Today we will discuss cost-benefit analysis in project management. This technique is also known as benefit-cost analysis, cost-benefit ratio, project cost analysis, etc.
It is rare for an organization to have unlimited resources, so they routinely must choose the best option from all the opportunities available. One of the ways organizations make these decisions is by using cost-benefit analysis.
This technique is also very helpful when deciding on a new course of action.
Cost-benefit analysis has a vast scope, and explaining it in one blog post is not easy, so I will provide a preliminary outline of this project’s cost analysis technique.
Cost-Benefit Analysis
Cost-benefit analysis is a benefit measurement method usually performed by top management.
This technique is useful during the feasibility study to determine if the project is worth taking.
Also, cost-benefit analysis helps management select the right project from multiple options during the project selection analysis. They gather data, analyze all the projects, and then try to discover which project is more profitable.
Cost-benefit analysis provides valuable information, such as:
- Expected Profit
- Time value of the profit
- The basis for comparing the projects
Expected Profit
The cost-benefit analysis finds and converts the benefits into monetary values. Then, the investment costs are subtracted from the benefits to get the result.
You can proceed if the result is positive; if not, abandon the idea.
For instance, suppose your company is involved with manual bookbinding, and you propose that management buy equipment to improve efficiency.
Before submitting the proposal, you will perform a cost-benefit analysis. You will list the costs of the investment.
For example:
- Machine cost
- Maintenance cost
- Cost of electricity used by these machines
Then you will identify the benefits, such as
- Profit from improved production
- Cost of reduced workforce
- Cost of the better-quality product
You will figure out the investment cost and the monetary value of the benefits.
You will then perform the cost-benefit analysis by subtracting investment cost from the benefits. Use this figure with management to justify your proposal.
Time Value of the Profit
In cost-benefit analysis, you calculate the expenditure and the expected profit. Remember that profit earned after several years will not have the same value as today, so consider inflation while analyzing the cost. Inflation erodes the value of money, so your profits won’t go as far.
For example, assume a 5% inflation yearly. What you can buy for 100 USD today will cost 105 USD after one year.
Calculating the Current Worth
Assume that you invest 100,000 USD in a project. You expect to earn a 10,000 USD profit after one year.
Considering yearly inflation of 5%, what will the current value be?
The formula to find the Current Value is
FV = CV(1+r/100)^n
Here,
FV = Future Value
CV = Current Value
r = Inflation
n = time
Given values,
FV = 10,000 USD
r = 5
n =1
Putting these values in the formula,
10,000 = CV(1+0.05)^1
CV = 10,000/1.05
CV = 9,523.80
Therefore, the current value of your profit is 9,523.80 USD.
There is no specific cost-benefit analysis formula; however, simple equations can provide accurate information.
The Basis to Compare the Projects
Cost-benefit analysis helps you select the best project when faced with many options. Here you compare the profit earned from each project in current values and choose the one with the highest profit.
If it is a multi-year project, you will not realize a profit in today’s value. You may hope you will profit from it; however, a Net Present Value (NPV) analysis could be eye-opening and worth doing.
The Advantages of Cost-Benefit Analysis
Cost-benefit analysis has many advantages. It helps organizations conduct feasibility studies and select prudently from many choices. It is also useful when an organization takes a new course of action. This analysis has several basic advantages:
- It justifies selecting a project.
- It helps to compare the cost invested and benefits.
- It provides a baseline for comparing available options.
- It compares future earnings with today’s dollar value.
- It helps select the most profitable project.
Limitations of Cost-Benefit Analysis
The benefit-cost analysis has a few limitations.
It is useful for small projects with shorter durations. As the duration increases, this technique gets more complex and unwieldy. Bigger projects are more difficult; converting intangible costs is not easy, so this technique is no longer useful.
As the project grows more complex, intangible costs and benefits rise. Converting these costs and benefits into monetary form is not an easy task. Inflation plays an important role in longer projects. Also, the greater the project duration, the greater the risks.
Summary
The cost-benefit technique is a systematic approach to calculate the investment cost and received benefits. It is a simple technique that lets you know if you should proceed with the project or which project you should select among many.
Cost-benefit analysis is an important concept from a PMP exam point of view. Make sure you fully understand it.
