The benefit cost ratio, or BCR, looks to identify components of the relations between the cost of a project and its potential benefits. Although It can be used in any situation where a transaction will take place, this ratio is most often used within the world of corporate finance. It can assign a value to a new project or replacing an old one.
To calculate the BCR, you must divide the total discount value of the expected benefits by the total discounted value of the costs involved. To calculate these values, you would take the net present value formula, where the discount rate is raised to the number of periods involved.
If you receive a benefit cost ratio that is above 1, then the benefits of the project outweigh the costs. That means a project which is significantly above 1 should be considered. If the benefit cost ratio is below 1, then the costs are expected to be greater than the profits, so the idea should be abandoned.
Here are the advantages and disadvantages to consider when using the benefit cost ratio.
List of the Advantages of the Benefit Cost Ratio
1. It provides an added level of clarity.
The benefit cost ratio allows you to dive into the specifics of a project. You can see where your spending happens to be or where your cash inflows are happening. You must define these, then list the inflows and outflows of cash, to evaluate the project involved. Although there are always going to be unpredictable costs, there are usually unpredictable profits which occur as well, offsetting one another. That’s why a BCR above 1 is considered a positive indication.
2. It creates a look at a project’s overall feasibility.
Think of the benefit cost ratio as an “educated guess.” If you’ve calculated your costs and benefits accurately, then you’ll have a good idea of what the expected outcome should look like. The goal here is to be able to make a decision with greater confidence. The results are a forecast that, if all things go well, something successful is about to happen.
3. It provides a glimpse of current affordability.
With the benefit cost ratio, you can look at the various additional costs that will be required for a decision to proceed. You’ll be able to know right away if your finances will be able to handle the added costs. Even if your BCR is positive, those costs could get in the way of your eventual success if more debt must be added to make that success happen. Knowing that you can afford the costs of a decision is a step in the right direction.
4. It can help provide insight into the unknown.
There are several different variables that may occur when the decision is made to pursue a project. Performing the calculations for the benefit cost ratio can help you find some of the potential variables that could affect your bottom line. If you were required to take out financing to cover costs, for example, then your interest rate on that debt could become a variable expense. By figuring out more of these variables, you’ll be able to create a BCR that is more accurate, which then leads you to a decision that is more confident.
5. It can develop beneficial policies.
Understanding the benefit cost ratio helps an organization, or a society, determine certain rules or regulations that should be followed. By understanding how benefits can be maximized, people can be encouraged to follow a certain path to make those benefits happen. That process further lessens the risk of the BCR being inaccurate.
List of the Disadvantages of the Benefit Cost Ratio
1. It can lead to false confidence.
Many have used the benefit cost ratio to justify a project because they believed their calculations would lead to guaranteed success. It is important to remember that this is a tool to use to evaluate risk. Anything above 1 has a higher risk of success. Anything below 1 has a higher risk of failure. Success or failure can occur on either side of the ratio. Thinking that you’ll automatically succeed with a good BCR often leads people to failure.
2. It can act as a validation.
Many people like to invest into projects because they have a gut instinct telling them to do so. The benefit cost ratio can provide the validation required to pursue that gut instinct. Although you must look at your costs and benefits in an objective manner to calculate the ratio, those figures can also be manipulated to serve someone’s personal purpose.
If Jeff Sessions can quote Romans 13 to justify separating children from their families, an investor can tweak a couple of numbers to create a better BCR to suit their purposes too.
3. It does not always factor in the indirect benefits.
There are several indirect benefits that a project creates which may not be reflected in the initial calculations of the benefit cost ratio. That is because the world is ever-changing and there are new ways of generating revenues which are hard to predicted. Your project might generate revenues through social media clicks or added brand awareness.
You might generate more loyalty within your targeted demographics by offering items or services with added value. Not every indirect value has a monetary assignment to it, which further complicates this calculation.
4. It may add more value to biased variables.
The value of the benefits (or the costs) is often determined by those who are closest to the project. Someone who is over-ambitious about a project might offer a value that is too high compared to what an outside observer might offer. On the other hand, the costs being presented for a calculation of the benefit cost ratio may be too low.
If either event occurs, the BCR will be inaccurate. To avoid this issue, never assume a discount will be offered. Always double-check anticipated revenues, costs, and benefits.
5. It may offer numerous unknown variables.
The unknown variables of a project can be so extensive that they invalidate the benefit cost ratio. Anything that is not considered, not known, or overlooked is classified as an unknown variable for BCR purposes. Most benefit cost ratio calculations will not have access to every exact benefit or cost figure.
External factors can become extreme and invalidate the calculations should they occur. Think about Hurricane Katrina. That is an extreme unknown variable that likely wiped out many BCR calculations.
6. It offers a lot of room for subjectivity.
Let’s say that three people are looking at an historic property. The house on the property is on the national historic register. The building is rundown, but still usable. The local tax assessor has placed the value of the property at $440,000.
The first person sees the historic value of the property and that its value could be doubled if properly restored. The second person sees a home that costs way too much to restore and will cost a fortune to heat. The third person wants to live on the property because they love historic homes.
All three people will value the benefits and costs of this property in different ways. The same is true for any other business project.
7. It does not assign specific benefit values in certain areas.
When conducting a benefit cost ratio calculation, it is difficult to calculate the benefits and costs associated in the areas of environmental, health, and safety regulations. Some factors in these areas cannot be accurately measured, much less quantified. Although there can be some benefit to attempting a cost assignment in these areas, issuing policies or expecting to hit specific revenue projections when they are involved in an impractical way to use a BCR.
8. It could be used to create moral decisions.
One of the greatest dangers of the benefit cost ratio is that it can be used to define morality. From a health standpoint, death has no measurable value. No one can transfer assets to someone after they die to restore their life. Those assets would only transfer to their estate. Trying to decide if a medical treatment is necessary, therefore, would place the value of a life at the cost of the procedure. Instead of weighing the pros and cons of that procedure, an effort should be made to save that life.
The advantages and disadvantages of the benefit cost ratio make it possible to evaluate risk with more certainty. There is a risk in making any business decision that leads a company forward. With the BCR, you don’t eliminate risk. You just manage it more effectively because you create values from the costs and benefits involved. That is why decisions can be made with more confidence.