Cost-benefit analysis Discuss the topic, case study on the topic

Cost-benefit analysis
What Is a Cost-Benefit Analysis? A cost-benefit analysis is a systematic process that
businesses use to analyze which decisions to make and which to forgo. 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. Some consultants or analysts also build
models to assign a dollar value on intangible items, such as the benefits and costs
associated with living in a certain town. A cost-benefit analysis is the process used to
measure the benefits of a decision or taking action minus the costs associated with taking
that action. A cost-benefit analysis involves measurable financial metrics such as revenue
earned, or costs saved as a result of the decision to pursue a project. cost-benefit analysis
can also include intangible benefits and costs or effects from a decision such as employees
morale and customer satisfaction. Complex cost-benefit analysis may incorporate
sensitivity analysis, discounting of cash flows, and what-if scenario analysis for multiple
options. all Else being equal, an analysis that results in more benefits than costs will
generally be a favorable project for the company to undertake.
Understanding Cost-Benefit Analysis Before building a new plant or taking on a new
project, prudent managers conduct a cost-benefit analysis to evaluate all the potential costs
and revenues that a company might generate from the project. The outcome of the analysis
will determine whether the project is financially feasible or if the company should pursue
another project. In many models, a cost-benefit analysis will also factor the opportunity
cost into the decision-making process. Opportunity costs are alternative benefits that could
have been realized when choosing one alternative over another. In other words, the
opportunity cost is the forgone or missed opportunity as a result of a choice or decision.
Factoring in opportunity costs allows project managers to weigh the benefits from
alternative courses of action and not merely the current path or choice being considered in
the cost-benefit analysis. By considering all options and the potential missed opportunities,
the cost-benefit analysis is more thorough and allows for better decision-making. Finally,
the results of the aggregate costs and benefits should be compared quantitatively to
determine if the benefits outweigh the costs. If so, then the rational decision is to go
forward with the project. If not, the business should review the project to see if it can make
adjustments to either increase benefits or decrease costs to make the project viable.
Otherwise, the company should likely avoid the project. The Cost-Benefit Analysis
Process There is no single universally accepted method of performing a cost-benefit
analysis. However, every process usually has some variation of the following five steps.
Identify Project Scope.
The first step of a cost-benefit analysis is to understand your situation, identify your goals,
and create a framework to mold your scope. The project scope is kicked off by identifying
the purpose of the cost-benefit analysis. An example of a cost-benefit analysis purpose
could be “to determine whether to expand to increase market share” or “to decide whether
to renovate a company’s website”. This initial stage is where the project planning takes
place, including the timeline, resources needed, constraints, personnel required, or
evaluation techniques. It is at this point that a company should assess whether it is
equipped to perform the analysis. For example, a company may realize it does not have the
technical staff required to perform an adequate analysis.
During the project scope development phase, key stakeholders should be identified,
notified, and given a chance to provide their input along the process. It may be wise to
include those most impacted by the outcome of the analysis depending on the findings if
the outcome is to renovate a company’s website, IT may be required to hire multiple
additional staff and should be consulted. Determine the Cost With the framework behind
us, it’s time to start looking at numbers. The second step of a cost-benefit analysis is to
determine the project costs. Costs may include the following. Direct costs would be direct
labor involved in manufacturing, inventory, raw materials, manufacturing expenses.
Indirect costs might include electricity, overhead costs from management, rent, utilities.
costs of a decision, such as the impact on customers, employees, or delivery times.
Opportunity costs such as alternative investments or buying a plant versus building one.
Cost of potential risks such as regulatory risks, competition, and environmental impacts.

Cost- Benefit analysis case study

By
Virgil Chichernea
Romanian American University
–Bucharest, B-dul Expozitiei nr. 1a, Sector 1
e-mail: vchichernea@rau.ro

Introduction

The first part of the paper describes a case study in the use of COST/BENEFIT
ANALYSIS in project appraisal which serves to illustrate different aspects of the
practical problem (the use of several Cost/Benefit Indicators, Shadow Rates,
Sensitivity Analysis and Risk Analysis). In the second part it describes the features
and use of the Cost/Benefit Package (CBPACK/PC). The package is designed to
support the cost/benefit analysis of investment projects and includes computational
procedures to obtain the following: Rate of Return (RR); Present Value (PV); First
Year Benefit (FYB); Benefit Cost Ratio (BCR); Cost Parametric Analysis (CPA) of
rate of return computation; Risk Analysis. Some examples are run on PC with package.

