What is benefit cost ratio?
- 1 What is benefit cost ratio?
- 2 Why should I use benefit cost ratio? And why is it important?
- 3 What does a BCR value of 1 mean?
- 4 What does a BCR value less than 1 mean?
- 5 What does a BCR value greater than 1 mean?
- 6 What is the benefit cost ratio formula?
- 7 An example benefit cost ratio calculation
- 8 Benefit Cost Ratio Calculator
Benefit cost ratio, also known as BCR, is an analytical exercise for directly comparing the proposed revenues (or, ‘benefits’) of a particular business project, with the estimated costs for completing it.
The result is a ratio which tells you ‘how many times over’ the expected benefits of your project will cover or match the related cost associated with fulfilling it.
That is to say, if the benefits of a business project over a period matches the sum of the costs exactly – the benefit cost ratio equals 1.
This would mean, the expected benefits of this project compared with its costs is identical (exactly the same.)
Why should I use benefit cost ratio? And why is it important?
A benefit cost ratio is used to assist strategic financial decisions on whether a business project is worth investing in.
How does BCR indicate the worthiness of an investment opportunity?
Simply, the resulting number of the calculation tells you whether you should expect to see an overall profit (return on investment) from completing your proposed business project…nor not.
What does a BCR value of 1 mean?
A ratio of 1 means that your proposed business project will produce an exact match of revenue figure compared with the cost of performing the project.
In other words, with a BCR value of 1 – the business project is expected neither to return any profit, nor will it make a loss. You’ll break even.
What does a BCR value less than 1 mean?
Ratios of less than 1 mean your business project is expected to cost you more than the projected revenues.
This would be a loss making project by estimation.
Therefore in such cases it is not advised to proceed with startup.
What does a BCR value greater than 1 mean?
BCR above 1 means your proposed business project is expected to return a profit beyond paying back all costs.
This type of business project is an attractive investment opportunity to most.
The higher the BCR ratio, the most profit expected and therefore the more valuable a project is esteemed.
What is the benefit cost ratio formula?
Benefit Cost Ratio (BCR) = ‘Project’s Expected Benefits (Cumulative Net Present Value of Cash flows) Over Project Duration’ / ‘Project’s Estimated Costs Over Project Duration’
[N.B. To better understand how the BCR formula above is to be practically applied, we have to first define Net Present Value (NPV) of Cash Flows.
What is Net Present Value (NPV)?
This is the present day money value of future expected cash flows.
Why is this necessary?
…when we consider a business project in light of the future cash flows that we expect to receive from it, we must also account for the very real ‘loss’ of monetary buying power through economic inflation (rising costs of goods and services).
You account for this loss by ‘adjusting’ the value of projected future money by the expected rate of inflation.
When you apply this inflationary rate across the total sum of monies expected throughout future project periods of trade, this will leave you with a return figure, which is ‘net’ of the falling value of money.]
To calculate the net present value of a sum of money minus the cost of inflation, we use the following formula:
To simplify the formula above – we write:
*Net Present Value = Value of future cash flows in today’s money – Value of initial sum invested
An example benefit cost ratio calculation
So, let’s say you run a dairy farm.
You have a steady and established core business operation and you have done for years.
The difference now is that you are looking for increased cash flows within the business.
You consider various diversification options and you settle on the idea of setting up a free-range egg business unit under the same umbrella.
You have the land and utilities – all you need is the startup capital to buy equipment, bird feed and day old chicks to grow into mature layer hens for eggs.
Your current milk delivery customers have already expressed interest in ordering eggs from you, so marketing costs would not be needed.
You decide to calculate the Benefit Cost Ratio of your proposed free-range egg farm operation:
- You estimate your project costs over 5 years to be £450,000
- The inflation rate expected over the project duration is 2.5%
- Your free range egg sales per annum is £109,500
Step-by-step calculation of your benefit cost ratio:
Calculating your NPV (net present value) of £109,500 over 5 years
- £109,500 / (1 + 0.025)^1 = £106,829.27
- £109,500 / (1 + 0.025)^2 = £104,223.68
- £109,500 / (1 + 0.025)^3 = £101,681.64
- £109,500 / (1 + 0.025)^4 = £99,201.60
- £109,500 / (1 + 0.025)^5 = £96,782.04
The net present value therefore based on the future cash flows presented above is:
- £106,829.27 +
- £104,223.68 +
- £101,681.64 +
- £99,201.60 +
= £508,718.23 (Net Present Value)
The benefit cost ratio of the project will be calculated to give a BCR value:
- £508,718.23 / £450,000
- = 1.13 (Your Benefit Cost Ratio)
What does this mean?
(A) Proposed egg farm project is estimated to return an ROI benefit of 1.13x (times) the cost to complete it
(B) Project benefits cover the associated costs 1.13 times.
Benefit Cost Ratio Calculator
Try this benefit cost ratio calculator for your own proposed business project.
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