Cost Benefit Analysis

Cost Benefit AnalysisCost Benefit Analysis

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Strategic management is the art of formulating, implementing and cross functional decisions that will enable an organization to achieve its objectives.

Strategic cost management can be defined as" scrutinizing every process within your organization, knocking down departmental barriers, understanding your suppliers' business, and helping improve their processes"

Origin of Cost Benefit AnalyOrigin of Cost Benefit Analysissis In 1936 Congress passed the Flood Control

Act which contained the wording, "the Federal Government should improve or participate in the improvement of navigable waters or their tributaries, including watersheds thereof, for flood-control purposes if the benefits to whomsoever they may accrue are in excess of the estimated costs.“

Economists have influenced and improved the Corps' methods since then and cost-benefit analysis has been adapted to most areas of public decision-making.

COST BENEFIT ANALYSISCOST BENEFIT ANALYSIS

In the cost reduction program the differentiation between necessary costs & unnecessary costs is essential. If necessary costs are reduced, the benefits created by the resources consumed are reduced. Such cost reduction leads lower than required quality, extended delivery periods, increased rejections.

Therefore the effective way of cost reduction is to search for unnecessary costs and eliminate them entirely.

Following steps are involved in establishing the benefits created by resources consumed in the business. The steps are analytical, concerned with separating resources into the appropriate activities and establishing the reasons for their consumption.

CBA is most commonly used for public decisions– policy proposals, programs, and projects, e.g., dams, bridges, traffic circles, riverfront parks, libraries, drunk driving laws, and anything else the government might fund. CBA can be used to rank alternative projects as well as evaluating the social value of one particular project.

Even if CBA is not explicit, any decision, public or private, reveals a cost-benefit calculus consistent with the observed choice.

The CBA could be fully quantitative or qualitative or a mixture of both. The CBA becomes complex when costs and benefits are intangible or notional or long term. Many a times costs and benefits may not be known till execution phase of a project.For eg - A socially relevant project which involve a lot of public intervention.

STEP I Cost Analysis

It involves an analysis of all costs and activities. This can usually be done from any reasonably designed accounting system.

STEP II Contribution Analysis

Analyzing the value of what each activity contributes in terms of income or benefits is important in establishing the real wealth-creating activities of the business.

STEP III Benefit AnalysisCosts are broken down on the basis of the reasons why they are

incurred and then to assess the benefits. Following queries are raised.

Would the contribution of the activity or group of activities be reduced if the reason for spending be eliminated? If answer is no, elimination of the reason for spending should be carefully considered.

Are adequate benefits received from those reasons for spending which are considered necessary? If the answer is no, either the degree of spending should be reduced or benefits increased.

STEP IV Cost Reduction Develop a cost reduction programme by establishing those reasons for incurring cost which:Do not contribute to an activity’s earning potential.Do not create benefitsDo not create adequate benefits for the level of cost.The analyst’s role at this point is two fold:To present the facts & figures objectively.To set an example by reducing unnecessary costs in his own area of resposibility.

STEP V Profit ImprovementDevelop a profit improvement programme by determining those areas which can create additional income from existing and new resources, based on rationalisation and reduced costs of existing activities.

Theory of Cost-Benefit AnalysisTheory of Cost-Benefit Analysis

Public Policy Objective: Choose the level of output of a good or service to maximize net social benefits (NSB)

NSB = TSB – TSC

where

TSB = total social benefits

TSC = total social costs

Marginal Social Benefit (MSB) = additional social benefits from one more unit of output

Marginal Social Cost (MSC) = additional social costs of producing one more unit of output

MSB = d TSB/d QMSC = d TSC/d QQ = quantity of a publicly provided good or service

NSB are max when MSB = MSC Social Decision Rule: Choose Q for which MSB = MSC

COST BENEFIT ANALYSISCOST BENEFIT ANALYSIS

Incremental Cost Benefit Analysis are required for quick conclusions on ongoing business decisions where one cannot waste time because of nature of business.

Eg – Extra credit for a week’s time to a retailer may lead to much higher sales and subsequent profits. In such case the incremental amount of gross profit will have to be compared to incremental or extra cost of credit incurred by the firm. As long as the incremental cost of credit is less than incremental cost of sales the firm can allow extra period for credit.

Contd..Contd..

Sustainable Net Incremental Benefit – It is very often a key Strategic decision. One may agree to incur a loss for initial periods of time with an ultimate eye on large sustainable long term profit.

Eg –Power projects, road projects, Communication projects are some of examples where a firm applies concept of Sustainable Net Incremental Benefit.

COST BENEFIT ANALYSIS (CBA)COST BENEFIT ANALYSIS (CBA)Sustainable Net Incremental Benefit Sustainable Net Incremental Benefit

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Expected Long Term CBA

Qualitative and Quantitative factoQualitative and Quantitative factorsrs

It is difficult to quantify all decisions in monetary terms. Many a times decision is not dictated by Quantitative but Qualitative factors.

For eg – Decision to purchase from outside supplier can result in closure of company’s facilities for manufacturing of a component. This may lead to redundancies and decline morale of employees resulting in low output. Also company may become dependent on outside employer who may not always supply on time. This may lead to the company’s reputation to suffer and may lead to loss of customer goodwill and decline in future sales.

The following non-quantitative factors are to be considered while taking a decision :-

Make/Buy decision ◦ Quality reliability ◦ Adherence to delivery schedule ◦ Continuous source supply ◦ Availability of space if company decided to start

operations in future.

Overtime vs. additional shift - Quality of work on second shift - Training problems of new workers if they are assigned the

second shift. - Balancing trained and new workers in second shift Expand or Contract

Quality should not go down Workers with required level of experience may not be

available

Continued operation vs. Temporary Shut down

- Loss of trained personnel

- Regular customers may be lost

Cost-Benefit Analysis of Delhi Cost-Benefit Analysis of Delhi

MetrMetro o The Delhi Metro provides multiple benefits:

reduction in air pollution, time saving to passengers, reduction in accidents, reduction in traffic congestion and fuel savings. There are incremental benefits and costs to a number of economic agents: government, private transporters, passengers, general public and unskilled labour.

The social cost-benefit analysis of Delhi Metro was done to measure all these benefits and costs from Phase I and Phase Iv projects covering a total distance of 108 kms in Delhi.

conclusionconclusionThe economic benefits from the

reduced number of vehicles on Delhi roads due to the Metro could be identified as the following:

Savings in Foreign Exchange due to reduced Fuel Consumption

Reduction in Pollution

Contd..Contd..Savings in Time for all passengers

using Metro and Roads Savings in Accidents Savings in Vehicle Operating Cost

(VOC) due to decongestion for residual traffic

Savings in Capital and Operating cost of diverted vehicles

Savings in the cost of Road Infrastructure