What Is The Cost-Benefit Ratio Formula? (With Examples)
Updated 12 October 2022
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Organisations use various methods to determine whether a project could be profitable. They may use the cost-benefit ratio to compare the cost of a project to its projected profits. If you are a project manager or work in a similar role, learning about this technique can help you assess the viability of projects. In this article, we discuss what the cost-benefit ratio is, outline its importance, highlight its advantages and limitations, share the cost-benefit ratio formula and provide some examples to help you understand the concept better.
What Is The Cost-Benefit Ratio Formula?
The cost-benefit ratio formula is a metric that professionals use to determine the profitability of investing in a project. The ratio compares the expected incremental benefits from a project with its expected costs. If the cost-benefit ratio is high, a project's benefits outweigh its costs and provide a better return on investment. If the cost-benefit ratio is low, a project's costs outweigh its benefits.
Sometimes, it is essential for professionals to consider not only quantitative but qualitative measures when assessing the viability of a project. For example, if an organisation in collaboration with the local government invests in renovating a playground for kids, the objective is not to make a profit but to improve a community.
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How To Use The Cost-Benefit Ratio Formula
Follow these steps if you want to use this formula to determine a project's profitability:
1. Establish a framework
In the first step, identify the project's goals and objectives. Conduct a feasibility analysis of the project by listing its pros and cons. You may also define what the project aims to accomplish. For example, some project proposals may aim to generate revenue and increase profit, whereas others may want to focus on non-financial metrics, such as community building, wellness and innovation. Performing this preliminary analysis is a prerequisite to conducting the cost-benefit analysis.
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2. Find the present value factor
Companies use the present value (PV) factor to determine the present value of a sum they would receive at a future date. It presumes that capital received at the present date is more valuable than capital received later. This is because companies can re-invest the capital received at the present date to generate more revenue. The PV factor is always below one. Find the formula to calculate the PV factor:
PV factor = 1 / (1 + discounted rate) n
3. Find the present value of the expected costs
Costs are expenses that a company incurs during the manufacturing or development of a product. This can include both direct and additional costs. Direct costs include costs related to labour, manufacturing, material and inventory. This is the cost required to make a product or service. Additional costs include:
Indirect costs: These are fixed expenses, such as rent and utilities, that a business incurs as overhead costs.
Intangible costs: It may be difficult for businesses to measure and quantify these costs. An example includes a reduction in customers because of the quality of customer service.
Opportunity costs: This refers to missed opportunities while undertaking a project.
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4. Find the present value of the expected benefits
After calculating the costs associated with the project, determine its benefits. These are some types of benefits associated with the success of a project:
Direct: This is the revenue generated from sales after launching a product.
Indirect: It refers to an increase in brand awareness through marketing.
Intangible: This refers to improved employee morale due to the successful launch of a product and recognition.
Competitive: Some businesses may be the first in the industry to develop a unique product or service, which gives them a competitive advantage.
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5. Determine the discount rate
Discounting rate is the annual rate of interest applied to future cash flows of an investment to calculate its present value. For example, if you invested ₹100 in the present day at an interest rate of 10%, you would get ₹110. This means ₹110, which is the future value of an investment when discounted by 10% yields ₹100, which is the present value. There are several return rates, including target return rates, capital costs and risk-adjusted market interest rates. When there are multiple periods, raise the discount rate by the power of that period.
Related: What Is The Profitability Index? (And How To Calculate It)
6. Find the cost-benefit ratio
The formula to calculate the cost-benefit ratio is:
Cost-benefit ratio = ∑ (Present value of expected benefits) / ∑ (present value of expected costs)
Present value of expected benefits = future benefits x present value factor
Present value of expected costs = future costs x present value factor
Input the values into the above formula to determine the cost-benefit ratio. Consider the example:
A company wants to assess the profitability of a project where it plans to invest ₹5,00,000. The rate of inflation is 3%. It expects to generate ₹10,00,000 for the next three years. You do not require discounting the PV of the total cost since the company pays it up front instead of in parts.
Discount rate = rate of inflation = 3%
Present value factor for the first year = 1 / (1 + 3%) = 0.97
Total PV of expected benefits = [₹10,00,000 x 1 / (1 + 3%)1] + [₹10,00,000 x 1 / (1 + 3%)²] + [₹10,00,000 x 1 / (1 + 3%)³] = ₹28,23,573
Total PV of costs = ₹5,00,000
Cost-benefit ratio = ₹28,23,573 / ₹5,00,000 = 5.64
7. Evaluate the cost-benefit ratio
In the previous example, the cost-benefit ratio is 5.64. For every ₹1 in cost, the company generates ₹5.64 in benefits. Since the benefits outweigh the costs, the project is a good investment.
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Advantages And Limitations Of Cost-Benefit Analysis
The advantages and limitations of cost-benefit analysis are:
Here are some advantages of performing cost-benefit analysis:
It is a data-driven approach. It evaluates the financial metrics of a project, allowing organisations to take evidence-based decisions. This enables bias-free decision-making in an organisation.
It simplifies the decision-making process. Analysing the viability of a project can be complex because of several variables involved. Using cost and benefit to compare a project's cost and projected revenue can help simplify decision-making.
It enables strategic planning. Organisations can benefit from using this technique to determine projects that can generate higher revenue in the future. This helps them set monetary budgets and prepare short-term and long-term goals.
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Here are some limitations to performing cost-benefit analysis:
It may not measure the quality aspects of a project. Some elements of a project may not offer monetary benefits, depending on their mission and purpose. The cost-benefit analysis does not consider non-financial metrics in its calculation.
It may give skewed results if there is an inconsistency in data. The analysis is reliant on forecasts to determine the expected revenue. Inconsistencies in data can cause errors in expected findings.
It may be unnecessary for smaller projects. The analysis requires capital and resources and may not be necessary for projects with less budget and shorter time frames.
It does not consider external factors. The technique does not consider external factors such as geopolitical situations, inflation and recession, market fluctuations and supply and demand. This method may not be the best choice for very long-term projects with significant investments.
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Why Is It Important To Calculate The Cost-Benefit Ratio?
A cost-benefit ratio is important for the following reasons:
Investors can use it to decide if investing in a project would yield a good return on investment (ROI).
Businesses can benchmark two or more projects to choose one that is more profitable.
Companies can prioritise projects that have a higher return.
Companies can use this ratio to quantify their decision-making process.
Related: What Is Implicit Cost And Explicit Cost? (With Examples)
Example For Cost-Benefit Analysis
Here is another example to help you understand how to perform a cost-benefit analysis for a project:
A machinery company plans to invest ₹2,00,000 to renovate some of its machines. It estimates an incremental benefit of ₹25,000 in the first year, ₹21,000 in the second year and ₹19,000 in the third year. It wants to know if the project would yield a profit if the discounting rate is 5%.
The total cost of investment: ₹2,00,000
PV of benefit in the first year: ₹25,000 / (1 + 5%)¹ = ₹23,809.5
PV of benefit in the second year: ₹21,000 / (1 + 5%)² = ₹19,047.6
PV of benefit in the second year: ₹19,000 / (1 + 5%)³ = ₹16,412.1
PV of future benefits = ₹23,809.5 + ₹19,047.6 + ₹16,412.1 = ₹59,269.2
The PV formula for costs is the same as the total investment because the company pays it at once instead of paying it in parts over three years.
PV of future costs = total investment = ₹2,00,000
Cost-benefit ratio = PV of future benefits / PV of future costs = 59269.2 / 200000 = 0.29
Since the ratio is below one, the project's costs outweigh its benefits. The company does not require undertaking this renovation.
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