Benefit to Cost Ration - Essay Example

Benefit to cost ration Name Institution Date Benefit to Cost Ration In finance there are very many terms that are used to describe a situation, comparison or analysis. Therefore, benefit to cost ratio is used to describe a financial comparison between production of goods in a firm and expenditure burden experienced when making a product. Evaluation is hence mandatory to analyze whether venture is profitable or the converse. Thus when the expenditure exceeds other parameters then the business is more of a time waster than a profit making organization. In this event it is litmus test of cost-benefit analysis which depicts the significance of money spent. It can also be described as a ratio between the costs and benefits or returns which are in monetary terms. It is mostly used in cost-benefits appraisal. The peek net present value of money is seen in most firms with the absence of funding constraints. In the presence of a budget constraint Net Present Value versus the costs incurred within the allocated constraint is mainly applied. Under normal circumstances the ratio of Present Value of the projected profits in a goal oriented firm is usually seen and evaluated as a Benefit-cost ratio (Charlotte, 2010). Emergence of benefit to cost ratio The concept was first introduced by a French engineer (Jules Dupuit) in the early 18th century. The formula was further updated by an economist which became the foundation of benefit to cost ratio. However to was not brought into use until the implementation of the Federal Navigation Act. The act was targeted at engineers who were with projects in the United States are worth more to the public than the injected capital in the business projects. The ratio however should be in the present monetary values discounted. This was thus very handy to the general public as the families of the affected individuals were far more secure than the actual project. The Act was in this way a life saving move to the public (Boardman, 1996). Technique of calculating There are various techniques of calculating the Benefit to Cost Ratio. For instance in an organization which is of course profit making business say a beverage making firm. Note the amount of money obtained through selling the product over a certain period of time. For example the firm makes £567,000 in a gross period of six months for selling the beverage. Hence the benefits or returns would be £567,000. Afterwards figure out the amount of expenditure so far experienced during the same time. Say the firm incurred £100,000 for the product to be worthy to the clients, this includes the promotion of the products and other miscellaneous costs i.e. rental fee, labor services, transport cost, security and purchasing of raw material. The expenditure is hence £100,000. Therefore divide the total returns and the expenditure so far incurred. That is £567,000 by £100,000. Results obtained will in this way be 5.67 which are approximately 6. Hence the conclusion made would be the benefit to cost ratio is 6-to-1 or alternatively 6:1 (Charlotte, 2010). Advantages Using the ratio it facilitated the business to know the merits and demerits of both extreme ends i.e. profit and loss. In creation of a proposal it would show what the firm is oriented to. It is very simple to make ones own analysis with the application of the formula. Though there are other considerations that make the determination of this hard such as production line breakdown and employee performance and output. This would cause a dramatic alteration on the ratio. This should be taken into account when formulating a good proposal of the firm. The beverage firm showed a profitable future since the output exceeded the input showing positive future. For the business to stay afloat it should maintain a positive ratio to cater for its needs and any eventuality ahead (Cohn, 1972). Benefit to cost ratio is an evaluation tool that is mainly employed in the financial world. It is used to measure the investment made versus the output that would be obtained. For instance a Widgets Company invests in an oil and gas production plant in Abu Dhabi. Engineering works done to the company was budgeted to be £270 million. This was majorly targeting towards developing and erecting the oil and gas fields. After all necessary needs were put in place the company commenced distributing oil and gas within the UAE region. Through application of positive corporate governance the company after half a decade had £540 million. Applying the tool the ratio would be 540/270 which is estimated to about 2. The firm therefore uses it as a tool to determine its path towards profit. This relayed to the investors that the firm is potentially prospective (Hoffmann, 2007). Critics would hence try to ask what kind of evaluation tool is Benefit to Cost ratio. Through the employment of the ratio formula it is observed that it gives quantitative results which can be used for economic evaluation. Because the values are in monetary terms it would be expressed in the cash flow analysis. The ratio as seen in the second case is best used in long term cases rather than short term cases which would relay very minute changes. Say for instance a firm in the Euro zone i.e. Coke Cola Company which is known worldwide. The company sells its products to different countries in this way varying markets. When the company invests on production of one of its products such as “Fanta” and sales made reflect the expected profits or loss. Because the monetary value is large when assessed over a short period of time the results would be to a high extent below zero and therefore does not show much of what is expected. The tool thus is used to measure various things in a firm such as Net benefits, internal return rates and benefits to cost ratio. The tool is hence very useful in today’s economy as they assess if the projects are worthwhile or a mere waste of resources. Projects that can be assessed include: infrastructural and healthcare systems (Powell, 2007). Principles and disadvantage of cost benefit ratio The concept during its computations entities involved that is the costs incurred and the benefits so far obtained can be appreciated on first sight. However there are others which fail this test. Hence need to develop principles to offer guidance towards solving them. The major disadvantage completely ignore some peripherals such size of payoffs. The measure must in this way be a common unit. For one to reach a valid conclusion either positive or negative the entities should be of a common unit. Hence use of monetary terms as the most common unit of value measurement. It is therefore requires that all the expenditures and the inputted cost should be I terms of money value. Though most people would expect benefits in terms