What Is the Benefit-Cost Ratio (BRC)?

The benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis to summarize the ov🀅erall relationship between the relative costs and benefits of a proposed project.

BCR can be expresse༒d in monetary or qualitative terms. If a project has a BCR greater than 1.0, the project is expected to deliver a positive net present value to a firm and its investors.

How the Benefit-Cost Ratio (BCR) Works

Benefit-cost ratios (BCRs) are most often used in 澳洲幸运5官方开奖结果体彩网:capital budgeting to analyze the overall value for money of undertaking a new project. However, the cost-benefit analyses for large projects can be hard to get right, because there are so many assumptions and uncertainties that are hard to quantify. This is why there is ༒usually a wide range of potential BCR outcomes.

The BCR also does not provide any sense of how much economic value will be created, so the BCR is usually used to get a rough idea about the viability of a project and how much the internal rate of return (IRR) exceeds the discount rate, which is the company’s 澳洲幸运5官方开奖结果体彩网:weighted average cost of capit♈al (WACC)—the opportunity cost of that capital.

The BCR is calculated by dividing the proposed total cash benefit of a project by the proposed total cash cost of the project. Prior to dividing the numbers, the net present value of the respective cash flows over the proposed lifetime of the project—taking into account the 澳洲幸运5官方开奖结果体彩网:terminal values, ꧙including salvage/remediation costs—is calculated.

What Does the BCR Tell You?

If a project has a BCR that is greater than 1.0, the project is expected to deliver a positive 澳洲幸运5官方开奖结果体彩网:net present value (NPV) and will have an 澳洲幸运5官方开奖结果体彩网:internal rate of return (IRR) above the discount rate used in the DCF calculations. This suggests that the NPV of the project’s 澳洲幸运5官方开奖结果体彩网:cash flows out♛weighs the NPV oꦑf the costs, and the project should be considered.

If the BC𝓡R is equal to 1.0, the ratio indicates that the NPV of expected profits equals the costs. If a project’s BCR is less than 1.0, the project’s costs outweigh the benefits, and it should not be considered.

Example of How to Use the BCR

As an example, assume Company ABC wishes to assess the profitability of a project that involves renovating an apartment building over the next year. The company decides to lease the equipment needed for the project for $50,000 rather than purchase it. The inflation rate is 2%, and the renovations are expected to increase the company’s annual profit by $100,000 for the next three years.

The NPV of the total cost of the lease does not need to be discounted, because the initial cost of $50,000 is paid upfront. The NPV of the projected benefits is $288,388, or ($100,000 / (1 + 0.02)^1) + ($100,000 / (1 + 0.02)^2) + ($100,00 / (1 + 0.02)^3). Consequently, the BCR is 5.77, or $288,388 divided by $50,000.

In this example, our company has a BCR of 5.77, which indicates that the project’s estimated benefits significantly outweigh its costs. Moreove🧔r, Company ABC could expect $5.77 in benefits for each $1 of costs.

Limitations of the BCR

The primary limitation of the BCR is that it reduces a project to a simple number when the success or failure of an investment or expansion reli💮es on many factors ꧑and can be undermined by unforeseen events. Simply following a rule that above 1.0 means success and below 1.0 spells failure is misleading and can provide a false sense of comfort with a project.

The BCR must be u꧑sed as a tool in conjunction with other types of analysis𝕴 to make a well-informed decision.

The Bottom Line

The benefit-cost ratio (BCR) is used in a cost-benefit analysis to get a summary of the overall relationship between the relative costs and benefits of a proposed project. A project with a BCR greater than 1.0 is expected to deliver a positive net present value (NPV) to a firm and its investors.