CBA - cost benefit analysis

Post date: Apr 12, 2013 9:56:43 PM

In simple words CBA is an analysis to determine what is the cost to start, run and maintain a project (or something else) and what are the benefits during certain period. By CBA we make a comparative analysis of all the benefits we anticipate and all the cost associated with the project.

Why cost benefit analysis?

- To take a decision before starting a project or selecting one among many projects.
- To set right goals for project.
- To define success criteria of a project by identifying quantifiable results. What to measure and how to measure.
- To estimate of the projects and identify resources required in the project.

Important things to consider

Often assumptions are taken about benefits of a project without defining how benefits will come and how they will be measured. Quantifying returns/benefits is the only way to achieve it later. Most important is how will benefits be measured? A famous saying is "If you can not measure something you can not make it". Often projects are started because it is a buzz in the market, every one is repeating 4 lines of benefits so we should also do it to get those benefits.

Here are some important points to consider while considering cost and benefits focusing on IT projects:

Cost

Development cost

If it's a software development project following to consider:

- Feasibility or due diligence cost
- Estimated RA, Design, Coding, Testing, Deployment cost ( developer cost or salaries)
- Training cost
- Tools, IDEs etc required for development
- Equipment cost

Operational Cost

- Installation cost
- Maintenance costs
- Personal cost
- Equipment cost
- Site upgrades
- End user training cost

Non recurring costs

Capital cost

- Data Processing Equipment
  - Desktops
  - Laptops
  - Servers
- Networking equipments
- Software
  - Application
  - Systems (OS)
  - Database

Other non recurring or one time cost

- Infrastructure
- Salaries and other compensation (one time)
- Contracting
- Studies
- Data collection, preparation or correction
- Hardware (non capital)
- Software conversion (non capital)
- Travel
- Training
- Any overheads
- Parallel system run cost

Recurring cost

- Rent and other expenditure of regular nature in infrastructure
- Salaries and compensations (recurring type)
- Contracting
- Data Collection
- Software
- Software upgrade
- Software/system maintenance and support
- Travel
- Training
- Supplies
- Other recurring expenses

Intangible cost

- Productivity Loss
- Management overhead

Benefits

Direct benefits (Tangible)

Direct benefits are those which impact bottom line of a business. They can be measured and quantifiable easily.

- Reduced effort/man-power
- Reduced cost other than man power
- Better and/or more services to internal or external customers (new business)
- Operational efficiency
- Cost savings from improved business process
- Service cost reduction

Indirect benefits (Intangible)

Indirect benefits are those benefits which are hard to measure. Their impact in the organization is positive but they directly doesn't reflect in account books. It is important to measure them and quantify to consider and capture them. For these types of benefits, strict guidelines on how to measure, what will be considered and a measure and benefits should be defined beforehand. In most of the cases percentage of indirect benefits should be a little as compared to direct benefits. If in cost benefit analysis contribution of indirect benefits is more that direct benefits, it may be sign of future risk and ambiguity. Basis of this statement is: If it is so hard to show direct benefits of a project now, how difficult will it be to achieve and quantify it later. It can become a case of high claim no gains.

Analysis

Total cost

Sum the recurring and non recurring cost (means add all cost) for each year of system life and calculate cost of the system for its whole life.

Total benefits

Calculate total benefits by adding all the benefits defined above.

Cumulative benefits

Add all the benefits for a year (cash inflows) and then calculate cumulative benefits at the end of each year.

Net benefits/Net cash-flow

Subtract total cost with total benefits for each year to obtain net benefits.

NPV (Net present value)

NPV (for a period of N) = [R1/(1+i)¹ + R2/(1+i)² + R3/(1+i)³ ...Rn/(1+i)ⁿ]- Initial investment

Where

R stands for net cash flow at the end of each period

i stands for required rate of return per period (it is defined by an organization). Or discount rate.

N stands for number of periods a project is going to generate cash inflows

One of the way to choose the discount rate factor i is to decide the rate which the funds needed for a project could return if invested in a different investment instrument.

IRR (Internal rate of return)

It is used to compare profitability of investment in two projects. IRR is that discount rate at which NPV is zero.

If you are comparing two projects the project with higher IRR would be selected.