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Cost Benefit Analysis

A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them.

Categories of Cost Benefit Analysis


1. 2. 3. 4. 5. Hardware Costs Personnel Costs Facility Costs Operating Costs Supply Costs

Procedure for Cost/Benefit Determination


1. Identify the cost and benefits pertaining to a given project. 2. Categorize the various costs and benefits for analysis. The next step in cost and benefit determine is to categorize costs and benefits. Cost and benefits are classified below a. Tangible or Intangible Cost and Benefits Tangible (Outlay of cash for an item or activity) means something that you can touch, your furniture, T.V. Set, your car, your lawn, whatever you can feel and see that belongs to you. Intangible property is much different and many people have lost fortunes because of it. In the great stock market crash of 1929, a lot of people, who thought they were worth millions, found out in a very short time, that they had only fortunes made of paper. The Great Depression was brought about by intangible property. Investments in the stock market are intangible property. You may have a piece of paper that says you have 1,000 shares of a company, but you can't hold it or touch it and it isn't actual money. If the company shares drop on the stock market and the company goes out of business, the money you invested is gone too. Before you paid for the stock, you had the money. Maybe it was in the bank and you could withdraw it and it was in your hand. When you bought the stock,

you gave it to an idea. You got a piece of paper

b. Direct or Indirect Cost Benefits Direct cost are those with which a monitory (in terms of money) figure can be directly associated in a project. They are applied directly to the operation. The direct costs of treatment in a hospital or a community centre cover:

doctors nurses medication facilities tests medical equipment (accounts for a very small part of overall treatment cost)

Indirect costs are the results of operations that are not directly associated with a given system or activity. They are often referred to as overhead. A system that reduces overhead (extra expenditure which is unplanned) realizes a savings. There are a number of indirect costs related to further patient treatment:

physical and psychological therapy rehabilitation medication medical supplies

c. Fixed or Variable Costs and Benefits Some costs and benefits are constant, regardless of how well a system is used. Fixed costs (after the {act are sunk costs. They are constant and do not change. Once encountered, they will not recur. Examples are straight-line depreciation of hardware exempt employee salaries, and insurance. In contrast, variable costs are incurred on a regular (weekly, monthly) basis. They are usually proportional to work volume and

continue as long as the system is in operation. For example, the costs of computer forms vary in proportion to the amount of processing or the length of the reports required. Fixed benefits are also constant and do not change. An example is a decrease in the number of personnel by 20 percent resulting from the use of a new computer. The benefit of personnel savings may recur every month Variable benefits, on the other hand, are realized on a regular basis. For example, consider a safe deposit tracking system that saves 20 minutes preparing customer notices compared with the manual system. The amount of time saved varies with the number of notices produced.

Saving Verses Cost Advantage Savings are realized when there is some kind of cost advantages. A cost advantage reduces or eliminates expenditures. So we can say that a true saving reduces or eliminates various costs being incurred. 3. Select Evaluation Method a. Net Benefit Analysis i. Procedure Total benefit minus total cost ii. Advantages 1. Easy to calculate 2. Easy to 3. Easy to iii. Limitations 1. Does not account for the time value of money iv. Example

Benefit for the propose system

Profile = Total Benefit Total Cost = 300 154 = 146 Since we are gaining, this system is feasible. b. Present Value Analysis The time value of money is usually expressed in the form of interest on the funds invested to realize the future value. In developing long term projects, it is often difficult to compute todays cost with the full value of tomorrows benefits. i. Procedure P = F/ (1+ i) n P = Present value of an investment F= Future value of an investment i = Interest rate per compounding period n = number of year ii. Advantages 1. Easy to calculate 2. Equates different investment opportunities with various costs and benefits and discount rates 3. Accounts for time value of money iii. Limitations 1. It is only a relative (not absolute) measure of a projects return on investment iv. Example Suppose Present value of $3000 invested at 15% interest at the end of 5th year is calculates as P = 3000/ (1 + .15)5 = 1491.53 Table below shows present value analysis for 5 years P1 = 3000/(1 + .15)1 = 2608.69 For 1st Year