Keywords: cost/benefit analysis, package programs, investment project

Background of the case

The Cost/Benefit Analysis, developed by World Bank, is a complex method for critical
examination of the profitability by using the financial rate of return and the updating
techniques. The purpose of any cost/benefit analysis is to balance the cost against the
benefits associated with any activity. Economic investment, research and development
projects, information processing, etc. should be measured by their ability to provide
sufficient to justify their cost. One of the more difficult aspects is the
multidimensional nature of uncertain costs and benefits data.
The objective is to establish the combination of characteristics that provides the best
overall cost/benefit performance. The major objective of this method is to use
economic criteria in all our judgments to select effectively feasibility projects. The
financial cost and the time constrain involved in a Risk Analysis are very important
elements in the decisions. The major advantage of the Risk Analysis is that it enables
us, to attack more difficult problems and to make decisions we would not have felt
competent to make. The Risk Analysis provides an efficient tool to handle the
difficulties of optimization under uncertainty (Project Identification, Marginal Projects,
Optimization of Project Specifications).

Evaluation of the case

The CBPACK (available on PC/AT) is designed for Cost/Benefit Analysis used in the
Feasibility Projects and includes computational procedures to obtain cost/benefit
indicators. The objectives of the CBPACK package are the following:
o to cover the complete set of computations and situations arising in the cost/benefit analysis of
projects.
o to give the user full control of his analysis.
o to make program and data handling easier for the user.
The software demonstrations illustrate the type of problems that may be solved with CBPACK. The case
study chosen gives an idea about the potential and usefulness of the method and the CBPACK package
for:
o specification of streams and storage data (The cost and benefit sources during the life of the project).
o use of several Cost/Benefit Indicators (rate of return, benefit/cost ratio, first year benefit, net
present value).
o use of Shadow Rates and Sensitive Analysis (Perform a cost parametric analysis of the value of
the rate of return of the project).
o use of Risk Analysis (All costs and benefit streams have a probability distribution associated:
Uniform, Step-Rectangular, Discrete, Triangular, Normal, Beta).
Alternative course of action
The hardware minimum configuration is PC, 10MB RAM, Color Display, S-VGA.
The case method is often compared to other teaching methods such as lectures, simulation, or role
playing with respect to its ability to reach specific course objectives. Teaching with cases have been
shown to be more powerful an lectures, simulations, or role playing with respect to its ability to reach
specific course objectives.
Teaching with cases has been shown to more powerful than lectures, for instance, in increasing students’
analytical skills, decision – making skills, evaluation and judgement skills. In the case of the writing
process, we have the following steps: identifying the needs, searching for leads, data gathering case
plan preparation, second interview, writing the case, case release, experimentation in the classroom,
final draft and teaching notes.
The Cost/Benefits Analysis, developed by World Bank to, is a complex method for critical
examination of the project profitableness by using the financial rate of return and the update
techniques. The purpose of this method is to balance the cost against the benefits associated with an
investment project (economic investment, research and development projects, information system,
etc.).
The financial cost and the time constrain involved in a risk analysis are very important elements in the
decisions. The major advantage of risk analysis is that it enables us to attack more difficult problems
and to make decisions we wouldn’t have felt competent to make.

“The Electrification of a Railway Segment” – example

The project includes the electrification of a railway segment in order to extend the traffic and cut down
the operation and maintenance expenses. The cost of this project (new equipment’s (C1), materials
(C2), labor (C3)), is about 12300 monetary units (m.u.) and the working time is 1 year. The actual
operation expenses are 6350 m.u./year and the operation expenses of the project (when this project is
operational) will be roughly 3800 m.u./year and the operation expenses of the new project in 8 years,
and the last stage rate of return is 12%. We need to decide if this project is acceptable.
We observe that the differences between old operation expenses and the new ones signify the net profit
of this project. The new project achievement is simultaneous with the utilization of the
actual railway system. Consequently, the total cost in the first year is: 6350 + 12300 =
18650
mu. The data of this project are presented in table 1.
Table 1. Financial analysis

