For small businesses, running a benefit-to-cost calculation is a bit like looking into a crystal ball. It allows you to scope out the long-term benefits of a particular project against the costs associated with that project. A good benefit-to-cost analysis measures both the monetary and non-monetary aspects of the project because sometimes a project's value cannot be understood in purely quantitative terms.
The benefit-to-cost ratio identifies whether a project will be profitable to the business.
What is the Benefit-to-Cost Ratio?
The BCR is a financial ratio that's used to weigh up whether the amount of money made through a project will be greater than the costs incurred in executing the project. If the costs outweigh the benefits, then the project does not deliver value for money under the assumed conditions. The benefit-to-cost ratio has two elements: the benefits of a project or proposal, and the costs of the project or proposal. Qualitative factors, such as the benefit a project might have to society, should be expressed in monetary terms where possible to ensure an accurate result.
Understanding the Net Present Value
All cost-benefit analyses turn on the present value of the project's cost and benefit. Present values are included because it's assumed the money you have now is worth more than the same amount of money in the future, due to the effects of inflation. You calculate the net present value using the formula:
NPV = value / (1 + r)^t
- "r" is the discount rate such as the rate of inflation.
- "t" is the service life of the project, that is, the period the project will provide benefits.
As an example, let's assume you're thinking about replacing a key piece of manufacturing equipment. The equipment costs $625,000 to purchase. The rate of inflation is 3 percent, and upgrading the equipment is expected to boost your profits by $220,000 a year for each of the next three years. The net present value of the project's benefits is $622,294.49, calculated as follows:
- Year one: $220,000 / (1 + 0.03)^1 = $213,592.23
- Year two: $220,000 / (1 + 0.03)^2 = $207,371.1
- Year three: $220,000 / (1 + 0.03)^3 = $201,331.16
NPV = $213,592.23 + $207,371.10 + $201,331.16 = $622,294.49.
How to Calculate the Benefit-to-Cost Ratio
The benefit-cost ratio formula is the discounted value of the project's benefits divided by the discounted value of the project's costs:
BCR = Discounted value of benefits/ discounted value of costs.
You'll need to use the NPV formula above or a benefit-cost ratio calculator online to help you find the discounted value of each cost and benefit. In the above example, the total cost is just the initial investment of $625,000 – there's no discount to calculate since you're paying the whole amount upfront. The discounted value of the benefits is calculated as $622,294.49. Divide benefits by costs for a cost-benefit ratio of 0.995.
What It All Means
A BCR equal to one suggests a cost-neutral project. The business will neither make nor lose money if it green-lights this scheme. A BCR greater than one is a positive return. The business should consider moving forward with this project, especially if the BCR is significantly greater than one. A BCR less than one means the costs outweigh the benefits and the project would run at a loss. In the previous example, the project achieved a BCR of 0.995 which means that the project's costs marginally outweigh its benefits. Executing this project would return only 99.5 cents in benefits for each dollar spent.
Had you not adjusted for inflation, the project benefits would total $660,000 ($220,000 per year for three years). Dividing $660,000 by $625,000 gives a positive cost-benefit ratio of 1.056. The result would be skewed.