We all expect to gain some benefits from the projects we undertake. Otherwise, what would be the point of going through all the trouble? Given that it takes up resources to undertake and complete a project successfully, you should have a way of establishing what you will get back compared to what you are spending on it.
This is where the benefit-cost ratio comes in. In this article, we answer all your questions on this financial business technique. We will look at what it is, when to calculate the benefit-cost ratio, why it is essential, and how to calculate this ratio. We will also look at a few advantages and disadvantages of a benefit-cost ratio.
Keep in mind that you need this to plan your finances properly. Please stick to the end of the article to learn how BCR can be a game-changer for your business when undertaking projects and how it enables you to save on the project’s costs and maximize the benefits.
What is Benefit-Cost Ratio?
The benefit-cost ratio is what you gain from the project against the project cost. This financial technique allows you to assess the project’s viability based on the intended expenditure and the benefits you expect to get back.
It is essential to keep in mind that sometimes, it can be challenging to determine a project’s benefits. A good example is projects meant to impact communities, whose benefits are more of a qualitative nature. Even so, employee cost per hour should be factored into the equation. Knowing this can help organizations determine how much they will need to invest in a project and how long it will take for that investment to pay off. However, if the project was for a business and the expected benefits are in monetary value (in revenue form), having a strategic plan that discusses the BCR is paramount.
A benefit-cost ratio allows you to know whether your strategic plan towards the project is viable or not. A BCR can either be positive or negative. A positive ratio is where you get a value of more than one, while a negative gives you a value of less than one. A positive ratio means that the project is worth the money plowed into it. On the other hand, a negative benefit-cost ratio implies that the project is losing money and is, therefore, a bad investment. If you get a BCR of 1, then it is even, meaning that the project will give back the same value of benefits as the amount spent on it.
When to Calculate Benefit-Cost Ratio
As mentioned before, BCR helps you to plan your finances and ensure that you get the most benefit from your project. Therefore, we recommend that you calculate the benefit-cost ratio of your project before commencing. It would be best if you did it in the project’s planning stage to give you the go-ahead.
Therefore, once you have a budget and the planned allocations for every phase of the project and the entire project, determine the expected returns before starting the project. By calculating the benefit-cost ratio from the onset, you can decide if the project is worth the investment and risks or if it will be a waste of money.
The benefit-cost ratio will save you a lot of money since once you note a project will be a loss to your business, you have the opportunity to come up with a new strategy to benefit the organization and bring in profits.
Why it is Important to Calculate Benefit-Cost Ratio
A benefit-cost ratio will help you know the overall value of money for the project you are about to undertake. This is important and makes the BRC a profitability index for you. You will therefore know how to budget and plan your finances appropriately.
Calculating the benefit-cost ratio allows you to make better investments and not just plow money into every project idea you come across. The higher the benefit-cost percentage, the more returns you get.
How to Calculate Benefit-Cost Ratio
To come up with an accurate benefit—cost ratio that will help you make the best decisions, you need to use cost-benefit analysis. This process allows you to arrive at the correct ratio by weighing the sum of the benefits you will get from a project versus the costs you incur. It is not as complex as it sounds, and you will soon realize that you can execute it in an instant.
Therefore, divide the benefits expected from the project with the costs to be incurred. That is, b/c.
When conducting the analysis, it would be best to account for everything, both the direct and indirect benefits. For the costs, do not forget to account for the opportunity cost. This way, you will get a more accurate ratio when performing the analysis as it will reflect a sum of all the benefits and all the costs.
So far, everything seems simple and easy. However, there are a few steps you need to stick by for an accurate ratio representation. Let us discuss them below.
- Have a compiled list
When analyzing to get the benefit-cost ratio, the first step to getting the most accurate results is to have a compiled list of all the costs you expect to incur when undertaking the project. Ensure that this accounts for the tangible things like raw material and the opportunity cost, just like we mentioned. What do we mean by opportunity cost? It is what you stand to gain or lose by picking one item over the other.
Like costs, have a list of all the benefits you stand to gain should the project be completed successfully. Just like you did for the expenses, also remember to include the intangible benefits.
- Attach monetary value to the costs and benefits
Once you have a comprehensive list of the costs and benefits, you need to assign each cost and benefit monetary value. This applies to both the tangible and intangible aspects of both. For instance, if buying new equipment will cost you 100,000 USD, add that value to costs. However, if it takes 4 hours to set up the equipment, the employees won’t be working for those 4 hours, which means that time will be lost, standing in the way of money that you could have generated. Therefore, ensure that you conduct comprehensive calculations and attach the figures to the list you have.
