Benefit-cost ratio
Encyclopedia
A benefit-cost ratio is an indicator, used in the formal discipline of cost-benefit analysis
, that attempts to summarize the overall value for money
of a project or proposal. A BCR is the ratio of the benefits of a project or proposal, expressed in monetary terms, relative to its costs, also expressed in monetary terms. All benefits and costs should be expressed in discounted present value
s.
. Where there is a budget constraint, the ratio of NPV
to the expenditure falling within the constraint should be used. In practice, the ratio of PV of future net benefits to expenditure is expressed as a BCR. (NPV-to-investment is net BCR.) BCRs have been used most extensively in the field of transport cost-benefit appraisals. The NPV should be evaluated over the service life of the project.
, are very sensitive to the discount rate
used in the calculation of net present value, and there is often no consensus on the appropriate rate to use.
The handling of non-monetary impacts also present problems. They are usually incorporated by estimating them in monetary terms, using measures such as WTP (willingness to pay
), though these are often difficult to assess. Alternative approaches include the UK's New Approach to Appraisal
framework.
A further complication with BCRs concerns the precise definitions of benefits and costs. These can vary depending on the funding agency.
Cost-benefit analysis
Cost–benefit analysis , sometimes called benefit–cost analysis , is a systematic process for calculating and comparing benefits and costs of a project for two purposes: to determine if it is a sound investment , to see how it compares with alternate projects...
, that attempts to summarize the overall value for money
Value for Money
Value for Money is a 1955 British comedy film directed by Ken Annakin and starring John Gregson, Donald Pleasence, Leslie Phillips, Joan Hickson, Derek Farr and Diana Dors.-Cast:* John Gregson as Chayley Broadbent* Diana Dors as Ruthine West...
of a project or proposal. A BCR is the ratio of the benefits of a project or proposal, expressed in monetary terms, relative to its costs, also expressed in monetary terms. All benefits and costs should be expressed in discounted present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
s.
Rationale
In the absence of funding constraints, the best value for money projects are those with the highest net present valueNet present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
. Where there is a budget constraint, the ratio of NPV
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
to the expenditure falling within the constraint should be used. In practice, the ratio of PV of future net benefits to expenditure is expressed as a BCR. (NPV-to-investment is net BCR.) BCRs have been used most extensively in the field of transport cost-benefit appraisals. The NPV should be evaluated over the service life of the project.
Problems
Long-term BCRs, such as those involved in climate changeClimate change
Climate change is a significant and lasting change in the statistical distribution of weather patterns over periods ranging from decades to millions of years. It may be a change in average weather conditions or the distribution of events around that average...
, are very sensitive to the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
used in the calculation of net present value, and there is often no consensus on the appropriate rate to use.
The handling of non-monetary impacts also present problems. They are usually incorporated by estimating them in monetary terms, using measures such as WTP (willingness to pay
Willingness to pay
In economics, the willingness to pay is the maximum amount a person would be willing to pay, sacrifice or exchange in order to receive a good or to avoid something undesired, such as pollution...
), though these are often difficult to assess. Alternative approaches include the UK's New Approach to Appraisal
New Approach to Appraisal
The New Approach to Appraisal was the name given to a multi-criteria decision framework used to appraise transport projects and proposals in the United Kingdom...
framework.
A further complication with BCRs concerns the precise definitions of benefits and costs. These can vary depending on the funding agency.
See also
- Benefit shortfallBenefit shortfallA benefit shortfall results from the actual benefits of a venture being lower than the projected, or estimated, benefits of that venture. If, for instance, a company is launching a new product or service and projected sales are 40 million dollars per year, whereas actual annual sales turn out to be...
- Cost-benefit analysisCost-benefit analysisCost–benefit analysis , sometimes called benefit–cost analysis , is a systematic process for calculating and comparing benefits and costs of a project for two purposes: to determine if it is a sound investment , to see how it compares with alternate projects...
- Cost overrunCost overrunA cost overrun, also known as a cost increase or budget overrun, is an unexpected cost incurred in excess of a budgeted amount due to an under-estimation of the actual cost during budgeting...
- Business efficiency