Cost benefits analysis

Cost benefits analysis is one of the simple economic accounting techniques widely used by the managements in deciding when and whether to make changes. The analysis was first formulated by one of the main contributors of economics theory Alfred Marshall. The procedures for carrying out cost benefits analysis are very simple. The value of the benefits derived from a specific course of action is subtracted from the total costs of undertaking the project. The cost involved in the cost analysis can be grouped as fixed or variable costs. Fixed costs are one-off meaning that they are incurred only once. The variable cost is incurred as an ongoing concern provided the firm is still in operations. The benefits to be realized are acquired over a period of time during the life of the project. The effects of the benefits are calculated during the payback period by getting their present values and comparing it with the present values of the costs. The basis for making the decision will be the period it will take to recoup the expenses incurred. The best project will be chosen from profit making enterprise that will recoup the cost in the least time possible.

The simple form in cost benefit analysis compares only the financial costs and benefits. An example of cost benefits analysis is building a rail road. The viability of the project will be the benefits derived from improved transport minus the costs of building the railroad. Some of the measures in this project that ought to be included in other analysis are the environmental damage costs or faster transportation but are not included as inputs of the cost benefits analysis. Intangible financial assets may be included in cost benefits analysis but has the disadvantage of making the decision to be too subjective.

Decision making process in cost benefits analysis is very straight forward. Capital decision can be formulated by looking at the Net present value, payback period or the internal rate of return. The basis for choosing a project based on net present value will be to select projects will positive net present values. A positive Net present value will imply that all the cost incurred in the project will be recouped. When we choose to use internal rates of return as our decision making criterion we choose the internal rate of return that is higher than the current market interests rates. A higher internal rate of return which is greater than the current interest rates implies that the project is viable and there is no project in the market that will give this benefits given the costs inputs.

Decision making process based on the payback period will consider the minimum period set by the company when all the cost that have been incurred in the project is recouped through benefits. The company might set the payback period for short term period to be three year, 5-10 years for medium projects and over 15 years for long term projects.

The main problem facing the cost benefit analysis is computation of some benefits and costs whose methods of measurement are not suggested.

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{ 1 comment… read it below or add one }

mj imam January 6, 2013 at 4:38 am

Good and simple explanation of the concept.But there is the need to elaborate on the problems of application of the approach to general decision making in societies.

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