Cost Benefit Analysis - Explained
What is a Cost-Benefit Analysis?
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What is a Cost-Benefit Analysis?
Cost benefits analysis refers to a technique used to measure the return against cost in both financial and environmental aspects. The technique provides a better analysis of the data under evaluation. The current economy is based on analytics, and people make many decisions based on daily activities. These decisions are made for the purpose of marketing studies, business plans. The analysis of the data helps the organization to achieve an effective evaluation of the economic and social outcomes of the activities. In this regard, the cost-benefit analysis plays an important role in helping the organizations, companies, and institutions to make an informed economic and social decision. Besides, it helps the organizations to determine the feasibility of the projects the investor intend to invest. During the analysis, both the direct and indirect cost from a project is evaluated to determine its feasibility. After conducting the cost-benefits analysis, the planner or managers should make decisions based on the following question; it is worth investing in the project? Should the project continue? Since cost-benefits analysis is carried throughout the project`s life, these questions are therefore asked in every stage of project life.
How does a Cost-Benefit Analysis Work?
The cost-benefit analysis technique is used to measure the costs per unit of a product produced against profits generated by that product when it is sold. When the ratio obtained is high, it means that the investor has generated higher profit at a lower cost. This makes the fundamental analysis for the future investment. When planning to make an investment decision, it is important for the investor to evaluate the ratio between cots and benefits to determine the viability of the project. Variables that determine cots benefit ratio. The cost and benefit ratio are influenced by various variables. Some of the variables that affect cost and benefits include:
- The cost of investment leasing, financial margin, employees, taxes repelling of sales, discount for prompt payments, liabilities such as insurance claims and contribution to the security of the employees.
- The final prices of produced products and profit margin per unit.
- The level of optional production
- Turnover rate
- Depreciation expenses and their provisions for services or goods.
- The cost for financing loans or credits and the interest charged on loans.
These variables play an important role in determining the cost-benefit ratio and help the investor to make a decision whether a project is worth investing or not based on its profitability and cost. Usually, the investor seeks at least a ratio of 3 monetary units of profit for every monetary unit of cost. In this regard, have that wider ratio margin covers future contingencies that might arise unexpectedly such as lose of court cases, machinery attrition, decreased in production, diminishing marginal profit and the speculative attacks on the project. It also covers the contingencies that may arise due to change in consumer preferences concerning the products produced by the company, stiff or unfair competition and actions of the untrustworthy employees. For example, let's assume that an investor wants to start up mango export business to the US. The sales are projected to be 10, 000 mango fruits per month. The price per unit mango to be 1 Euro. The provision for wear and tears due to distribution to be 10%, tax to be 20% and the distribution cost and other fixed costs to be 30%. The time for mango consumption is projected to be 6 months. Therefore, the cost-benefit analysis is determined as demonstrated below; Gross profit = units * price per unit = 10, 000 * 1 = 10,000 Euro Total cost = product wear + taxes + fixed cost = 10% + 20% + 30% = 60% Therefore, the total costs = 60% * 10,000 Euro Net profit = gross profit costs 10, 000 Euro 6000 Euro = 4000 Euro per month Therefore, the total profit for this project will be; 4000 Euro * 6 months = 24000 Euro
- Total Utility (Economics)
- Efficiency Principle
- Indifference Curve
- Time Preference Theory of Interest
- Diminishing Marginal Utility
- Sunk Costs
- Production Possibilities Frontier
- Law of Diminishing Returns
- Economic Efficiency
- Efficiency Theory
- Productive Efficiency
- Capacity Utilization Rate
- Pareto Efficient
- Comparative Advantage
- Criticisms of the Economic Approach
- Behavioral Economics
- Normative Economics
- Positive Economics
- Invisible Hand
- Sunk cost