Cost-Benefit Analysis

cost-benefit analysis?

Cost-benefit analysis is a technique used to evaluate the economic feasibility of a project. It involves comparing the total expected costs of a project to the total expected benefits of the project, and determining whether the benefits outweigh the costs. This analysis helps decision-makers determine whether a project is worth pursuing, and if so, which development strategy is the most economically feasible.

We consider only the three most common methods: payback analysis, return on investment analysis, and present value analysis.

 

 

          Return on investment (ROI). 

Return on investment (ROI) is a financial analysis tool used to measure the profitability of a project by comparing the total net benefits (the return) received from a project to the total costs (the investment) of the project. It is expressed as a percentage rate. A higher ROI indicates a more profitable project.

■In many organizations, projects must meet or exceed a minimum ROI.

■If a company requires a minimum ROI of 15%, for example, then both Projects A and B would meet the criterion.

■ROI can be used for ranking projects. 

Payback analysis  

Payback analysis is the process of determining how long it takes an information system to pay for itself. The time it takes to recover the system's cost is called the payback period. Steps:

■Determine the initial development cost of the system.

■ Estimate annual benefits.

■Determine annual operating costs.

■ Find the payback period by comparing total development and operating costs to the accumulated value of the benefits produced by the system.

When conducting a payback analysis, you calculate the time it takes for the accumulated benefits of an information system to equal the accumulated costs of developing and operating the system. The dashed line indicates the payback period.

PRESENT VALUE ANALYSIS

■The present value of a future dollar is the amount of money that, when invested today at a specified interest rate, grows to exactly one dollar at a certain point in the future.

■To perform present value analysis, adjustment factors for various interest rates and numbers of years can be found in tables called present value tables.

STEPS OF PRESENT VALUE ANALYSIS

To perform present value analysis, you must time-adjust the cost and benefit figures.

■Multiply each of the projected benefits and costs by the proper present value factor

■ Sum all the time-adjusted benefits and time-adjusted costs

■ Calculate the Net Present Value (NPV) of the project, i.e., the

total present value of the benefits minus the total present value of the costs

Any project with a positive NPV is economically feasible. NPV also can be used to compare and rank projects. All things being equal, the project with the highest NPV is the best investment.

Present Value Analysis provides solutions to the shortcomings of payback analysis and ROI.

Unlike payback analysis, present value analysis considers all the costs and benefits, and not just the earlier values.

In addition, present value analysis takes into account the timing of costs and benefits and recognizes the time value of money.

However, companies often use all three methods to get more input for making decisions.

   A company is considering two proposals for a new information system. The ROI for Proposal A is 18% and ROI for Proposal B is 20%. If the company requires a minimum ROI of 15%, which proposal are you going to recommend to the management?

Based on the given information, both proposals have an ROI greater than the minimum required ROI of 15%. However, Proposal B has a higher ROI of 20%, which indicates that it is more profitable than Proposal A. Therefore, I would recommend Proposal B to the management.

 

 Compare ROI with Payback Analysis.

Criteria	ROI	Payback Analysis
Definition	A percentage rate that measures profitability by comparing the total net benefits (the return) received from a project to the total costs (the investment) of the project.	A technique used to determine how long it takes an information system to pay for itself through reduced costs and increased benefits.
Calculation	ROI = (total benefits - total costs) / total costs	Payback period = total costs / annual net cash inflows
Focus	Emphasizes profitability	Emphasizes time
Decision Rule	Higher ROI is better	Shorter payback period is better
Advantages	Considers the entire life cycle of the project	Easy to understand and calculate
Disadvantages	Requires accurate estimation of costs and benefits	Ignores cash flows beyond the payback period