YEAR NET BENEFIT UPDATE

NET BENEFIT
Rmin = 10% Rmax = 12%
1 -12300 -11181.82 -10982.14
2 +2550 2107.44 2032.84
3 +2550 1915.85 1815.04
4 +2550 1741.68 1620.57
5 +2550 1583.35 1446.94
6 +2550 1439.41 1291.91
7 +2550 1308.55 1153.49
8 +2550 1189.59 1029.90
TOTAL 5550 104.06 -591.45

Cost/Benefit Indicators

1. Rate of Return (RR):

N N1
j −1 Bij − Cij N j =1
RR=  =0 (1)
j −1 (1 +
0.01R)i−1
where the equation (a polynomial of (n-1) degree) is solved by successive approximation
for the range -20% to 100%. R is the discount rate the project in years.

2. Benefit/Cost Ratio (BCR):

Benefit /Cost Ratio (BCR) is defined as ratio expressed as a decimal fraction,
between the present value of total benefits and the present value of total costs of a project:

N2
N
Bij 
j =1
BCR = i =1 (1 + 0.01 R)
i-1
(2)
N1
N  Cij
 i =1 i-1
(1 + 0.01 R)
i =1
where all symbols have the same meaning as in (1).

3. The Cost Parametric Analysis (CPA)

CPA explores the effect of changes in construction costs or in benefit streams on the
internal rate of return and timing of the project. The analysis is performed for the
changes of each benefit stream or cost stream (between -15% and +15%) or the
changes of a combination of benefit and/or cost streams.
4. Risk Analysis
Risk Analysis can be performed over any cost of benefit streams. Every stream has a
probability distribution associated (uniform, normal, beta, discreet, step rectangular,
triangular). The streams affected by uncertainty are designed by the user. The
generation of a randomly distributed according to a given probability density function
and the perform these procedures is made by CBA package.

CBPACK Package

The CBPACK package is a running task operational under PC, 10MB RAM, Color
Display, S- VGA.

The objectives are the following:

o To cover the complete set of situations arising in the cost/benefit analysis of projects.
o To give the user full control of his analysis.
o To make program and data handling easier for the user.
The demo software illustrates the type of problems that may be solved with CBA
package - for instance - specification of streams and storage data (the cost and
benefits streams have a probability distribution associated: Uniform, Normal, Beta,
Discrete, Step – Rectangular, Triangular). The input data are stored in this file; we can
run the computing, updating, printing or deleting procedures by using the menu of
options.
From this case study, we can obtain the report:
PRESENT VALUE: 104.06 : -591.45
BENEFIT/COST RATIO: 1.00 :
1.02 RATE OF RETURN = 10.28125

Recommendation Remarks

The cost/benefit indicators from the case study presented, computing by CBPACK package
is: BCR = 1.00, PV = -591 < 0, RR = 10.28 < 12.
Cost Parametric Analysis and Risk Analysis confirm the idea of rejecting this project. In
this context the management team researches new technical solutions (new projects) for
investment.

References

1. C h i c h e r n e a , V. - Sisteme support de decizie, Editura PRINT GROUP, Bucureşti,

2006
2. P o l i q u e n , L. V. - Risk Analysis in project appraisal, The World Bank Groupe
3. ***, Cost Benefit Method, The World Bank Groupe

Abordarea bazată pe studii de caz în instruirea privind proiectele de fezabilitate

utilizând analiza cost/beneficiu

Rezumat

În prima parte a articolului se prezintă un studiu de caz în care se utilizează metoda

de analiză cost- beneficiu, prin care se ilustrează aspectele practice legate de
memorarea datelor proiectului, calculul indicatorilor, analiza de sensibilitate şi
analiza de risc. În partea a doua se prezintă pachetul de programe CBPACK,
disponibil pe PC, proiectat pentru a efectua analiza economică şi financiară a
proiectului de investiţii (calculul de indicatori ACB, analiza de sensibilitate şi analiza
de risc, împreună cu aspecte legate de gestiunea datelor proiectului).