HKSM

Cost-benefit analysis is a technique that compares the total expected costs of an option with its expected benefits, usually in monetary terms, to determine net value and the preferred alternative. It supports selection, prioritization, and ongoing value management across predictive and adaptive approaches.

Key Points

• Compares total lifecycle costs and benefits, typically converted to monetary terms, to judge net value.
• Helps select among alternatives, prioritize initiatives, and maintain a valid business justification.
• Common metrics include net present value (NPV), benefit-cost ratio (BCR), return on investment (ROI), and payback period.
• Uses the time value of money by discounting future cash flows to present value.
• Considers tangible and, where feasible, monetized intangible benefits; non-financial factors should be noted separately.
• Requires explicit assumptions, time horizon, and sensitivity or risk analysis to reduce bias and uncertainty.

Purpose of Analysis

• Demonstrate whether an initiative delivers net economic value.
• Compare competing options on a consistent basis to support investment decisions.
• Inform stage-gate or ongoing funding decisions as conditions change.
• Communicate expected value and key drivers to stakeholders.

Method Steps

• Define alternatives and the decision criteria (e.g., maximize NPV, meet minimum BCR).
• Identify all relevant costs and benefits across the full lifecycle (initial, operating, maintenance, disposal).
• Estimate timing and amounts for each cash flow; document assumptions and constraints.
• Select a discount rate and analysis horizon consistent with organizational policy.
• Convert future cash flows to present value; calculate NPV, BCR, ROI, and payback period.
• Perform sensitivity and risk analysis on key variables (costs, benefits, timing, discount rate).
• Compare alternatives, summarize findings, and recommend the preferred option with rationale.

Inputs Needed

• Business need, objectives, and selection criteria.
• Defined alternatives and scope boundaries.
• Cost estimates (capital, operating, maintenance, transition, disposal).
• Benefit estimates and benefit realization timeline.
• Discount rate and analysis horizon from organizational policy.
• Key assumptions, constraints, and risk data (ranges, probabilities).
• Historical data, benchmarks, or expert judgment for validation.

Outputs Produced

• Calculated metrics: NPV, BCR, ROI, and payback period.
• Present value cash flow summary by year or period.
• Sensitivity results showing impact of changes in key drivers.
• Recommendation of the preferred alternative with rationale.
• Documented assumptions, risks, and uncertainties for decision makers.

Interpretation Tips

• Positive NPV indicates net value creation; higher NPV is generally preferred among options.
• BCR greater than 1.0 suggests benefits exceed costs; use alongside NPV for context.
• Shorter payback reduces exposure but should not override value-based metrics like NPV.
• Consider risk-adjusted results or scenarios, not just single-point estimates.
• Ensure comparisons use the same time horizon, discount rate, and scope of costs/benefits.
• Highlight non-financial impacts (compliance, safety, strategic alignment) that may influence the decision.

Example

A sponsor asks you to compare two alternatives over three years at a 10% discount rate.

• Option A: Initial cost 200, annual benefit 90 for 3 years, annual O&M cost 10.
• Option B: Initial cost 240, annual benefit 120 for 3 years, annual O&M cost 15.

Present value factor for a 3-year annuity at 10% is about 2.487.

• Option A PV benefits: 90 x 2.487 = 223.8; PV O&M: 10 x 2.487 = 24.9; NPV ≈ (223.8 - 24.9) - 200 = -1.1. BCR ≈ 223.8 / (200 + 24.9) = 0.99.
• Option B PV benefits: 120 x 2.487 = 298.4; PV O&M: 15 x 2.487 = 37.3; NPV ≈ (298.4 - 37.3) - 240 = 21.1. BCR ≈ 298.4 / (240 + 37.3) = 1.08.

Recommendation: Option B provides positive NPV and BCR > 1, so it is preferred.

Pitfalls

• Omitting lifecycle costs such as operations, maintenance, or end-of-life expenses.
• Double-counting benefits or ignoring negative externalities.
• Over-optimistic estimates that are not validated by data or expert review.
• Using inconsistent time horizons or discount rates across options.
• Relying solely on payback period and neglecting overall value (NPV) and risk.
• Failing to document assumptions and sensitivity, making results hard to trust.

PMP Example Question

While evaluating multiple project proposals with different cash flow timings, which metric is most appropriate to compare their economic value?

1. Simple payback period.
2. Net present value (NPV).
3. Total undiscounted benefits.
4. Return on hours worked.

Correct Answer: B - Net present value (NPV).

Explanation: NPV discounts future cash flows to present value and directly measures net value. Payback and undiscounted totals can mislead when timing differs.