Unit-2

Cost Benfit Analysis:-

Cost-benefit analysis (CBA) is a technique used to compare the total costs of a

programme/project with its benefits, using a common metric (most commonly
monetary units). This enables the calculation of the net cost or benefit associated
with the programme. 

As a technique, it is used most often at the start of a programme or project when

different options or courses of action are being appraised and compared, as an
option for choosing the best approach.

It can also be used, however, to evaluate the overall impact of a programme in

quantifiable and monetised terms.

CBA adds up the total costs of a programme or activity and compares it against its
total benefits. The technique assumes that a monetary value can be placed on all
the costs and benefits of a programme, including tangible and intangible returns to
other people and organisations in addition to those immediately impacted.

As such, a major advantage of cost-benefit analysis lies in forcing people to

explicitly and systematically consider the various factors which should influence
strategic choice.

Decisions are made through CBA by comparing the net present value (NPV) of the
programme or project’s costs with the net present value of its benefits.

Why Use Cost Benefit Analysis?

Organizations rely on cost benefit analysis to support decision making because it provides an agnostic,
evidence-based view of the issue being evaluated—without the influences of opinion, politics, or bias. By
providing an unclouded view of the consequences of a decision, cost benefit analysis is an invaluable tool
in developing business strategy, evaluating a new hire, or making resource allocation or purchase
decisions.

Scenarios Utilizing Cost Benefit Analysis

As mentioned previously, cost benefit analysis is the foundation of the decision-making process
across a wide variety of disciplines. In business, government, finance, and even the nonprofit
world, cost benefit analysis offers unique and valuable insight when:

 Developing benchmarks for comparing projects

 Deciding whether to pursue a proposed project
 Evaluating new hires
  Weighing investment opportunities
 Measuring social benefits
 Appraising the desirability of suggested policies
 Assessing change initiatives
 Quantifying effects on stakeholders and participants

How to Do a Cost Benefit Analysis

While there is no “standard” format for performing a cost benefit analysis, there are certain core
elements that will be present across almost all analyses. Use the structure that works best for
your situation or industry, or try one of the resources and tools listed at the end of this article.
We’ll go through the five basic steps to performing a cost benefit analysis in the sections below,
but first, here’s a high-level of overview:
 

1. Establish a framework to outline the parameters of the analysis

2. Identify costs and benefits so they can be categorized by type, and intent
3. Calculate costs and benefits across the assumed life of a project or initiative
4. Compare cost and benefits using aggregate information
5. Analyze results and make an informed, final recommendation

 
As with any process, it’s important to work through all the steps thoroughly and not give in to the
temptation to cut corners or base assumptions on opinion or “best guesses.” According to a
paper from Dr. Josiah Kaplan, former Research Associate at the University of Oxford, it’s
important to ensure that your analysis is as comprehensive as possible:
 
“The best cost-benefit analyses take a broad view of costs and benefits, including indirect and
longer-term effects, reflecting the interests of all stakeholders who will be affected by the
program.”

How to Calculate Costs and Benefits

With the framework and categories in place, you can start outlining overall costs and benefits.
As mentioned earlier, it’s important to take both the short and long term into consideration, so
ensure that you make your projections based on the life of the program or initiative, and look at
how both costs and benefits will evolve over time.

Example:

 
TIP: People often make the mistake of monetizing incorrectly when projecting costs and benefits, and
therefore end up with flawed results. When factoring in future costs and benefits, always be sure to adjust
the figures and convert them into present value.

Cash Flow Forecasting

Cash flow is the movement of the money in and out of an organisation. It involves
the expenditure and income of an organisation.
Cash Flow Forecasting:
In simple words, it is the estimation of the cash flow over a period of time. It is
important to do cash flow forecasting in order to ensure that the project has
sufficient funds to survive. It gives an estimation that when income and
expenditure will take place during the software project’s life cycle. It must be done
time to time especially for start-ups and small enterprises. However, if the cash
flow of the business is more stable then forecasting cash flow weekly or monthly is
enough.

Cash flow is of two types:

 Positive Cash Flow:
If an organisation expects to receive income more than it spends then it is said
to have a positive cash flow and the company will never go low on funds for
the software project’s completion.
 Negative Cash Flow:
If an organisation expects to receive income less than it spends then it is said
to have a negative cash flow and the company will go low on funds for the
software project’s completion in future.

