Module 05

Benefit-Cost Ratio
 Is commonly used to evaluate public projects.
Several facets unique to public-project analysis are
neatly addressed by benefit cost analysis
 Is an important feature of the economic analysis
period.
Three Goals
1. Maximize the benefits for any given sets of costs (or
budgets)
2. Maximize the net benefits when both benefits and
costs vary.
3. Minimize costs in order to achieve any given level of
benefits (Cost Effectiveness analysis)
Benefits
By definition, it is something that is advantageous
and good
Classifications of BENEFITS
1. Primary Benefits – a benefit directly attributable
to the project
2. Secondary Benefits - a benefit indirectly
attributable to the project

If primary benefits alone are sufficient to justify

projects costs, the secondary benefits need not be
quantified.
Costs

 Itis the price or required amount

(specified amount of money) before it
can be acquired.
Steps in Benefit-Cost Analysis

STEP 01 : Identify the Benefits

Calculate all benefits in monetary values
Calculate all disbenefits in monetary values
Calculate Net Benefit = Benefit – Disbenefit

Step 02 : Identify the Costs

Determine the NON-RECURRING costs such as the Capital expenditure
and salvage value at the end of the project period
Determine RECURRING costs such as operating and maintenance
costs, renovation and etc.
Determine annual revenues (fees) generated from the project.
Calculate the net annual costs = (Recurring + Nonrecurring –
Revenues or fees charged – salvage value)
Steps in Benefit-Cost Analysis

STEP 03 : Perform benefit-

cost analysis
Determine the interest rate to use in
the benefit costs analysis
Determine the equivalent net benefits
Determine the equivalent costs
Calculate the benefit-cost ratio
Formula for Benefit and Cost
𝑁

𝐵 = ෍ 𝑏𝑛(1 + 𝑖)^ − 𝑛
𝑛=0

𝐶 = ෍ 𝑐𝑛(1 + 𝑖)^ − 𝑛
𝑛=0

Bn = benefits at the end of period n

Cn = expenses/cost at the end of period n
N = Project Life
i = interest rate
Formula for Benefit and Cost I is the SERIES OF
𝐾 INVESTMENTS during the first
𝐼 = ෍ 𝑐𝑛(1 + 𝑖)^ − 𝑛 periods K.
𝑛=0 Normally, Costs accrual start
after 1 year after the K
𝑁 periods of investment.
𝐶′ = ෍ 𝑐𝑛(1 + 𝑖)^ − 𝑛 The B/C Ratio is defined as
𝑛=𝐾+1
BC(i) = B/C = B/(I+C’) ;
C = I + C’
where I+C’ > 0.
Since B & C is in Present Worth

__B__ > 1
(I + C’)

B > I + C’

B - (I + C’) > 0

PW(i) = B – C > 0
Example :
A public project being considered by a local
government has the following estimated benefit-
cost profile.
Assume that i = 10%, N = 5, and K = 1. Compute for
B, C, I, C’ and BC(10%).

N Bn Cn An
0 - $10 -$10
1 - $10 -$10
2 $20 $5 $15
3 $30 $5 $25
4 $30 $8 $22
5 $20 $8 $12
Cash flow
BENEFIT(bn)

$20 $30 $30 $20

0 1 2 3 4 5

$10 $10 $5 $5 $8 $8

Investment Cost(cn) Recurring Cost(cn)

Benefits B = $71.98

$20 $30 $30 $20

0 1 2 3 4 5

B = $20(P/F,10%,2) + $20(P/F,10%,3) +
$10 $30(P/F,10%,4)
$10 $5 + $20(P/F,10%,5)
$5 $8 = $71.98
$8
Cost C = $37.41

I = $19.09
C = $10 + $10(P/F,10%,1) + $5(P/F,10%,2) +
$20 $30 $30 $20
$5(P/F,10%,3) + $8(P/F,10%,4) + $8(P/F,10%,5) =
$37.41

0 1 2 3 4 5

$10 $10 $5 $5 $8 $8

I = $10 + C’ = $5(P/F,10%,2) + $5(P/F,10%,3) +

$10(P/F,10%,1) $8(P/F,10%,4) + $8(P/F,10%,5) = C’ = C – I = $18.32
I = $19.09 C’ = $18.32
Benefit-Cost Ratio BC(10%) = B / I+C’ = B / C
BC(10%) = ____$71.98___
$19.09 + $18.32
BC(10%) = 1.92 > 1

