What Is the Benefit Cost Ratio (BCR)? Definition, Formula ...

The benefit cost ratio (or benefit-to-cost ratio) compares the present value of all benefits with that of the cost and investments of a project or investment. SkiptocontentHomeProjectManagementCost-BenefitAnalysisWhatIstheBenefitCostRatio(BCR)?Definition,Formula,Example.TheBenefitCostRatio(BCR),alsoreferredtoasBenefit-to-CostRatioisanindicatorthatistypicallyusedwithinacostbenefitanalysis.Inprojectmanagement,thebenefitcostratiocansupportthecost-benefitanalysisofabusinesscase.ThePMIProjectManagementBodyofKnowledgeliststheBCRunderprojectsuccessmeasures,nexttothenetpresentvalueandreturnoninvestment(source:PMBOK®,6thed.,part1,ch.1.2.6.4,p.34).Ifyoucompareinvestmentalternatives, assessdifferentprojectoptionsorprepareforyourPMPexam,youwillwantto understandthemeaningandcalculationofthecost-to-benefitratio.Readonto learnthedefinitionoftheBCRandhowitiscalculated.ContentsDefinitionandMeaningofBenefitCostRatioWhatDoesaBCR<1Indicate?WhatIstheMeaningofaBCR=1?HowIsaBCR>1Interpreted?AdvantagesandDisadvantagesoftheBenefit-to-CostRatioProsConsHowIstheBenefitCostRatioCalculated?TheBCRFormulaComponentsoftheBCRFormula1.PresentValueofBenefits2.PresentValueofCost3.RatioofBothPresentValuesInputParametersandAssumptionsCashFlows(BenefitsandCosts)DiscountRateExampleProjectedCashFlowsDiscountedCashFlowsandCalculatedBenefitCostRatiosInterpretationofResultsConclusionDefinitionandMeaningofBenefitCostRatioThebenefitcostratio(orbenefit-to-cost ratio)comparesthepresentvalueofallbenefitswiththatofthecostand investmentsofaprojectorinvestment.Thesebenefitsandcostsaretreatedas monetarycashflowsortheirequivalents,e.g.fornon-monetarybenefitsor company-internalcosts. Itsmeaningdependsonthevalueitis indicating.Fortheinterpretation,refertothefollowing3genericrangesof BCRvalues:ValueRangeofBenefitCostRatioGenericInterpretationBCR<1Investmentoptiongenerateslosses.BCR=1Investmentoptionisneitherprofitablenorlossy.BCR>1InvestmentoptionisprofitableReadontolearnmoreaboutthe interpretationofBCRresults.WhatDoesaBCR<1Indicate?Thepresentvalueofthebenefitsina seriesofcashflowsislowerthanthepresentvalueofthecorrespondingcosts. ThelowertheBCR,thehighertheexcessofdiscountedcostscomparedtothe discountedbenefits.Ingeneral,pursuinginvestmentswitha negativeBCRisnotrecommended.Thesameholdsbasicallytruefordifferent projectoptions.However,therearecertaintypesof projectsthatneedtobeconductedeveniftheyarenotgeneratingsufficienttangible orquantifiablebenefitstocoverthecosts,e.g.theimplementationof regulatoryorlegalrequirements.Inthesecases,theoptionwiththehighest BCR(yetbelow1)maybetheleastunprofitableimplementationscenario.WhatIstheMeaningofaBCR=1?Thepresentvalueofbenefitsofaseries ofcashflowsequalsthelikewisediscountedcosts.Thissituationisobviously morepreferablethanoptionswithaBCRlowerthan1.However,ifthereare alternativeswithabenefit-to-costratioexceeding1,theyarelikelytobe favored.HowIsaBCR>1Interpreted?Thisvaluerangeindicatesthatthe discountedbenefitsexceedthepresentvalueofthecostsandinvestments.The generalruleisthatthehighertheBCRthegreatertheprofitaninvestment optionorprojectisexpectedtogenerate.Apartfromthebenefitcostratio,there