of dollars however a program may provide benefits which are not in monetary terms (Caroline, 1996). For example the firm would offer medical care to individuals for an allocated period of time. Instead of the benefits expected the firm offers services which are of the same value as expected. The cost and the expenditure should be in the value in use at that time. This is due factors such as inflation i.e. the value of money at this particular time is less than the same amount five years from now. With this in mind the money available now could be put into use and at the end of five years would be worth more. Using interest rates as R and time taken to be T years then we have (1 + R) T. Money that will be used to generate (1 + R) T is (1 + R) -T at that given time T, this is the discount value. When the product of returns value of money in future and discounted value at also the same time we obtain the value of the returns of the firm, similarly to the expenditures. Therefore the net returns of the firm would be the difference of the sum of returns and the present expenditure value (Caroline, 1996). Benefit to cost ratio should be a representation of the consumer’s valuation by their normal behavior. The expenditure and the returns obtained show the preference of the consumers and producers. For instance making improvement on the infrastructure mostly would promote saving of other unnecessary costs. Hence the measure of financial value of the time saved is required. Which value the time saved is the one which reveals choices that time and the money obtained is involved in a tradeoff. It is very difficult to find the tradeoffs that depict the choices made in the past. On the other hand the returns are measurable through market options. When a consumer purchase goods and services it reveals that the goods and services are similar to the money spend. Consumption of the product will inflate until additional units equal the marginal returns. Marginal return is equal to the market price for any product purchased by the consumer. The marginal returns would decrease simultaneously with market pricing and conversely increase when the consumer makes more purchases. The affiliation draw between the two components is demand schedule. It hence relays meaningful data on marginal returns required to place a money value on inflated purchase (Sasmita, 1996). The benefits of inflated purchasing thereby consuming is usually covered under the demand curve. When returns inflate consumption also does so, this is a summation of marginal benefits by any increase in consumption. The demand curve has more similarities to than differences to marginal benefit curve. Though some analysis of some returns highly demand for valuation of life. Therefore the project analysis recommends the inclusion of without versus with comparison (Sasmita, 1996). Application and example Benefit to cost ratio can be applicable in very many areas in today’s world. For instance in a infrastructural improvement project such as Highway 101 into San Jose. The highway which was nicknamed “blood alley” had no median divider which led to a high frequency of fatal accidents. Improvement to the highway intends to increase its carriage way thereby increasing the number of traffic flow. As a result a lot of time will be saved and decline the frequency of accidents. The hypothetical data is as shown below: Trip data No extension “blood alley” only 101 Extension and “blood Alley” Rush hours Passenger Trips (per hour) 3,000 4,000 Trip Time (minutes) 50 30 Value of time ($/minute) $0.10 $0.10 Passenger Trips (per hour) 500 555.55 Trip Time (minutes) 35 25 Value of time ($/minute) $0.08 $0.08 Traffic Fatalities (per year) 12 6 Source: (Thayer, 2005) The data thus depicts the changes that occurred before and after the improvement was done. After the improvement the number of vehicles through the highway per unit time had increased. The number of roads users has since inflated. Therefore the project saves $2 and $0.80 for rush-hour and non-rush-hour trips respectively. The trips that have so far been made after implementation of the project is one and a half times the value of saved time. The returns generated after an hour is $7,000 and $422.22 both in rush and non-rush hours respectively. The benefits can be seen on annual basis through calculating the number of rush hours per year and non-rush hours them find their product by the daily rate. Due to reduced accidents and can be obtained by economic value people place on their lives when taking risks. The annual benefits thus are overwhelming and overshadow the risks incurred (Thayer, 2005). Deducing the negativity and positivity of the project to their monetary value, the benefit to cost ratio determines the worth of the project. Data collected from the consumer and producer is used as a framework for equivalent monetary value that is effects of the project of demand and supply. A project that is beneficial is one which discount benefits value is more appreciable than expenditure value. The project will therefore have positive returns (Mishra, 2009). Application of the concept in the real world proves to be difficult unless theoretical. This is because it needs conversion of all returns and benefits into monetary values. It is however, difficult to evaluate some cost which are intangible and assign them monetary value such as projects that have environmental outcomes. The ratio is also very controversial in that the option is sensitive of discount rate. The ratio therefore can only be obtained through use of present values (Teal, 1996). Conclusion Benefit to cost ratio is a very important tool in the economy. It provides a base for making decision in a firm. It is used for the evaluation of projects. It thus includes all necessary peripherals needed for evaluation which defines them clearly. Conclusive comparisons are easily made through this for projects to be invested in. it therefore makes one to omit bad projects and proposals. Reference Boardman, A. L. (1996). Cost Benefit Analysis: Concepts and Practice. New Jersey: Prentice Hall. Cohn, E. (1972). Public Expenditure Analysis, with Special Reference to Human Resources. Toronto: Lexington Books. Gittinger, J. P. (1982). Economic Analysis of Agricultural Projects. Baltimore: Johns Hopkins University Press. Hoffmann, M. (2007.). Implication of Stakeholders and the Sharehlders. New York: GRIN. Johnson, C. (2010). How to Calculate the Benefit to Cost Ratio. eHow . Mishra, S. (2009). Engineering Economics and Costing. New York: PHI Learning Pvt. Ltd. Powell, J. (2007). Benefit-Cost Analysis. 1-28. Teal, C. D. (1996). Principles of cost-benefit analysis for developing countries. London: Cambridge University Press. Watkins, T. (2005). An Introduction to Cost Benefit Analysis. Alabama. Read More