B = $71.98
C = $37.41
I = $19.09
C’ = $18.32
Since BC > 1, It means that users benefits
exceeds the users cost.
Incremental Cost Benefit Analysis
It is used in choosing the best BC Analysis from multiple mutual
exclusive projects.
5 Steps in using Incremental Analysis in BC
Analysis
1. Eliminate any alternatives with a BC Ratio less than 1.
2. Arrange the remaining alternatives in increasing order of the
denominator (I + C’).
1. The alternative with the smallest denominator should be the first (j).
2. The alternative with the second smallest (k) should be the second.
3. So on and so forth.
3. Compute for the incremental differences for each term (B,I, C’) for
the paired alternatives(j,k) in the list.
1. ∆B = Bk – Bj ;
2. ∆I = Ik – Ij ;
3. ∆C’ = C’k – C’j ;
Step 4 & 5 If BC(i)k-j > 1,
4. Compute for BC(i) on incremental Select the Kth alternative,
investments by evaluating If BC(i)k-j <1, Choose the
BC(i)k-j = ∆B / (∆I + ∆C’)
Jth Alternative
5. Compare the selected alternative with the next one on
the list by repeating the Steps 1 to 4.

We modify the conditions when the following are met

1. If ∆I + ∆C’ = 0 : This means both alternatives require the
same investment. In this case we choose the alternative
with the greater B value.
2. In situations where projects with unequal service lives
are to be compared but the alternatives can be
repeated, we may compute all components values (B, I,
C’) on an annual basis and use them in incremental
analysis.
Example
 Consider three investment projects: A1, A2 and A3. Each project has
the same service life, and the present worth of each component
value (B, I & C’) is computed at 10% as follows:
A. If all projects are independent, which projects would be selected,
based on BC(i)?
B. If the three projects are mutually exclusive, which project would be
the best alternative?

PROJECT
A1 A2 A3
B $12,000 $35,000 $21,000
I $5,000 $20,000 $14,000
C’ $4,000 $8,000 $1,000
PW(i) $3,000 $7,000 $6,000
 PROJECT
Incremental A1 A2 A3
Analysis (BC) B $12,000 $35,000 $21,000
I $5,000 $20,000 $14,000
C’ $4,000 $8,000 $1,000
PW(i) $3,000 $7,000 $6,000
BC(i) 1.33 1.25 1.40

Under PW Criterion,
A2 would be selected

Under BC(i) Analysis,

A3 is the best while
A2 is the least desired
alternative.
Incremental Analysis A3 & A1
Step 01 : Eliminate Since no alternatives have
Alternatives with BC a BC Ratio < 1, NO
Ratio < 1. Elimination was done.

Step 02 : Rank the I + Ranking Base A1 A3 A2

C’ in increasing order I + C’ $9,000 $15,000 $28,000

Ranking Base A1 A3 A2
B $12,000 $21,000 $35,000

Step 03 & 4 : Compute

BC(i)A3-A1 = $21,000 - $12,000
for Incremental
$15,000 - $9,000
Differences
BC(i)A3-A1 = 1.50, A3 is a better choice.
Incremental Analysis A3 & A2
Ranking Base A1 A3 A2
Step 02 : Rank the I +
I + C’ $9,000 $15,000 $28,000
C’ in increasing order
Ranking Base A1 A3 A2
B $12,000 $21,000 $35,000

Step 03 & 4 : Compute

BC(i)A2-A3 = $35,000 - $21,000
for Incremental
$28,000 - $15,000
Differences
BC(i)A2-A3 = 1.07, A2 is a better choice.

With no further alternatives, A2 is the best choice/alternative.

Profitability Index
 Another method similar to the benefit-cost
analysis.
 Thisindex attempts to identify the
relationship between the costs and benefits of
a proposal project through the use of a ratio.
 Bydefinition, profitability index, PI(i),
considers only the initial capital expenditure
as cash outlay, and the annual net benefits are
used.
𝐵−𝐶 ′
 𝑃𝐼 𝑖 = ,I>0
𝐼
Conceptual differences between BCR & PI

