOW (DCF)

AND NET PRESENT VALUE (NPV)
▪ Discounted cash flow (DCF) analysis is a way of calculating
the value of money flowing into and out of an organisation
over time (the cash flows) based on the concept of its
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present value. Future cash flows are estimated and then

discounted to give their net present values (NPVs).
▪ The discount rate used varies, but one commonly used
method of discounting is to calculate how much money
would have to be invested in the present at a given rate of
rate of return in order to achieve the cash flow in the
future. The rate of return may be based on current interest
rates plus a risk premium that reflects the risk that the
future cash flow may not be forthcoming. The future value
(FV) of an investment can be calculated as:
▪ FV = NPV x (1 + i)n

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DISCOUNTED CASH FLOW (DCF) AND

NET PRESENT VALUE (NPV) CONT’D

▪ Where NPV is the net present value of the

future cash flow, i is the interest rate (including

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any risk premium), and n is the time in years
until the cash flow occurs (the unit of time used
can be adjusted to reflect the time within which
a return on investment is anticipated).
▪ Rearranging the formula to get the net present
value, we get:
▪ NPV = FV/(1+i)n

Advantages using DCF & NPV

▪ This formula represents a relatively simplistic approach
that assumes that the interest rate (including the risk
premium) remains constant. The formula is applied to
both positive and negative cash flows. In a typical project
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scenario, the cash flows are likely to be negative until

some point after the project is completed.
▪ The important thing to remember is that at some point in
the future (the break-even point), the NPV (represented
by the sum of the discounted cash flows up to that point)
should acquire a positive value (i.e. it should be greater
than zero). Essentially, if the NPV has a positive value at
some point the project will have paid for itself. If not, it
will have lost money.

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Advantages using DCF & NPV

▪ To take a simple example, let's assume a project has a
total cost of RM100,000 over a twelve month period (Year
0). The project is expected to produce cost benefits in
the form of an additional annual income of RM25,000.00

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per annum, and is expected to pay for itself within five
years from completion of the project. If a value for i of
7.5% is used, the result will be a small positive NPV, as
illustrated below (note that increasing the value of i to
8.0% results in a small negative NPV).

EXAMPLE NPV CALCULATION

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▪ The calculations involved can be set up in any spreadsheet program

in a few minutes, enabling a range of outcomes to be calculated by
varying factors such as the value of i. The notion of discounted cash
flow can be used to calculate how much value a project will add to
the organisation over a given period of time. If the net present value

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at some pre-determined future date is greater than zero, then the
project has added value to the organisation.

▪ If not, there will be no point (from a financial point of view at least) in

continuing with the project. The example given is a relatively simple
one and has been used in order to demonstrate the basic principles.
In reality such calculations can be affected by a great number of
variables, but it is beyond the scope of these pages to consider the
implications of this any further.

▪ Bear in mind also that even if the calculations result in an

unfavourable outcome from a purely monetary point of view, the
project may still have long term intangible benefits that cannot be
measured in purely financial terms. There could be serious negative
consequences as a result of not going ahead with a project.

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COST BENEFIT ANALYSIS

TEMPLATE

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q What is the functions of CBA?

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q What is CBA?
q Why CBA is needed?
q How to calculate CBA?
q What are the information required to
caclculate CBA?

Fara Diva Mus tapa QS@ U TM

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