areotherimportantquantitativeandqualitativeconsiderationsthough–in reality,aprojectorinvestmentdecisionisbasedonanumberofdifferent criteriaratherthanrelyingontheBCRonly.TypicalUsesoftheBenefitCostRatioTheBCRistypicallyusedforcostbenefitanalyses,alongwithothermeasuressuchasthenetpresentvalue,returnoninvestment,internalrateofreturn,etc.Theconsiderationofabsoluteamountsofcostandbenefitssetsthisratioapartfrommanyotherindicators.Theresultofthenetpresentvalue(NPV)calculationisonesinglefigurethatrepresentstheexpectednetvalueofallcostandbenefitwithoutgivinganideaofthevolumeandtherelationoftheunderlyinggrosscashflows.TheBCRcanbeusedtosupplementthismissingpieceofinformation.Representingtheratioofdiscountedbenefitstodiscountedcosts,itisarelativemeasureofwhetherandtowhichextentthepresentvalueofthebenefitsexceedsthatoftheinvestmentsandcost.Forinstance,aprojectmanagercouldbe workingonacostbenefitanalysisofdifferentprojectoptionsthatmay involveproductsorresultswithdifferencesintheirprofitmargins.WhiletheNPVisbasedonthenetamountofthesemarginsonly,theBCRwouldbegreater foraprojectwithlowerinvestmentsandcostsandhigherbenefitsand revenues,regardlessofthenetamounts.AdvantagesandDisadvantagesoftheBenefit-to-CostRatioProsTheBCRtranslatestheabsolute amountsofbenefitsandcostsintoaratioItfacilitatesthecomparison ofdifferentinvestmentorprojectalternativesTheratiohelpsinterpretthe ‘inherentriskiness’offorecastednetcashflowsandprofitability,e.g.in caseswheresmallprofitmarginsarepronetoahigherriskwhilelargemargins offerabufferforpriceadjustmentsItconsidersthevalueofcash flowsinrelationtothetimeoftheiroccurrenceConsTheBCRalonedoesnotindicatetheliquidity/fundingaspectsoftheanalyzedoptions,e.g.anoptionmayrequirelargeinvestmentsandexpensesinearlierperiodswhileproducingreturnsinfarlaterstages(forqualitativeaspects,checkWikipedia)Itissubjecttovariousassumptionsforthediscountrate,residualvalueandcashflowforecast.Theseassumptionscansignificantlyimpacttheoutcomeofabenefitcostanalysiswithoutconsideringtheinherentinsecuritiesoftheseparameters(readthecorrespondingdiscussionofassumptionsinthisarticleontheNPV)HowIstheBenefitCostRatioCalculated?TheBCRFormulaThebenefitcostratioiscalculatedby dividingthepresentvalueofbenefitsbythatofcostsandinvestments.Thisistheconsolidatedformula(source):where:BCR=BenefitCostRatioPV=PresentValueCF=CashFlowofaperiod(classifiedasbenefitandcost,respectively)i=DiscountRateorInterestRateN=TotalNumberofPeriodst=PeriodinwhichtheCashFlowsoccurNotethatinthisformula,bothpresentvaluesneedtobeinsertedwiththeirabsolute,non-negativeamounts.Ifyouhaveconsistentlyusednegativecashflowsforeitherthecostorthebenefitside,yourresultwillbenegative.Youwillthenneedtomultiplyitwith(-1).BenefitCostRatio(BCR)CalculatorComponentsoftheBCRFormulaTheFormulaforcalculatingthebenefit costratioconsistsofthreecomponents:Thepresentvalueofallbenefits,the presentvalueofallcostsand,finally,thedivisionofthesepresentvalues. Wewilldiscusstheminthissubsection.1.PresentValueofBenefitsThepresentvalueofbenefitsiscalculated asthesumofdiscountedbenefits.Todeterminethissum,allinflowsina period(i.e.cashflowsconsideredasbenefits)needtobediscountedwith1 plusthediscountrateitothepoweroftheperiod.Thiscalculationneedsto