Benefit Cost Profitability

Ratio Index

B >1 B – C’ > 1
I + C’ I

To see whether the To quantify the amount

benefits outweights the of value created per
cost unit of investment
Example
 Assume a five-year program that will commit the
government to the stream of real (or constant
dollar) expenditures to generate a series of real
benefits for a public project. Assume that i = 7%. N
= 5 and K = 1. Compute for PI (7%) and determine
whether it is worth funding the program.
N Bn Cn An
0 $10 -$10
1 $20 -$20
2 $35 $5 $30
3 $30 $5 $25
4 $20 $7 $13
5 $10 $7 $3
Compute for B, I and C’
B= $35(P/F,7%,2) + $30(P/F,7%,3) +
$20(P/F,7%,4) + $10(P/F,7%,5) = $77.44
PI = (B-C’)/I
= 58.67/28.69
I = $ 10 + $20(P/F,7%,1) = $28.69 2.044 > 1

Since PI is > 1, The

C’ = $5(P/F,7%,2) + $5(P/F,7%,3) + project is worth
$7(P/F,7%,4) + $7(P/F,7%,5) = $18.78 undertaking.

B – C’ = 58.67
Incremental Profitability Index
It is used in choosing the best Profitability Index from multiple mutual
exclusive projects.
5 Steps in using Incremental Analysis in
Profitability Index
1. Eliminate any alternatives with a PI less than 1.
2. Arrange the remaining alternatives in increasing order of the
denominator I.
1. The alternative with the smallest denominator should be the first (j).
2. The alternative with the second smallest (k) should be the second.
3. So on and so forth.
3. Compute for the incremental differences for each term (B,I, C’) for
the paired alternatives(j,k) in the list.
1. ∆B = Bk – Bj ;
2. ∆I = Ik – Ij ;
3. ∆C’ = C’k – C’j ;
Step 4 & 5 If PI(i)k-j > 1,
4. Compute for PI(i) on incremental Select the Kth alternative,
investments by evaluating If PI(i)k-j <1, Choose the
PI(i)k-j = (∆B - ∆C’) /∆I
Jth Alternative
5. Compare the selected alternative with the next one on
the list by repeating the Steps 1 to 4.

We modify the conditions when the following are met

1. If ∆I = 0 : This means both alternatives require the same
investment. In this case we choose the alternative with
the greater (B-C’) value.
2. In situations where projects with unequal service lives
are to be compared but the alternatives can be
repeated, we may compute all components values (B, I,
C’) on an annual basis and use them in incremental
analysis.
Example
 Consider three investment projects: A1, A2 and A3. Each project has
the same service life, and the present worth of each component
value (B, I & C’) is computed at 10% as follows:
A. If all projects are independent, which projects would be selected,
based on PI(i)?
B. If the three projects are mutually exclusive, which project would be
the best alternative?

PROJECT
A1 A2 A3
B $12,000 $35,000 $21,000
I $5,000 $20,000 $14,000
C’ $4,000 $8,000 $1,000
PW(i) $3,000 $7,000 $6,000
 PROJECT
Incremental A1 A2 A3
Analysis (PI) B $12,000 $35,000 $21,000
I $5,000 $20,000 $14,000
C’ $4,000 $8,000 $1,000
PW(i) $3,000 $7,000 $6,000
PI(i) 1.60 1.35 1.43

Under PW Criterion,
A2 would be selected

Under PI Analysis, A1
is the best while A2 is
the least desired
alternative.
Incremental Analysis A3 & A1
Step 01 : Eliminate Since no alternatives have
Alternatives with PI a PI < 1, NO Elimination
Ratio < 1. was done.

Step 02 : Rank the I in Ranking Base A1 A3 A2

increasing order I $5,000 $14,000 $20,000

Ranking Base A1 A3 A2
B – C’ $8,000 $20,000 $27,000

Step 03 & 4 : Compute

PI(i)A3-A1 = $20,000 - $8,000
for Incremental
$14,000 - $5,000
Differences
PI(i)A3-A1 = 1.33, A3 is a better choice.
Incremental Analysis A3 & A2

Step 02 : Rank the I in Ranking Base A1 A3 A2

I $5,000 $14,000 $20,000
increasing order
Ranking Base A1 A3 A2
B – C’ $8,000 $20,000 $27,000

Step 03 & 4 : Compute

PI(i)A2-A3 = $27,000 - $20,000
for Incremental
$20,000 - $14,000
Differences
PI(i)A2-A3 = 1.17, A2 is a better choice.

With no further alternatives, A2 is the best choice/alternative.

 Present
Worth Annuity
Worth

Future BC Ratio &

Proceed to BEP? Profitability
Worth Index

Break Even
Point