Importance of Cash Flow Forecasting:

 It allows the management to plan the expenditures based upon the income in
future.
 It helps the organization to analyse its expenditures and incomes.
 Makes sure that the company can afford to pay the employees and suppliers.
 Helps in financial planning.
 Goals of Cash Flow Forecasting
The main goal of a cash flow forecasting is to assist with managing liquidity
within an organisation and ensuring that the business has the necessary cash to
meet its obligations and avoid funding issues, essentially better management of
working capital. Underneath the high level goal of liquidity management, there
are often a number of reasons why companies set up a cash flow forecasting
process, these include:

• Covenant forecasting and half/ full year reporting visibility.

• Interest and debt reduction.
• Short term liquidity planning.
• Long Term Planning/ Budgeting Purposes (e.g. 3 year plan)

Methods of Cash Flow Forecasting

There are essentially two main types of cash forecasting methods – direct or
indirect.

Direct cash forecasting is a method of forecasting cash flows and balances for
short term liquidity management purposes, typically less than 90 days in
duration.

Direct cash forecasts often but not always include system based cash flows so
as to make the cash forecast as close to real time as possible.

Indirect cash forecasting is often longer term in nature and it relies on various
indirect methods of building up a cash forecast such as using projected balance
sheets and income statements.

The table below outlines the main differences between direct and indirect cash
flow forecasting:
Management of a Cash Flow Forecasting Process
In larger companies, the management of a cash forecasting process is controlled
by the head office treasury or finance team.
The work to be done in terms of assembling a forecast position generally
involves sourcing data from both systems and people. The more complex an
organisation, the more systems will contribute to the process, therefore it is
critical to have the sources of cashflow data  mapped and clearly defined.
Although systems are important, it will be the buy-in and engagement of people
that will determine how successful a cash forecasting process will be. Involving
the people who will be accountable and ensuring their buy-in is a key factor for
success particularly for direct cash flow forecasting.

 Cost Benefit Evaluation Techniques:

• Costs and benefits have to be expressed using the same scale to be

comparable

• Usually expressed in payments at certain times (cash flow table)

• Payments at different points in time are not comparable based only on the
amount

•Time of payment should be considered

• Techniques:

1. Net profit
2. Payback period
3. Return on investment
4. Net present value
5. Internal rate of return

1. Net Profit:

• Difference between total cost and total income

• Pros: Easy to calculate

• Cons

– Does not show profit relative to size investment (e.g., consider Project 2)

– Does not consider timing of payments (e.g., compare Projects 1 and 3)

• Not very useful other than for "back of envelope" evaluations

2. Payback Period

• Time taken to break even

• Pros

– Easy to calculate

– Gives some idea of cash flow impact

• Cons: Ignores overall profitability

• Not very useful by itself, but a good measure for cash flow impact
 3. Return On Investment

• Also known as the accounting rate of return (ARR)

• Provides a way of comparing the net profitability to the investment required

• The common formula

– ROI = (average annual profit/total investment) X 100

Pros: Easy to calculate

• Cons

– Does not consider the timing of payments

– Misleading: does not consider bank interest rates

• Not very useful other than for "back of envelope" evaluations

4. Net Present Value

• A project evaluation technique that takes into account the profitability of a

project and the timing of the cash flows that are produced

• Sum of all incoming and outgoing payments, discounted using an interest rate,
to a fixed point in time (the present)

• Present value = (value in year t)/(1+r)^t – r is the discount rate – t is the

number of years into the future that the cash flow occurs

• (1+r)^t is known as discount factor

• In the case of 10% rate and one year

– Discount factor = 1/(1+0.10) = 0.9091

• In the case of 10% rate and two years

– Discount factor = 1/(1.10 x 1.10) = 0.8294

 •

Pros

– Takes into account profitability

– Considers timing of payments

– Considers economic situation through discount rate

• Cons: Discount rate can be difficult to choose

• Standard measure to compare different options

5. Internal Rate of Return

• Internal rate of return (IRR) is the discount rate that would produce an NPV
of 0 for the project

• Can be used to compare different investment opportunities

• There is a Microsoft Excel function to calculate IRR

• May be estimated by plotting a series of guesses

• Pros

– Calculates figure which is easily comparable to interest rates

• Cons: Difficult to calculate (iterative)

• Standard way to compare projects

• Given two NPVs, one positive the other negative, estimate IRR as:

– IRR = int1 - npv1 * ((int2-int1)/(npv2-npv1))

– Calculate NPV at this rate

– Use estimated rate as one data point in next iteration

What is Risk?