beperformedforeveryperiod.2.PresentValueofCostThepresentvalueofcostsiscalculatedanalogouslythatofthebenefits.Thedifferenceisthatforthisfigure,theoutflowsareconsideredasrepresentingcosts,ratherthantheinflows.3.RatioofBothPresentValuesTocalculatetheBCR,thepresentvalueof benefitsisdividedbythepresentvalueofcosts.Thereby,bothamountsshould beabsolute,i.e.non-negative.InputParametersandAssumptionsThecalculationoftheBCRrequires3input parametersforeachperiod:cashflows(benefits),cashflows(costs),andinterestordiscountrate.CashFlows(BenefitsandCosts)Thecashflowsusedforcalculatingthe benefitcostratioaretypicallymonetaryvaluesstemmingfromabusiness forecast.Wherebenefitsdonotmaterializeintheformofmonetarycashflows, anequivalentshouldbeused.Otherwise,thisindicatorisnotapplicableto theparticulartypeofanalysis.Cashflowsneedtobeestimatedseparatelyforbenefitsandcosts.Benefitsincludebutarenotlimitedtorevenue,sales,savings,increasesofvaluesofassets,interestpaymentsreceived,etc.Examplesofcostcashflowsaretheinitialinvestments,expensesforthecreationofproductsorresults,administrativecosts,disposalcosts,etc.Youmightalsoconsideraresidualvalueat theendoftheprojection’stimehorizon,whichmaybetheexpectedmarket value(benefit),disposalcost(acostcashflow)orthepresentvalueofa perpetuity,aninfiniteseriesofcashflows.Ifyouusethelatter,makesure yousplittheinfinitecashflowsintocostandbenefitsanddiscounteach groupofcashflowsseparately.DiscountRateDefinethediscountorinterestrateof yourBCRanalysis.Itcanrepresentthecapitalcostortargetreturnratesofyour organization(oftenusedforassessmentofprojects)orarisk-adjustedmarket interestrate.Ifadetailedcalculationisrequired,you mayconsiderusingdifferentinterestratesamongtheprojectionperiodor applyingdifferentrisk-adjustedratestocertaintypesofcostsandbenefits.Forfurtherdetailsontheseparametersandrelatedconsiderations,readtherespectivesectionofournetpresentvalueintroduction.ExampleAprojectmanagerisperformingthecost-benefit analysisof3differentsoftwareoptions.Thecompanyexpectsareturnrateof 12%whichisreflectedinacorrespondingdiscountrate.ProjectedCashFlowsThecashflowprojectionisasfollows,Option1NowYear1Year2Year3Year4Year5Year6Costs-5,000-5,000-1,000-500-500-1,000-1,000Benefits –   –   3,000 5,000 5,000 4,000 4,000NetCash Flow-5,000-5,000 2,000 4,500 4,500 3,000 3,000Option2NowYear1Year2Year3Year4Year5Year6Costs-15,000-1,000-1,000-1,000-500-500-1,000Benefits –   2,500 5,000 5,000 5,000 5,000 5,000NetCashFlow-15,000 1,500 4,000 4,000 4,500 4,500 4,000Option3NowYear1Year2Year3Year4Year5Year6Costs-3,000-3,000-2,500-1,000-500-500-500Benefits –   –   3,000 4,000 4,000 3,000 3,000NetCashFlow-3,000-3,000 500 3,000 3,500 2,500 2,500DiscountedCashFlowsandCalculatedBenefitCostRatiosOncethecashflowsareestimated,theyare discountedtotheirpresentvalue.Thesumofdiscountedbenefitsis consequentlydividedbythesumofdiscountedcosts.Doingthesestepsleadsto thefollowingresulttables:Option1Now 1 2 3 4 5 6Costs-5,000-5,000-1,000-500-500-1,000-1,000Benefits –   –   3,000 5,000 5,000 4,000 4,000NetCashFlow-5,000-5,000 2,000 4,500 4,500 3,000 3,000 Discounted Costs-5,000-4,464-797-356-318-567-507 Discounted Benefits –   –   2,392 3,559 3,178 2,270 