Evaluation

Evaluation Of Cost/Benefit Analysis

BY:- Varnit Agarwal Navodit Thareja Pranav Mohindru Abhay Rana

Cost/Benefit Analysis Cost/benefit analysis gives a picture of the

various costs,benefits and rules associated with each alternative system.

Costs and benefits are classified as:1. Tangible & Intangible costs and benefits2. Direct & Indirect costs and benefits3. Fixed & variable costs and benefits

Cost/benefit analysis is done with the following procedure:

1. Identifying the costs and benefits related to the project.

2. Categorising the various costs and benefits for the analysis.

3. Selecting a method of evaluation.4. Interpreting the result of an analysis.5. Taking action.

Evaluation of cost/benefit analysis When all the financial data have been

identified, the analyst has to select a method of evaluation.

Based on that evaluation,the result has been interpreted. On the basis of the interpreted result, an action has been taken for the alternative system of an organisation.

Methods of evaluation

1. Net Benefit Analysis2. Present Value Analysis3. Net Present Value4. Payback Analysis5. Break-even Analysis6. Cash-flow Analysis

1. Net Benefit Analysis

It involves subtracting total cost from total benefits i.e.

Net Benefit=Total Benefit – Total Cost.

Example of net benefit analysis.

Contd…

Advantages: It is easy to calculate. It is easy to interpret. It is easy to present.

Disadvantage: It does not account for the time value of

money.

Present Value analysis is used for long-term projects where it is difficult to compare today’s cost with the benefits of tomorrow.

In this method cost and benefits are calculated in terms of today’s value of investment.

The present value analysis determines how

much money is invested now in order to receive a given return in some year’s time.

2. Present Value Analysis

The present value can be computed through the formula:

F=P(1+i)^nSo, P=F/(1+i)^n

E.g. The present value of Rs1500(which is estimated future value) invested at 10% interest at the end of fourth year is:

P=1500/(1+.10)^4 =1500/1.61=Rs 1027.39

i.e. if we invest Rs1027.39 today at 10% interest, we can expect to have Rs1500 in four years.

Contd…

Year Estimated future vale

Present value

Cumulative present value of benefits

1 Rs 1500 Rs 1363.63 Rs 1363.63

2 Rs 1500 Rs 1239.67 Rs 2603.30

3 Rs 1500 Rs 1127.82 Rs 3731.12

4 Rs 1500 Rs 1027.39 Rs 4758.51

Example: Present value Analysis using 10% interest rate(discounted)-Four-year summary

It shows that present value of a stream of estimated future values of Rs. 1500 each for the next 4 years after discounting for 10% is Rs. 4758.51

Advantages: It is easy to calculate. It equates different investment

opportunities with various costs and benefits and discount rates.

It accounts for time value of money.

Disadvantage: It is only a relative(not absolute) measure of

a project’s return on investment.

The present value analysis when carried out for the net benefits is called NET PRESENT VALUE(NPV).

Its equal to benefits minus costs. It is expressed as percentage of the investment.

NET PRESENT VALUE(%)=BENEFITS-COSTS

3. Net Present Value

Example:Suppose a company invested Rs 3000 for a

microcomputer that yields a cumulative benefit of Rs 4758.51. So, net present value(gain) of Rs 1758.51.

The net present value is expressed as a percentage of the investment. Therefore,

1758.51/3000=0.55=55%

Contd…

Advantages: It is relatively easy to calculate. It accounts for time value of money.

Disadvantage: It is only a relative(not absolute) measure of

a project’s return on investment.

When a project is started, costs are incurred while the benefits take time to start.

Payback analysis is to determine how long it will take for a project when the accumulated benefits equal the benefits used.

Payback analysis defines the period required to recover the money spent on a project. This period is called the payback period. The shorter the period ,the faster the benefits.

4. Payback Analysis

The table below shows the example of Payback Analysis.

Contd…

Year1 Year2 Year3 Year4 Year5

Initial cost 10000

Operating cost

1000 1000 1000 1000

Total cost 10000 1000 1000 1000 1000

Cumulative cost

10000 11000 12000 13000 14000

Benefits 0 5000 5000 5000 5000

Cumulative benefits

0 5000 10000 15000 20000

Advantage: It is easy to calculate. It has straightforward interpretation for

choice between two or more alternatives for candidate system.

Disadvantages: It is conservative economic measure applied

to one opportunity at a time. It does not compare profitability of multiple

investment alternatives. It does not allow for time value of money.

5. Break even Analysis

Break-even analysis is a technique which compares the costs of using present and candidate systems.

It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

Contd…

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume.

Sales value or production at which the business makes neither a profit nor a loss is known as the "break- even point".

The Break-even chart

It is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income with the same variation in activity.

The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines.

Advantage: It is easy to understand.

Disadvantage: It does not allow for time factor and

depreciation value of money.

6. Cash-flow Analysis

Cash flow analysis deals with the timing and amount of cash inflows/outflows from a firm or an investment.

Cash flow analysis keeps tracks of accumulated cost and revenues on regular basis.

Contd…

It is simply calculated by deducting the operating cost from revenues created from investment on a period-by-period basis and then calculates the accumulated cost.

Cash flow =Revenue – operating ExpensesAccumulated Cash Flow=Cash Flow (month

1) + Cash Flow(month 2) +…+Cash Flow(month n).

Here the payback period is of 3 years.

Example of cash flow

Advantage: It combines benefits of both break-even and

payback method.

Disadvantages: Ignores time value of money for limited

time period. It does not take into account the probability

of the project. Ignores behavioral implications of numbers

in the financial statement.

Conclusion

Once the evaluation of the project is complete, actual results are compared against standards or alternative investments.

The decision to adopt an alternative system can be highly subjective, depending on the analyst’s or user’s confidence in the estimated cost and benefit values and the magnitude of the investment.

Quiz !!!

1. Net Benefit Analysis is calculated through(a) Total cost –Total benefit(b) Total benefit – Total cost(c) Total cost + Total benefit

2. What is “break-even” point?(a) Profit with loss.(b) No profit but loss(c) Profit but no loss(d) Neither profit nor loss

3. What is the formula for calculating future value of a project?

(a) F=P(1+i)^n(b) F=P/(1+i)^n(c) F=P^n/(1+i)(d) None of the above.

4. Tangible cost can be(a) Measured(b) Identified(c) All of above

5. “Cost of breakdown of an online system during banking hours will cost the bank to lose deposit” is an example of

(a) Tangible cost(b) Indirect cost(c) Variable cost(d) Intangible cost

Thank You !!!