It’s disappointing to start a project only to realize that it costs more than you expected. Think about it, would you paint a house for a client at a cheaper cost, or would you find the right balance of cost and benefit during your paint job estimate?

The benefit-cost ratio is vital to know if you plan to launch a successful and profitable business. This is the ratio used to show the relationship between the benefits of your business process to its relative costs. The benefit-cost ratio is used in a cost-benefit analysis, and it can be presented as a monetary value or as a qualitative measure.

Here is a complete guideline on how to determine your benefit-cost ratio. 

What Is a Benefit to Cost Ratio (BCR)?

This is the value you get by comparing the benefits of a business project or investment to its subsequent costs. The value is determined as a monetary or a non-monetary outcome. Usually, project managers use the BCR to assess the viability of the overall project they are about to undertake.

In most cases, using the BCR for capital budgeting is straightforward, but it can pose some challenges with large projects because they come with additional uncertainties and assumptions. As such, your project manager will depict a variety of outcomes using the BCR.

Nonetheless, the benefit-cost ratio is an excellent method to assess the viability of a business project or an investment. 

What Does the BCR Tell You?

Every entrepreneur understands the importance of determining the rewards, risks, and economic realities of starting a business. Your benefit-cost ratio is part of that assessment in that the value you get from your BCR determines whether the project is worth pursuing or not.

So, what does the BCR tell you? It gives you an almost absolute amount of the cost and benefit for your business project, which, in turn, determines whether you should consider a project or not. This is based on the positivity of the net present value (NPV), return on investment, and the internal rate of return of your project vis a vis the net present value of the costs.

For instance, if you are considering a new project for your business, the BCR will identify your cash flow and the cost of investing in the project, compare that to the expected profits you make, and determine whether the project is a beneficial investment for your business.

How Is the Benefit-Cost Ratio Calculated?

Calculate the benefit to cost ratio by dividing the present benefit value by investment cost.

BCR = Benefits / Cost

Other factors in the BCR formula are the present value, cash flow of a period, interest or discount rate, and cash flow period. The BCR = Present value of Benefits / Present value of Cost.

Present Value of Benefits

This is the sum of your discounted benefits determined by discounting all of the benefits you expect as cash flow in a period with the number one added to your discount ratio and powered by your assessment period. That is:

Suppose t represents your period, “i” represents your discount ratio, and CF represents the cash flow benefit. In this case, your present value of benefits is calculated as:

PV (Benefits) = CFt (Benefits) / (1+it)t

Present Value of Cost

Calculating the present value of costs is identical to the present value of benefits. The primary difference is that you substitute the benefits for costs in the formula. That is, t is the period, CF is the cash flow costs, and i is the interest rate.

PV (Costs) = CFt (Costs) / (1+it)t

The Cash Flows

The cash flows in the BCR formula represent the monetary benefits or costs of the investment or project. CFt (Benefits) 's cash flow benefits are revenue, savings, cash discounts, sales, interest received from payments, or monetary value accrued from an increase in asset value.

The cash flow costs, CFt (Costs), are interest accrued from loans, initial investments, product production costs, disposal costs, or administration costs.

If the value in your BCR is not represented by money, use an equivalent value to determine the BCR. The critical thing to do is separate the costs from the benefits and ensure you assess your interest and discount rates in the BCR.

The BCR

During BCR calculation, both the present value of benefits and cost should be non-negative values. You can also use a BCR calculator to determine your BCR value.

BCR = Present value of Benefits / Present value of Cost

What Is a Good Benefit to Cost Ratio?

Your BCR depends on the value you get from the cost-benefit analysis. Usually, the BCR ranges based on the value of one, meaning your BCR will either be greater than, equal to, or less than one. Each of these values carries a different meaning:

If your BCR is < 1

This means that your project is bound to generate losses because the project's benefits will be lower than the project's cost. The cost of your project increases with a decrease in the value of the BCR.

Therefore, if you get a BCR ratio that is lower than 1, it is advised that you refrain from pursuing the project. However, specific projects still need pursuit regardless of whether the BCR value is less than 1. One example is business legal compliance.

 If your BCR is = 1

This means the benefits you expect to accrue from your investment or business equals the cost of implementing the project. Having a BCR value of 1 is preferred to having a value of less than 1. But if you have projects with a BCR that is greater than one, consider them the best options.

If your BCR is > 1

This is the best value to get for your protect BCR because it means your investment is valuable. In essence, a benefit-cost ratio greater than 1 means that the cost of carrying out the project is lesser than the project benefits.

