What is Benefit Cost Ratio (BCR)
Benefit Cost Ratio (BCR) is defined as a ratio between a project’s proposed total cash benefit to it’s planned total cost.
Benefit Cost Ratio is used to determine the profitability of a project.
The expenses, overall duration and revenue generated by the project are the main factors on which the benefit cost ratio will determine.
It is a cost benefit analysis that summarizes the overall connection between a proposed project related and benefits of its execution.
You might also like: How To Increase The Accounts Receivable Turnover Of A Company
Calculating the Benefit Cost Ratio (BCR)
Understanding the need for executing the project
The company needs to have a goal for executing the project. This goal can be in terms of the returns the project can fetch, in order to contribute to the overall revenue of the organization.
There can also be a group of projects the company decides to execute. From this analysis, the stakeholders can decide which project can be the most favorable by studying the benefit to cost ratio.
Predicting the revenue that the execution of project can generate.
The company decides to execute the project with target to achieving an added revenue for the company. Thus, the predicted revenue is the estimated revenue the company wants to grow in terms of financial well being.
Estimating the duration and the discounting factor for the project
One needs to calculate the duration of the project before commencing its execution. The duration is a major factor that will determine the profitability of the project. The longer the duration, the lower will be the benefits of executing the project.
Also, in order to factor the effects of inflation, repo rate and other external forces, the discounting factor is considered. This factor lowers the actual revenue predicted by the company on a particular project. As a rule of thumb, one can consider the discounting factor to be in a range of 0.06 to 0.08 (6-8%)
Calculating the Net Present Value (NPV) of the project
Net Present Value (NPV) is the present value of the future earning made after the execution of the project.
When the company has predicted the revenue to be made by the project, we need to estimate the net present value of the future gains. This is the realistic value of the revenue after the necessary deductions.
Calculation of Net Present Value
The formula for calculating Net Present Value is:
NPV = Expected revenue the project can make / (1 + R)^D
Where,
Expected revenue is the prediction made by the stakeholders by which the project can contribute in the revenue of the business if executed.
R = The rate of discounting. This is the discounting factor that is used to consider the true present value of the future revenue. As a rule of thumb, R can be taken as 0.08 (8%).
D = Duration, which is the total time that will require to execute and complete the project.
Calculating the total expense for project execution
This is the total cost the company will have to bear to set up and execute the project. The higher the expense, the lower will be benefits yielded from the project, considering the other factors to be constant.
Thus, in order to lower the overall expense, the project needs to have a thorough cost controlling mechanism.
Calculating the Benefit Cost Ratio
The Benefit Cost Ratio is computed by dividing the entire cash benefit projected by the total cash cost estimated for a project.
The formula for calculating the benefit cost ratio is:
Benefit Cost Ratio = Net Present Value of the project / Overall expense of the project
Higher the benefit cost ratio, higher will be the profitability of setting up the project.
Understanding the calculation of benefit cost ratio with an example
Consider a company is currently making a revenue of Rs. 5 crores and wants to increase it by 10%. Thus, in order to achieve this growth, the technical team develops a project proposal. But for the execution of project, the company will require an initial expense of Rs. 30 lakhs. The project duration is 2 years.
Thus, using the benefit cost ratio we need to find out if the project will be profitable if the company decides to spend Rs. 30 lakhs.
Solution:
The company is expecting a revenue of 10% raise, i.e. Rs. 50 lakhs.
The expected duration of the project is 2 years. For the simplicity of the problem, let’s consider the discounting factor to be 0.08.
Thus, calculating the net present value:
NPV = Expected revenue the project can make / (1 + R)^D
= 50,00,000 / ( 1 + 0.08)^2 = 42,86,694.101 =Rs. 43 lakhs
The overall expense for the project is estimated to be Rs. 30 lakhs
Thus, calculating the benefit cost ratio:
Benefit Cost Ratio = Net Present Value of the project / Overall expense of the project
= 42,86,694.101 / 30,00,000 = 1.42
From this ratio we can conclude that the project is indeed feasible to execute considering the expenses it will incur.
The ratio of 1.42 indicates that, the project will earn Rs. 1.42 for every Rs. 1 spent on the project.
Also Read: What Happens If Earning Per Share Becomes Negative
Importance of calculating the Benefit Cost Ratio (BCR)
Case 1: If the BCR is less than 1
When the BCR is less than 1, it indicates that the revenues made to execute the project is not justified to the expense it will incur. Thus, it is not feasible to execute this project.
Case 2: If the BCR is equal to 1
When the value of BCR is equal to 1, it indicates that the revenue generated by the project will be equal to the expenses it will incur to set it up. This is not a viable option to execute the project as the overall expenses does not hold any grounds for the revenue it would generate.
Case 3: If the BCR is greater than 1
In case when the BCR is greater that 1, it signals that the benefits yielded by the project are better than the overall expenses it will encounter.
Conclusion
The main limitation of Benefit Cost Ratio is that it simplifies a project to a single figure. While the success or failure of an investment or expansion is determined by a variety of factors and can be harmed by unanticipated occurrences.
Simply applying the premise that anything above 1 indicates success and anything below 1 indicates failure might be deceptive and lead to a false sense of security about a project.
Also Read: How To Calculate Price To Earning (PE) Ratio Of A Stock