Cost-benefit analysis is a data-driven decision-making process that helps to determine whether a project or business decision makes sense. The process involves identifying the costs and benefits of the proposed decision, assigning monetary values to each, and comparing them.
Once the framework and categories have been established, it’s time to begin crunching numbers. This includes determining the net present value of cashflows, and applying discount rates as necessary.
Microeconomics
Whether they realize it or not, consumers and companies use microeconomic principles when making decisions. They balance costs and benefits when deciding which product to buy, how much to charge for it, or where to shop. This is because microeconomics examines the smallest units of the economy such as households, consumers and businesses (or firms).
The most basic principle of cost-benefit analysis is that an action should be undertaken only if its benefits exceed its costs. However, a more sophisticated cost-benefit analysis requires more research into unpredictable expenses and understanding different types of benefits and effects. It also involves sensitivity analysis and discounting of cashflows to incorporate time value into the analysis.
Another important consideration is opportunity cost, which includes the benefits that could have been realized if a different course of action had been chosen. This is a key factor in determining whether a project should be pursued or not. It can be calculated using the NPV formula.
Macroeconomics
The principles of macroeconomics are based on the behavior of large aggregates like national income, growth, unemployment, and inflation. These aggregates are influenced by the decisions of individuals and firms. Macroeconomics also studies the interaction between prices and other factors, such as monetary policy. It is considered a more difficult discipline, but it can help with better understanding the ramifications of economic choices.
Cost-benefit analysis is a common tool used by businesses to make decisions. The process starts with identifying the costs and benefits of a project, which is important for determining its scope. This includes both direct and indirect costs, as well as intangible effects. It is important to include all the costs and benefits in a cost-benefit analysis, including unpredictable costs.
Once the costs and benefits are tallied up, it is easy to see whether or not a project is worthwhile. If the total benefits outweigh the total costs, then it makes sense to proceed with the project.
Benefit-Cost Ratio (BCR)
BCR is a simple and powerful measure of a project’s feasibility. It is based on the idea that any value generated by a project must be greater than its cost. However, the reliability of a BCR depends heavily on assumptions such as cash flow forecasting and an appropriate discount rate. It can be a useful starting point, but it should be used in conjunction with other ratios and further analysis.
In a BCR, benefits and costs are defined as monetary cash flows stemming from a business forecast. These may include sales, savings, increases in the value of assets or interest payments received. Costs are defined as initial investments, ongoing expenses, disposal costs and administrative costs.
A BCR over 1.0 suggests that on a broad level, a project should be financially successful; a BCR below 1.0 indicates that costs trump benefits. The PMI Project Management Body of Knowledge lists BCR as one of the project success indicators.
Net Present Value (NPV)
The net present value of a project is the sum of all future cash inflows minus the cost of the initial investment. It is the preferred metric for project managers when deciding which projects should be prioritised and allocated scarce investment budgets.
The advantage of NPV is that it takes the time value of money into account by translating future cash flows into today’s dollars. However, it relies on accurate assumptions about the timing and size of cash inflows and outflows. It also requires a rational choice of discount rate which should reflect the project’s true risk premium.
Other popular metrics for comparing projects include the internal rate of return (IRR) and the payback period, which does not consider the time value of money. Nevertheless, the NPV is still the best measure of an investment’s profitability. The higher the NPV, the more profitable the project. It also represents the most socially optimal and resource efficient outcome.