 Risk is inevitable in a business organization when undertaking projects.

However, the project manager needs to ensure that risks are kept to a
 minimal. Risks can be mainly divided between two types, negative impact
risk and positive impact risk.
 Not all the time would project managers be facing negative impact risks as
there are positive impact risks too. Once the risk has been identified, project
managers need to come up with a mitigation plan or any other solution to
counter attack the risk.

 There is a risk that software might exceed the original specification and that
a project will be completed early and under budget. That is not a risk that
need concern us.

 Every project involves risk of some form. When assessing and planning a
project, we are concerned with the risk of the project's not meeting its
objectives.
Risk identification and ranking
 In any project evaluation we should attempt to identify the risks and quantify
their potential effects.
 One common approach to risk analysis is to construct a project risk matrix
utilizing a checklist of possible risks and to classify each risk according to
its relative importance and likelihood.
 Note that the importance and likelihood need to be separately assessed - we
might be less concerned with something that, although serious, is very
unlikely to occur than with something less serious that is almost certain.
 Table 3.7 illustrates a basic project risk matrix listing some of the risks that
might be considered for a project, with their importance and likelihood
classified as high (H), medium (M), low (L) or exceedingly unlikely (—). So
that projects may be compared the list of risks must be the same for each
project being assessed. It is likely, in reality, that it would be somewhat
longer than shown and more precisely defined.
 The project risk matrix may be used as a way of evaluating projects (those
with high risks being less favoured) or as a means of identifying and ranking
the risks for a specific project.
Risk and net present value
 Where a project is relatively risky it is common practice to use a higher
discount rate to calculate net present value.
 This addition or risk premium, might, for example, be an additional 2% for a
reasonably safe project or 5% for a fairly risky one.
 Projects may be categorized as high, medium or low risk using a scoring
method and risk premiums designated for each category. The premiums,
even if arbitrary, provide a consistent method of taking risk into account.
Cost-benefit analysis
 A rather more sophisticated approach to the evaluation of risk is to consider
each possible outcome and estimate the probability of its occurring and the
corresponding value of the outcome.
 Rather than a single cash flow forecast for a project, we will then have a set
of cash flow forecasts, each with an associated probability of occurring.
  The value of the project is then obtained by summing the cost or benefit for
each possible outcome weighted by its corresponding probability. Exercise
3.7 illustrates how this may be done.

Risk profile analysis

 An approach which attempts to overcome some of the objections to cost-
benefit averaging is the construction of risk profiles using sensitivity
analysis.
  This involves varying each of the parameters that affect the project's cost or
benefits to ascertain how sensitive the project's profitability is to each factor.
 for example, vary one of our original estimates by plus or minus 5% and
recalculate the expected costs and benefits for the project. By repeating this
exercise for each of our estimates in turn we can evaluate the sensitivity of
the project to each factor.
 By studying the results of a sensitivity analysis we can identify those factors
that are most important to the success of the project.
 We then need to decide whether we can exercise greater control over them
or otherwise mitigate their effects. If neither is the case, then we must live
with the risk or abandon the project.
Using decision trees
 The approaches to risk analysis discussed previously rather assume that we
are passive bystanders allowing nature to take its own course - the best we
can do is to reject over-risky projects or choose those with the best risk
profile.
 There are many situations, however, where we can evaluate whether a risk is
important and, if it is, indicate a suitable course of action.
 Many such decisions will limit or affect future options and, at any point, it is
important to be able to see into the future to assess how a decision will affect
the future profitability of the project.
 Prior to giving Amanda the job of extending their invoicing system, IOE
must consider the alternative of completely replacing the existing system -
which they All three projects have the same expected profitability.
 The profitability of project A is unlikely to depart greatly from its expected
value (indicated by the vertical axis) compared to the likely variations for
project B. Project A is therefore less risky than project B.