- Use the Equation and Calculate
As we stated above, the formula for deriving the benefit-cost ratio is b/c. Once everything is in order, compound the sum total of all the benefits and divide it by the sum of all the costs. Keep in mind that this is a numerical equation.
If the benefits outweigh the costs, then that project is a wise investment, and you can proceed. However, if the costs outweigh the benefits, it would be best to take a step back, reconsider and make necessary adjustments.
Benefit-Cost Ratio Examples
Majimbo Company decides to expand and acquire new equipment. They need to run a benefit-cost ratio to determine whether it is wise to expand or not. Revenue is expected to increase by 50% if they acquire the new equipment.
In terms of cost, the new equipment is estimated to cost 80,000 USD. Recruitment for new employees will cost 4,000 USD, and training on usage and handling of the new equipment will cost an additional 4,000 USD. New workspace would cost 3,000 USD while licensing the equipment will need another 4,000 USD. This brings the total costs to 95,000 USD.
In terms of benefits, the company expects an increase in the yearly revenue by 120,000 USD. Customer satisfaction is also likely to increase by 10%, estimated at a value of 10,000 USD. Therefore, the total benefits are 130,000 USD.
Since the value you get is positive, the investment is worth it, and Majimbo Company can expand.
Goro Realtors want to undertake a project of building new rental complex buildings. The complex will have eight houses. In terms of cost, sourcing all raw materials is estimated to cost 800,000 USD. The designs will cost an estimated 5,000 USD. The contractor approached to undertake the project seeks to be paid 100,000 USD. Therefore, the total costs will amount to 905,000 USD.
Once the apartment complex is complete, Goro Realtors want to sell each apartment for 100,000 USD. Goro Realtors will get a total of 800,000 USD from selling the house.
Since the value is negative, this means that the project is a bad investment for Goro Realtors. They will have to go back to the drawing board and find a new strategy for undertaking the project, ensuring that they benefit from it. They could either find cheaper options for sourcing the raw materials or negotiate with the contractor to cut down on the cost. They could also find alternative ways of increasing value for the finished apartment complex to sell at a higher price, thereby increasing the benefits/returns.
Advantages of Benefit-Cost Ratio
- It offers clarity when undertaking the project.
You cannot just cook up a benefit-cost ratio. You need to have a comprehensive list that accounts for all specifics of the project. For the costs, you will be able to pinpoint what exactly you are spending. Therefore, this tool allows you to account for all money flowing in and out. Even though it may be challenging to do this for unpredictable costs or emergencies, you will always find that there will be unforeseen benefits at the end of the project. Therefore, they balance out.
- You can determine the viability of the project
If you account for everything, that is, the direct and indirect costs and benefits, you can calculate the BCR almost accurately, giving you a very educated guess. This will provide you with an insight on what to expect, and the end goal will be more precise, which will, in turn, boosts your confidence as you undertake the project and guarantees success.
Disadvantages of Benefit-Cost Ratio
- It can create a false sense of confidence.
It is essential to keep in mind that a BCR is used to evaluate risks. In as much as it may help ensure you are on the right track for success, it is not always a 100% assurance since there are many variables involved in a project. This means that a benefit-cost ratio of more than one shows higher chances of success and not 100% guaranteed success. Unfortunately, some people get a false sense of confidence with a higher BCR and end up failing.
- It can be challenging to account for all indirect benefits
During the initial calculation of the BCR, it may prove challenging to factor in all indirect benefits as some are unnoticeable at this point. This is because the business world is dynamic, and each new day presents new ways of capitalizing on opportunities, thereby raking in more revenue. For instance, new methods may come up using social media to make money that you may not be aware of when calculating the BCR. In addition to that, some benefits may be challenging to attach a monetary value to.
A benefit-cost ratio is an excellent way for a business to gain insight into a project they want to undertake. You can tell whether the investment is worth it or not using BCR. All you need to do is divide the sum of all the benefits expected to be gained from the project by the costs estimated to be spent on the said project. It would be best to account for indirect and direct costs and benefits for a more accurate benefit-cost ratio.
While BCR boosts your confidence for undertaking a project, as you will have insight into how the success should look, be careful not to get a false sense of faith as it does not automatically guarantee success. A positive BCR only implies that the chances for success are higher, while a negative BCR shows that the project is a bad investment and gives you a chance to go back to the drawing board and make adjustments where necessary. Always find ways of increasing value at the end, whether to the service or product, to ensure you get as many benefits as possible.
I hope that this article has been eye-opening and will improve your chances of success for the next project you undertake.