Cost-Benefit Ratio
Cost-Benefit Ratio Calculator help in analyzing the cost-benefit relationship of an investment or a project. It is also known by the name of Profitability Index. It is one of the most commonly used capital budgeting techniques. The cost-benefit ratio makes a comparison between the discounted values of the total cost of the project and its estimated future cash flows/benefit derived. Costs and benefits are discounted to their present values. It helps in comparing different budgets and selecting the one with higher returns. That is, it simply determines which investment proposal is beneficial for the company. Since everyone is aware of the importance of the time value of money, this concept becomes more advantageous as it considers the variation in the cash flows spread over the years.
Formula for Calculating Cost-Benefit Ratio
Formula to calculate the cost-benefit ratio is as follows:
Discounted Value of Benefits / Discounted Value of Costs
About the Calculator / Features
The cost-benefit ratio calculator effortlessly calculates the result when the user provides the following details to it.
- Discounted value of benefits.
- Discounted value of costs.
Calculator
How to Calculate using Calculator
The user has to simply insert the following data into the calculator:
Discounted Value of Benefits
The management of the company estimates the benefits that can be derived during the life of the project. These benefits in terms of cash flows over the years are discounted at to bring them all at par with their present values. This will take care of the difference in the timing of inflows.
Discounted Value of Cost
Costs are generally incurred at the zero period, but there could be instances where extra costs are required to incur in order to continue the project. These costs may include an additional working capital requirement or additional equipment, etc. The management discount these costs on their present value.
Example of Cost-Benefit Ratio
Let us try to understand the concept of cost-benefit ratio with the help of an example.
Suppose Company B Ltd., before investing its money in Project X, wants to make a cost-benefit analysis of the project. Following details with regard to the costs and estimated benefits of the projects are available.
- The life of a project is 3 years.
- Initial investment = $ 15,000
- Additional working capital at the end of 2nd year = $ 5,000
Estimated benefits at the end of each year:
| Year | 1 | 2 | 3 |
| Estimated Benefits | 10,000 | 17,000 | 8,000 |
- Discounting rate = 10%
| Particulars | Total | ||||
| Year | 0 | 1 | 2 | 3 | |
| Cost ($) | 15,000 | – | 5,000 | – | 20,000 |
| Discounted Value of Cost ($)/Outflows | 15,000 | – | 4,132 | – | 19,132 |
| Estimated Benefits ($) | – | 10,000 | 17,000 | 8,000 | 35,000 |
| Discounted Value of Benefits ($)/Inflows | – | 9,091 | 14,050 | 6,011 | 29,152 |
Benefit Cost Ratio = $ 29,152 / $ 19,132 = 1.52
Interpretation of Cost-Benefit Ratio
A cost-benefit ratio greater than 1 is generally treated as a good indicator. It means that the benefits derived from the investment are more than its costs. It states the benefit earned by the company on spending every dollar. In the example above, the benefit-cost ratio is 1.52, which means the company will earn $1.52 on every $1 investment.
Cautions
The management makes this cost-benefit analysis on the basis of assumptions and estimates of the future benefits. The analysis could go wrong in case of improper forecasting, wrong discounting rate, etc. A cost-benefit ratio is an easy tool as compared with other techniques of capital budgeting, but the management should also consider other techniques before arriving at the final decision. This should never be looked at in isolation.
