Benefit Cost Analysis
Benefit/cost (B/C) analysis is a method used to evaluate the economic feasibility of projects, particularly in the public sector.
- a way to compare the benefits of a project to its costs
- was developed to introduce objectivity into the economic analysis of public sector evaluation, thus reducing the effects of politics and special interests.
B/C Ratio Calculation
All cost and benefit estimates must be converted to a common equivalent monetary unit (present worth (PW), annual worth (AW), or future worth (FW)) at the discount rate (interest rate).
- B/C = PW or AW or FW of (Benefits/Cost)
Present worth is preferred to annual worth equivalencies and future worth values.
Costs are preceded by a minus sign
and salvage values are subtracted from costs.
Disbenefits are commonly subtracted from benefits and placed in the numerator.
If the numbers 10, 8, and 5 are used to represent the PW of benefits, disbenefits, and costs, respectively, the correct procedure results in B/C = (10 – 8)/5 = 0.40. The incorrect placement of disbenefits in the denominator results in B/C = 10/(8 + 5) = 0.77, which is approximately twice the correct B/C value of 0.40.
Decision Guideline
- If B/C ≥ 1.0, accept the project as economically acceptable
- If B/C < 1.0, the project is not economically acceptable.
- If the B/C value is exactly or very near 1.0, noneconomic factors will help make the decision.
Conventional B/C Ratio
- The conventional B/C ratio is calculated as
- In the conventional B/C ratio, disbenefits are subtracted from benefits, not added to costs.
Modified B/C Ratio
- The modified B/C ratio includes all the estimates associated with the project, once operational.
- Maintenance and operation (M&O) costs are placed in the numerator and treated in a manner similar to disbenefits.
- The denominator includes only the initial investment.
- Salvage value is usually included in the denominator as a negative cost.
- The modified B/C ratio will yield a different value than the conventional B/C method, but the modified procedure can change the magnitude of the ratio, but not the decision to accept or reject the project.
Benefit and Cost Difference
The benefit and cost difference measure of worth, which does not involve a ratio, is based on the difference between the PW, AW, or FW of benefits and costs, that is, B – C.
If (B – C) ≥ 0, the project is acceptable.
This method eliminates discrepancies noted when disbenefits are regarded as costs, because B represents net benefits.
Incremental B/C Analysis
- When comparing mutually exclusive alternatives, the incremental B/C ratio (ΔB/C) must be greater than or equal to 1.0 for the incremental equivalent total cost to be economically justified.
- The selection rule is as follows: if ΔB/C ≥ 1.0, choose the higher-cost alternative, because its extra cost is economically justified.
- The incremental B/C ratio is determined using PW, AW, or FW calculations.
- To perform an incremental B/C analysis, the alternatives are ordered by equivalent total cost, and the alternatives are compared in pairs, starting with the two lowest cost alternatives.
- If the incremental B/C ratio is greater than or equal to one for the higher cost alternative in a pair, then that alternative is retained for comparison with the next highest cost alternative. If the incremental B/C ratio is less than one, the lower cost alternative is retained.
- This process is repeated until a final alternative is chosen. The process parallels that for incremental rate of return analysis.
Special Considerations
- All costs have a positive sign in the B/C ratio.
- The ordering of alternatives is done on the basis of total costs in the denominator of the ratio.
- If two alternatives have equal costs (yielding a ΔB/C of infinity), the alternative with the larger benefits is selected by inspection.
- When alternatives have unequal lives, the use of PW or AW to determine the equivalent costs and benefits requires that the least common multiple (LCM) of lives be used to calculate ΔB/C.
Note: Public sector economics are substantially different from those of the private sector. The benefit/cost (B/C) ratio was developed, in part, to introduce objectivity into the economic analysis of public sector evaluation. Public sector projects can have ethical aspects. The examples in the sources include straightforward identification of benefits, disbenefits, and costs, but in actual situations, judgments are subject to interpretation. In public projects, benefits are usually offset by approximately equal disbenefits.
Service Sector Projects
- Service projects develop economic value largely based on the intangibles of the services provided to users, not the physical items associated with the process or system.
- Evaluation by B/C analysis can be difficult with no good way to make monetary estimates of benefits.
- Cost-effectiveness analysis (CEA) combines cost estimates and a nonmonetary effectiveness measure (the benefit) to evaluate independent or mutually exclusive projects using procedures that are similar to incremental rate of return and B/C analysis.
Relationship to Other Methods
- The B/C analysis can use equivalency computations based on PW, AW, or FW values.
- The B/C ratio can be used to make an accept/reject decision about a single project in the same way as the PW criterion.
- When comparing mutually exclusive alternatives, the B/C criterion leads to the same selection as the PW criterion.
- Incremental B/C analysis can be used to select the best of multiple alternatives.
- The profitability index (PI) is similar to the benefit-cost ratio. It considers only the initial capital expenditure as cash outlay, and the ratio of the present value of the future expected net benefit cash flows divided by the amount of the equivalent initial investment.
Limitations
- By the very nature of benefits and especially disbenefits, monetary estimates are difficult to make and will vary over a wide range.
- The B/C value could change considerably if disbenefits are regarded as costs.