How do you use cost-benefit analysis in your organization? Please share your thoughts in the comments section.
I am Mohammad Fahad Usmani, B.E. PMP, PMI-RMP. I have been blogging on project management topics since 2011. To date, thousands of professionals have passed the PMP exam using my resources.
Wow, a great way to put a lot of my questions and the proactive responsibility and tie it all in. Very helpful, thank you!
Please permit me to ask few questions here. Before I get confused. Shortly before I came across your blog, I have learnt that Cost benefit analysis also known as Return on Investment (ROI) can be calculated using this formula: (G-C)/C=ROI.
However, you gave FV=CV(1+r/100)^n as the formula for calculating the Future value of a project/current worth.
The question is looking at the two formulae above, one tends to measure ROI in percentage while the other, the current worth.
During an examination, how can we know which of the formulae to use?
Thank you
Cost/Benefit analysis is conducted in steps. Step one is the calculate the cost and benefits in today or current prices. That is,
the incremental gains G (or benefits) minus the incremental costs C divided by the costs C {(G-C)/C} to estimate the Return on Investment (ROI) The rule of thumb is that a project that gives a positive ROI is acceptable. +ROI means that for every unit of currency expended, you are receiving a higher sum in return.
However the formula {(G-C)/C} is a simplified statement of the true picture of project inflows and outflows, which come at different times in the life of the project. There is need to account for the time value of money. A unit of inflow or outflow today is rated more than the flows a year or more from now. Future flows or values (FV) are discounted at a given discount rate (r) to give a their current values (CV) to arrive at a Net Present Value (NPV). A project with a positive NPV is acceptable. The discount rate (r) at which the NPV=0 is called the Internal Rate of Return (IRR). A project is acceptable if the IRR is more than the ongoing savings interest rate. What that means is that, all things being equal, it is better to invest your money in a project than put it in the bank, and vice versa.
Simply, use the (G-C)/C formula to illustrate project cost/benefit analysis without consideration of the time value of money.
Thank you, it was very helpful to learn how intangible costs and inflation impact the overall CBA.
I’m commenting on this one:
“There is no specific cost-benefit analysis formula; however, simple equations can provide accurate information.”
There is actually! The ‘Engineering Economics’ provides pre-defined different types of solutions on how to calculate net value, whether it is present to annual, future to present, etc. The equations and calculations are pretty simple to follow and implement. I recommend everyone reading this to watch some videos on Youtube about this interesting discipline.
Thanks a lot Fahad for the great content.
Thank you. It was well put out, which encouraged ease in assimilation for me.
Thank you for sharing. It is really helpful for me as a project manager.
How do you quantify intangible benefits? are there standard procedures to do that?
Thank you for the valuable information, you’ve done great job by helping people, this our Mission as a human.
Thank you again
.
This blog has taught me so much. I am a newbie learning project management to hone my skills.
Thanks, Fahad. You made this very easy to understand.
you are doing good work bro.. thank you
thank you great blog!!!
I am an newbee in the field… still studying. How I do appreciate that analyzing the budget for a project prior to beginning it is an important part of the foundation we call project initiation.
Analyzing the expected cost and profits is a good strategy in all cases, provided that it is undertaken before the start of the implementation of the project to determine the extent of its economic feasibility for the company in addition to anticipating the general economic situation and making an account for the economic, technological and political market grades
Does this technique is performed outside of the project boundaries by senior management to determine if they should proceed with the project or terminate??
How can we say that benefit/cost analysis is done in initiation phase??? Because in initiation phase, we already get the selected project for which charter is developed.
This analysis is performed by the project sponser to see if it fulfills his objective.
Initiation phase and Initiation process groups are different. What you are talking is, initiation process group, not initiation phase.
How we can convert Benefit Cost Analysis into Monetary value or funds or money before submitting our proposal or project to the management?
Hello Tauseef, please refer below blog post:
https://pmstudycircle.com/2014/03/project-selection-methods/
Cost benefit analysis is performed during Initiating process group. I believe it falls under project integration management knowledge area.
Cost Benefit Analysis belongs to which process knowledge area
Thanks
Nice & simple blog. Thank u Fahad.
Thanks Ajay for your comments. See you again…