2,027CalculatedResultsforOption1:PresentValueofCosts:             12,009PresentValueofBenefits:         13,424BenefitCostRatio:                     1.12Option2Now 1 2 3 4 5 6Costs-15,000-1,000-1,000-1,000-500-500-1,000Benefits –   2,500 5,000 5,000 5,000 5,000 5,000NetCashFlow-15,000 1,500 4,000 4,000 4,500 4,500 4,000 Discounted Costs-15,000-893-797-712-318-284-507 Discounted Benefits –   2,232 3,986 3,559 3,178 2,837 2,533CalculatedResultsforOption2:PresentValueofCosts:             18,510PresentValueofBenefits:         18,325BenefitCostRatio:                     0.99Option3Now 1 2 3 4 5 6Costs-3,000-3,000-2,500-1,000-500-500-500Benefits –   –   3,000 4,000 4,000 3,000 3,000NetCashFlow-3,000-3,000 500 3,000 3,500 2,500 2,500 Discounted Costs-3,000-2,679-1,993-712-318-284-253 Discounted Benefits –   –   2,392 2,847 2,542 1,702 1,520CalculatedResultsforOption3:PresentValueofCosts:               9,238PresentValueofBenefits:         11,003BenefitCostRatio:                     1.19InterpretationofResultsIfthe3optionsarerankedbytheirBCR, Option3isthemostpromisingalternative,followedbyOption1.Option2has aBCRlowerthan1whichindicatesthatitisnotprofitableatall.RankProjectOptionBCRNPV1 Option31.191,764.822 Option11.121,415.123 Option20.99-185.04ThistableincludestheNPVforreference(checktheNPVsamplecalculationforthedetails).WhileitiscommonthattheNPVandBCRproduceasimilarrankingofoptions,thisisnotnecessarilyalwaysthecase.Iftherewereanoptionwithhigh investmentsandcostsandasmallrelativeprofitmargin,theNPVwouldpresent thisoptioninamorefavorablewayasitdiscountstheabsoluteprofitability amounts.AstheBCRisfocusingontherelativeprofitability,thelarger divisoroftheBCR(duetohighercosts)wouldlikelypushthisoptionbehind otheroptions.NotethatthenumbersusedinthisexampleareconsistentwiththeNPVexample.Thus,youcaneasilycomparethedifferentmechanicsandeffectsinthecalculationofbothindicators.BenefitCostRatio(BCR)CalculatorConclusionThebenefitcostratioisacommonindicatoroftheprofitabilityofapotentialinvestmentorproject.Whileitdoesnotcoverallaspectsofacostbenefitanalysis,itindicateswhetheranoptionisbeneficial.AstheBCRcomparesdiscountedbenefitswithdiscountedcosts,itoffersagoodindicationofhowbiga‘buffer’betweenbenefitsandcostsis.However,likeallotherindicators,theBCRshouldnotbeusedastheonlybasisforprojectorinvestmentdecisionsgiventhatitonlycoverscertainaspectsofaprojectoption.Postnavigation←PreviousPostNextPost→CategoriesSearchfor:RecentPostsHowtoCreateaProjectScheduleBaseline(6IllustratedSteps)ProjectScheduleBaseline:Definition|Purpose|ExamplePerformanceMeasurementBaseline:Definition|Example|6-StepGuideScopeBaseline:Definition|Example|4-StepGuide|UsesCost-BenefitAnalysisChecklistforProjectManagers(FreeDownload)StakeholderEngagementAssessmentMatrix:Uses&ExampleAgileReleasePlanninginHybridandAgileProjectsDefinitiveEstimatevs.ROM/RoughOrderofMagnitude(+Calculator)ProjectScheduleNetworkDiagram:Definition|Uses|ExamplePDM–PrecedenceDiagrammingMethod[FS,FF,SS,SF](+Example)WhatAreLeadsandLagsinProjectManagement?HowProjectManagementSoftwareImprovesProductivityEstimatingActivityDurations:Definition,Methods,PracticalUsesBottom-UpEstimating–Definition,Example,Pros&ConsPerformancePrismforPerformance&StakeholderManagement