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 cost analysis technique.
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, during the project selection analysis, cost-benefit analysis helps management select the right project from multiple options. They gather data and 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
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 the cost-benefit analysis. You will list the costs of the investment.
- 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 benefits.
You will then perform the cost-benefit analysis by subtracting the cost of investment 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
FV = Future Value
CV = Current Value
r = Inflation
n = time
FV = 10,000 USD
r = 5
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 you with 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 then 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 the 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.
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.