Concepts Behind Cost Benefit Analysis
What Is Cost Benefit Analysis?
Cost Benefit Analysis is a method through which an organization analyzes its decisions. As the name suggest, Cost Benefit Analysis means analyzing the cost and benefit of any decision taking. The cost is subtracted from the benefit and you know whether the decision is profitable or not.
As easy as it sounds, it is much more complicated. Costs are incurred in present but returns have to calculate as per the future. It can only be estimated. There is a lot of dollar indexing that comes into account while doing this because of the returns being in future.
It is difficult to measure the cost and benefit for the decisions. For example, a bridge is to be built which will take about 3 years to build. To calculate the cost for it in total, keeping in mind the inflation rates, it becomes quite difficult. Calculating the benefit of the bridge, in terms of toll revenue and social benefit becomes even more difficult. There are various other factors which need to be accounted for in a Cost Benefit analysis which are immeasurable.
A Cost Benefit Analysis is usually done for a business proposal or prospect where your investment is to be put up. You would want to know the return of the investment in respect to the money you are putting in. Hence, a Cost Benefit Analysis comes into picture. Not only profit and loss, it also shows the ratio between the gain and the cost which can be used to calculate many other indicators. These indicators are further used to analyze the profitability of a business decision.
How It Works?
A Cost Benefit Analysis takes both factors into account: qualitative and quantitative. For any business proposals, all the pros and the cons are to be identified and written down. All the factors have to be quantified. This is done using different tools. Once you have the elements written, the positives are to be written down under Benefits and the negatives are to written down under cost. Then you take a sum total of both the sides. If the cost is more than the benefits, it shows that the project or proposal is loss making and if the benefit is more than the cost, it shows that the proposal is making profits. This is also done when there are many business proposals and you want to invest in only one. You can see the difference in the benefits and choose the one offering you the maximum benefits.
While using a Cost Benefit Analysis, there are many formats that one can use.
The generally used format has the following elements-
- Total Cost
- Total Benefits
- Present Value of Cost(PV of Cost)
- Future Value of Cost(FV of Cost)
- Present Value of Benefits(FV of Cost)
- Future Value of Benefits(FV of Benefits)
- Cost-Benefit(Positive or Negative Value)
All the items are usually written in a tabular format making it easy to understand and analyze.
Difficulties Encountered In Cost Benefit Analysis
As mentioned above the most difficult part is to calculate the quantitative value of qualitative cost. This requires indexing and using Future Values of money. This is extremely complex and requires knowledge and understands of different formulas and calculations.
Most of the students find it hard to calculate non-monetary values of cost and benefits, After this, if the proposal is for a longer span, the future value needs to be calculated as well which becomes even more tedious. Even after calculating the Cost benefit amounts, analysis is still challenging. You have to keep in mind the quantitative values of net profit or loss and make the decision and come to a conclusion. Cost Benefit Analysis is usually long and extremely complex. Identifying elements from the problems and classifying them it becomes very tough for the students. Each element needs to be put down carefully to avoid any errors while making decisions.
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