Please note different factors affect the overall outcome of your project. While Your BCR is great for determining whether your project or investment will breed profits, it is not the only factor to consider. 

What Is a Benefit to Cost Ratio Example?

Suppose you own a real estate company and you just bought an apartment building. You've heard that apartment renovations have the potential to increase the value of property by at least $100,000 every year.

As such, you conduct a benefit-cost ratio for the renovation project for the next three years. If you choose to lease the renovation equipment, let's assume that the total cost of renovations, including labor, is $50,000 and paid upfront.

Also, let's assume that the inflation rate is 2% or 0.02. To calculate your BCR, you first need to determine the present value of benefits and costs for the three years.

• Present value of costs for the three years is = $50,000
• Present value of benefits = CFt (Benefits) / (1+it)t
• Present value of benefits for year 1 = $100,000 / (1 + 0.02)1 = $98,039
• Present value of benefits for year 2 = $100,000 / (1 + 0.02)2 = $96,117
• Present value of benefits for year 3= $100,000 / (1 + 0.02)3 = $94,232
• The total present value of benefits = $98,039 + $96,116 + $94,232 = $288,388
• BCR = Present value of Benefits / Present value of Cost
• BCR = $288,388 / $50,000 = 5.77

Since the BCR is a value greater than 1, it means that the renovation project is lucrative for your real estate business. This also means that for every $1 cost, your renovation project will make a $5.77 profit. 

Pros and Cons of the BCR

The benefit-cost ratio is an excellent measure for your business because it can evaluate the tangibles and the intangibles associated with your project. Nonetheless, the advantages of the BCR are tied to its disadvantages.

For instance, while the ratio provides you with clarity, it might not be apparent if your project is massive since it doesn't account for some project uncertainties. As such, here are the pros and cons of using the BCR. 

 BCR Pros

• A BCR ratio clarifies the total expenditure you are to incur in a project or investment. As such, you can easily anticipate any project challenges associated with expenses and costs.
• The BCR is an excellent way of making rational decisions for your business. When you launch your project or investment, you are sure that your primary reasons are more objective than emotion, giving you an added air of confidence.
• Your BCR helps you approach investments from an overall feasible perspective because it allows you to prepare for the costs beforehand. In ideal cases, you get to expand your cash flow in case of unexpected expenses.
• Unlike other analysis measures like the NPV, the benefit-cost ratio has a better probability of providing insight into the unknown variables associated with your project. For instance, the NPV fails to provide insight into the underlying gross cash flows or the volume of a project. This is information you get with a BCR.
• In some cases, the BCR helps organizations create business regulations and requirements about a given project to enhance profits. That is, once you determine that your BCR has a value greater than 1, generating strategies to attain those goals is done from an informed perspective, which, in turn, lessens business risks.
• You can compare different projects using the BCR to determine the one with the most significant benefits for your business. 

BCR Cons

• Even though the BCR provides clarity, it does not account for all the variables associated with a project. Therefore, part of your clarity is an illusion that you have everything figured out. For instance, an unexpected outcome might result in unforeseen additional costs not accounted for by the BCR. Or factors like unexpected market shifts can either dent your expected profit margins negatively or positively.
• While the BCR gives you an objective outlook and reason for investing in a project, it is not entirely wrong to follow your gut instinct. Feeling sure about a project regardless of the expense might still bear favorable fruits, as long as you keep the risks top of your mind.
• The BCR does not capture other benefits associated with starting a business project. For instance, marketing your project on social media might generate revenue from increased brand awareness, or your business value might increase due to increased brand loyalty. These are factors not easily reflected in the benefit-cost ratio.
• BCR is subjective, meaning different people might share different opinions about a similar project. Therefore, there is room for conflict when BCR is used to determine the viability of a project. For instance, BCR can justify morality in areas like the health sector. As such, procedures like determining the cost of saving a life should never be chosen using a BCR guideline. 

Conclusion

Unless you are a non-profit organization, one primary reason for starting your business is making a profit; what better way to know whether your new investment will profit than conducting a cost-benefit analysis. This is where the benefit-cost ratio comes in.

That said, if you take the leap and start your painting business, let Hoist help you simplify the process of running and scaling your business. The platform provides features to boost your training, lead generation, and marketing for business growth and sustainability at a fraction of the cost of a franchise. 

Sources:

Cost Benefit Analysis | Better Evaluation

Net present value (NPV) method - explanation, example, assumptions, advantages, disadvantages | Accounting For Management

7 Things Investors Look for Before Investing | Accion Opportunity Fund