What is the Benefit-Cost Ratio (BRC)?
The benefit-cost ratio (BCR) is used in a cost-benefit analysis to summarize the overall relationship between a proposed project’s relative costs and benefits. BCR can be expressed in monetary or qualitative terms. A project with a BCR greater than 1.0 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 capital budgeting to analyze the overall value for money of undertaking a new project. However, the cost-benefit analyses for large projects can be complex because so many assumptions and uncertainties are hard to quantify. This is why there is usually a wide range of potential BCR outcomes.
The BCR also does not indicate 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 weighted-average cost of capital (WACC)—the opportunity cost of that capital.
The BCR is calculated by dividing a project’s proposed total cash benefit by the proposed total cash cost. Before dividing the numbers, the net present value of the respective cash flows over the proposed lifetime of the project—taking into account the terminal values, including salvage and remediation costs—is calculated.
What does the BCR tell you?
If a project has a BCR greater than 1.0, it is expected to deliver a positive net present value (NPV). It will have an internal rate of return (IRR) above the discount rate used in the DCF calculations. This suggests that the NPV of the project’s cash flows outweighs the NPV of the costs, and the project should be considered.
Example of How to Use the BCR
For example, assume company ABC wishes to assess the profitability of a project that involves renovating an apartment building over the next year. The company decided to lease the equipment needed for the project for $50,000 rather than purchasing 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. Moreover, 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 relies on many factors and can be undermined by unforeseen events. They follow the rule that above 1.0 means success and below 1.0 spells failure, which is misleading and can provide a false sense of comfort with a project. The BCR must be used as a tool in conjunction with other types of analysis to make a well-informed decision.
What is the Benefit-Cost Ratio (BRC) used for?
The BRC is used in cost-benefit analysis to describe the connection between the costs and benefits of a potential project.
How Do You Calculate the Benefit-Cost Ratio?
The benefit-cost ratio is determined by dividing a project’s proposed total cash benefit by the project’s proposed total cash cost.
What Does a Benefit-Cost-Ratio Over 1.0 Suggest?
A reading over 1.0 suggests that, on a broad level, a project should be financially successful; a reading of 1.0 suggests that the benefits equal the costs; and a reading below 1.0 suggests that the costs trump the benefits.