P2 = 3000/(1 + .15)2 = 2268.43 For 2nd Year so on


Year 1 2 3 4 5 Estimation Future Present Value Value 3000 3000 3000 3000 3000 2608.69 2268.43 1972.54 1715.25 1491.53 Cumulative present Value of Benefits 2608.69 4877.12 6949.66 8564.91 10056.44

c. Net Present Value i. Procedure Discounted benefits minus discounted costs ii. Advantages 1. Relatively easy to calculate 2. Accounts for time value of money iii. Limitations 1. It is only a relative (not absolute) measure of a projects return on investment. iv. Example Net Present Value= Costs Benefits % = Net Present Value/Investments Example: Suppose total investment is $50000 and benefits are $80000 Then Net Present Value = $(80000 - 50000) = $30000 % = 30000/80000 =.375

d. Payback Analysis i. Procedure Investment divided by yearly savings. Compares costs & benefits of candidate system ii. Advantages

1. Easy to calculate 2. Has straightforward interpretation for choice b/w two or more alternative for candidates systems iii. Limitations 1. Conservative economic measure 2. Applied to one opportunity at a time. 3. Does not compare profitability of multiple investment alternative 4. Does not allow for time value of money iv. Example Calculated as:

Payback Period All other things being equal, the better investment is the one with the shorter payback period. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000 / $20,000, or five years. There are two main problems with the payback period method: 1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2. It ignores the time value of money.

e. Break-even Analysis Once we have determined what is estimated cost and benefit of the system it is also essential to know in what time will the benefits are realized. For that breakeven analysis is done. Break -even is the point where the cost of the proposed system and that of the current one are equal. Break-even method compares the costs of the current and candidate systems. In developing any candidate system, initially the costs exceed those of the current system. This is an investment period. When both costs are equal, it is break-even. Beyond that point, the candidate system provides greater benefit than the old one. This is return period.

i. Procedure Compares costs of using present and candidates systems ii. Advantages 1. Easy to understand iii. Limitations 1. Does not allow for time value of money iv. Example

Fig. 3.1 is a break-even chart comparing the costs of current and candidate systems. The attributes are processing cost and processing volume. Straight lines are used to show the model's relationships in terms of the variable, fixed, and total costs of two processing methods and their economic benefits. B' point is break-even. Area after B' is return period. A'AB' area is investment area. From the chart, it can be concluded that when the transaction are lower than 70,000 then the present system is economical while more than 70,000 transactions would prefer the candidate system. Break Even Analysis depends on Market condition when there is no profit and no loss.

f. Cash - flow i. Procedure Revenue minus expense on a period-by-period basis ii. Advantages

1. Combines benefits of break-even and payback methods iii. Limitations 1. Ignores time value of money. 2. For a limited time period, it does not take into account the profitability of the project. 3. Ignores behavioral implications of the numbers in the financial statement. iv. Example Analyzing an Example of a CFS Lets take a look at this CFS sample:

From this CFS, we can see that the cash flow for FY 2003 was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory. The purchasing of new equipment shows that the company has cash to invest in inventory for growth. Finally, the amount of cash available to the company should ease investors' minds regarding the notes payable, as cash is plentiful to cover that future loan expense. Of course, not all cash flow statements look this healthy, or exhibit a

positive cash flow. But a negative cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative cash flow is a result of a company's decision to expand its business at a certain point in time, which would be a good thing for the future. This is why analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether or not a company may be on the brink of bankruptcy or success.

4. Interpret the results of the analysis When the evaluation of the project is complete, the result has to be interpreted (understood). This entire comparing actual results against a standard or the result of an alternative investment. The interpretation phase as well the subsequent decision phase is subjective, requiring judgment & intuition. 5. Take action The decision to adopt an alternate candidate system can be high subjective, depending on the analysis or end users confidence in the estimated costs & benefits & the magnitude of the investment. In summary, cost/benefit analysis is a tool for evaluating projects rather than a replacement of the decision maker. In real life business situations, whenever a choice among alternatives is considered, cost/benefit analysis is an important tool. Like any tool, however, it has problems: 1. Valuation problem. Intangible costs & benefits are difficult to quantify and tangible costs are generally more pronounced than tangible benefits. In most cases, then a project must have substantial intangible benefits to be accepted. 2. Distortion problem. There are two ways of distorting the results of cost/benefit analysis. One is the intentional favoritism of an alternative for political reasons. The second is when data are incomplete or missing from the analysis. 3. Completeness problem. Occasionally an alternative is overlooked that compromises the quality of the final choice. Furthermore, the costs related to cost/benefit analysis may be on the high side or not enough costs may be considered to do a complete analysis. In either case, the reliability of the final choice is in doubt.

The System Proposal 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 analysts or users confidence in the estimated cost & benefit values & the magnitude of the investment.

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