Cost/benefit analysis gives a picture of the various costs,benefits and rules associated with each alternative system. Costs and benefits are classified as:1. Tangible & Intangible costs and benefits2. Direct & Indirect costs and benefits3. Fixed & variable costs and benefits
Cost/benefit analysis is done with the following procedure:1. Identifying the costs and benefits related to the project.2. Categorising the various costs and benefits for the analysis.3. Selecting a method of evaluation.4. Interpreting the result of an analysis.5. Taking action.
When all the financial data have been identified, the analyst has to select a method of evaluation. Based on that evaluation,the result has been interpreted. On the basis of the interpreted result, an action has been taken for the alternative system of an organisation.
1. Net Benefit Analysis2. Present Value Analysis3. Net Present Value4. Payback Analysis5. Break-even Analysis6. Cash-flow Analysis
It involves subtracting total cost from total benefits i.e. Net Benefit=Total Benefit – Total Cost.
Advantages: It is easy to calculate. It is easy to interpret. It is easy to present.Disadvantage: It does not account for the time value of money.
Present Value analysis is used for long-term projects where it is difficult to compare today’s cost with the benefits of tomorrow. In this method cost and benefits are calculated in terms of today’s value of investment. The present value analysis determines how much money is invested now in order to receive a given return in some year’s time.
The present value can be computed through the formula: F=P(1+i)^n So, P=F/(1+i)^nE.g. The present value of Rs1500(which is estimated future value) invested at 10% interest at the end of fourth year is: P=1500/(1+.10)^4 =1500/1.61=Rs 1027.39i.e. if we invest Rs1027.39 today at 10% interest, we can expect to have Rs1500 in four years.
Year Estimated Present Cumulative future vale value present value of benefits1 Rs 1500 Rs 1363.63 Rs 1363.632 Rs 1500 Rs 1239.67 Rs 2603.303 Rs 1500 Rs 1127.82 Rs 3731.124 Rs 1500 Rs 1027.39 Rs 4758.51It shows that present value of a stream of estimatedfuture values of Rs. 1500 each for the next 4 yearsafter discounting for 10% is Rs. 4758.51
Advantages: It is easy to calculate. It equates different investment opportunities with various costs and benefits and discount rates. It accounts for time value of money.Disadvantage: It is only a relative(not absolute) measure of a project’s return on investment.
The present value analysis when carried out for the net benefits is called NET PRESENT VALUE(NPV). Its equal to benefits minus costs. It is expressed as percentage of the investment. NET PRESENT VALUE(%)=BENEFITS-COSTS
Example:Suppose a company invested Rs 3000 for a microcomputer that yields a cumulative benefit of Rs 4758.51. So, net present value(gain) of Rs 1758.51.The net present value is expressed as a percentage of the investment. Therefore, 1758.51/3000=0.55=55%
Advantages: It is relatively easy to calculate. It accounts for time value of money.Disadvantage: It is only a relative(not absolute) measure of a project’s return on investment.
When a project is started, costs are incurred while the benefits take time to start. Payback analysis is to determine how long it will take for a project when the accumulated benefits equal the benefits used. Payback analysis defines the period required to recover the money spent on a project. This period is called the payback period. The shorter the period ,the faster the benefits.
Advantage: It is easy to calculate. It has straightforward interpretation for choice between two or more alternatives for candidate system.Disadvantages: It is conservative economic measure applied to one opportunity at a time. It does not compare profitability of multiple investment alternatives. It does not allow for time value of money.
Break-even analysis is a technique which compares the costs of using present and candidate systems. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume. Sales value or production at which the business makes neither a profit nor a loss is known as the "break- even point".
It is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines.
Advantage: It is easy to understand.Disadvantage: It does not allow for time factor and depreciation value of money.
Cash flow analysis deals with the timing and amount of cash inflows/outflows from a firm or an investment. Cash flow analysis keeps tracks of accumulated cost and revenues on regular basis.
It is simply calculated by deducting the operating cost from revenues created from investment on a period-by-period basis and then calculates the accumulated cost. Cash flow =Revenue – operating ExpensesAccumulated Cash Flow=Cash Flow (month 1) + Cash Flow(month 2) +…+Cash Flow(month n).
Advantage: It combines benefits of both break-even and payback method.Disadvantages: Ignores time value of money for limited time period. It does not take into account the probability of the project. Ignores behavioral implications of numbers in the financial statement.
Once the evaluation of the project is complete, actual results are compared against standards or alternative investments. The decision to adopt an alternative system can be highly subjective, depending on the analyst’s or user’s confidence in the estimated cost and benefit values and the magnitude of the investment.
1. Net Benefit Analysis is calculated through(a) Total cost –Total benefit(b) Total benefit – Total cost(c) Total cost + Total benefit2. What is “break-even” point?(a) Profit with loss.(b) No profit but loss(c) Profit but no loss(d) Neither profit nor loss
3. What is the formula for calculating future value of a project?(a) F=P(1+i)^n(b) F=P/(1+i)^n(c) F=P^n/(1+i)(d) None of the above.4. Tangible cost can be(a) Measured(b) Identified(c) All of above
5. “Cost of breakdown of an online system during banking hours will cost the bank to lose deposit” is an example of(a) Tangible cost(b) Indirect cost(c) Variable cost(d) Intangible cost