Cost/benefit analysis gives a picture of thevarious costs,benefits and rules associatedwith 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 thefollowing procedure:1. Identifying the costs and benefits related tothe project.2. Categorising the various costs and benefitsfor the analysis.3. Selecting a method of evaluation.4. Interpreting the result of an analysis.5. Taking action.
When all the financial data have beenidentified, the analyst has to select a methodof evaluation. Based on that evaluation,the result has beeninterpreted. On the basis of the interpretedresult, an action has been taken for thealternative 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 totalbenefits i.e.Net Benefit=Total Benefit – Total Cost.
Example of net benefit analysis.
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 ofmoney.
Present Value analysis is used for long-termprojects where it is difficult to comparetoday’s cost with the benefits of tomorrow. In this method cost and benefits arecalculated in terms of today’s value ofinvestment. The present value analysis determines howmuch money is invested now in order toreceive a given return in some year’s time.
The present value can be computed through theformula:F=P(1+i)^nSo, P=F/(1+i)^nE.g. The present value of Rs1500(which isestimated future value) invested at 10% interestat 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 fouryears.
Year Estimatedfuture valePresentvalueCumulativepresentvalue ofbenefits1 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 opportunitieswith various costs and benefits and discountrates. It accounts for time value of money.Disadvantage: It is only a relative(not absolute) measure of aproject’s return on investment.
The present value analysis when carried outfor the net benefits is called NET PRESENTVALUE(NPV). Its equal to benefits minus costs. It isexpressed as percentage of the investment. NET PRESENT VALUE(%)=BENEFITS-COSTS
Example:Suppose a company invested Rs 3000 for amicrocomputer that yields a cumulativebenefit of Rs 4758.51. So, net presentvalue(gain) of Rs 1758.51.The net present value is expressed as apercentage 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 aproject’s return on investment.
When a project is started, costs are incurredwhile the benefits take time to start. Payback analysis is to determine how long itwill take for a project when the accumulatedbenefits equal the benefits used. Payback analysis defines the period requiredto recover the money spent on a project. Thisperiod is called the payback period. Theshorter the period ,the faster the benefits.
Advantage: It is easy to calculate. It has straightforward interpretation forchoice between two or more alternatives forcandidate system.Disadvantages: It is conservative economic measure appliedto one opportunity at a time. It does not compare profitability of multipleinvestment alternatives. It does not allow for time value of money.
Break-even analysis is a technique whichcompares the costs of using present andcandidate systems. It is based on categorizing production costsbetween those which are "variable" (costs thatchange when the production output changes)and those that are "fixed" (costs not directlyrelated to the volume of production).
Total variable and fixed costs are comparedwith sales revenue in order to determine thelevel of sales volume. Sales value or production at which thebusiness makes neither a profit nor a loss isknown as the "break- even point".
It is a graphical representation of costs atvarious levels of activity shown on the samechart as the variation of income with thesame variation in activity. The point at which neither profit nor loss ismade is known as the "break-even point" andis represented on the chart below by theintersection of the two lines.
Advantage: It is easy to understand.Disadvantage: It does not allow for time factor anddepreciation value of money.
Cash flow analysis deals with the timing andamount of cash inflows/outflows from a firmor an investment. Cash flow analysis keeps tracks ofaccumulated cost and revenues on regularbasis.
It is simply calculated by deducting theoperating cost from revenues created frominvestment on a period-by-period basis andthen calculates the accumulated cost.Cash flow =Revenue – operating ExpensesAccumulated Cash Flow=Cash Flow (month 1)+ Cash Flow(month 2) +…+Cash Flow(monthn).
Here the payback period is of 3 years.
Advantage: It combines benefits of both break-even andpayback method.Disadvantages: Ignores time value of money for limited timeperiod. It does not take into account the probabilityof the project. Ignores behavioral implications of numbers inthe financial statement.
Once the evaluation of the project iscomplete, actual results are compared againststandards or alternative investments. The decision to adopt an alternative systemcan be highly subjective, depending on theanalyst’s or user’s confidence in theestimated cost and benefit values and themagnitude 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 futurevalue 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 systemduring banking hours will cost the bank tolose deposit” is an example of(a) Tangible cost(b) Indirect cost(c) Variable cost(d) Intangible cost