A profitability indicator used in cost-benefit analysis to determine the viability of cash flows generated from a project or asset
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What is the Benefit-Cost Ratio (BCR)?
The benefit-cost ratio (BCR) is a profitability indicator used in cost-benefit analysis to determine the viability of cash flows generated from an asset or project. The BCR compares the present value of all benefits generated from a project/asset to the present value of all costs. A BCR exceeding one indicates that the asset/project is expected to generate incremental value.
Formula for the Benefit-Cost Ratio
The formula for the benefit-cost ratio is outlined below:
Where:
- CF = Cash flow
- i = Discount rate
- n = Number of periods
- t = Period that the cash flow occurs
Although the formula above may appear complicated, the calculation is simply the discounted cash inflows divided by the discounted cash outflows. The discount rate used refers to the cost of capital, which can be the company’s required rate of return, the hurdle rate, or the weighted average cost of capital.
Summary
- The benefit-cost ratio is used to determine the viability of cash flows from an asset or project.
- The higher the ratio, the more attractive the project’s risk-return profile.
- Poor cash flow forecasting or an incorrect discount rate would lead to a flawed benefit-cost ratio.
Example of the Benefit-Cost Ratio
Cash flow projections for a project are provided below. The relevant discount rate is 10%.
Question: What is the benefit-cost ratio of the project?
Answer:
The benefit-cost ratio would be calculated as $97,670.72 / $33,625.09 = 2.90.
Interpreting the Benefit-Cost Ratio
The higher the BCR, the more attractive the risk-return profile of the project/asset. The value generated by the BCR indicates the dollar value generated per dollar cost.
For example, the BCR of 2.90 in the preceding example can be interpreted as “For each $1 of cost in the project, the expected dollar benefits generated is $2.90.” The following shows the value range of the BCR and its general interpretation:
Advantages of the Benefit-Cost Ratio
Key advantages of the benefit-cost ratio include:
- It is a useful starting point in determining a project’s feasibility and whether it can generate incremental value.
- If the inputs are known (cash flows, discount rate), the ratio is relatively easy to calculate.
- The ratio considers the time value of money through the discount rate.
- The ratio indicates the value generated per dollar of costs.
Limitations of the Benefit-Cost Ratio
Key limitations of the benefit-cost ratio include:
- The reliability of the BCR depends heavily on assumptions. Poor cash flow forecasting or an incorrect discount rate would lead to a flawed ratio.
- The ratio itself does not indicate the project’s size or provide a specific value on what the asset/project will generate. For example, both projects below show a BCR of 2, but present value cash flows are significantly different:
Final Thoughts
Although the benefit-cost ratio is a simple tool to gauge the attractiveness of a project or asset, it should not be the sole determinant of a project’s feasibility. Other ratios and further analysis are recommended.
The BCR is extremely sensitive to the cash flow forecasts and discount rates. If you think the underlying assumptions are incorrect or biased, the benefit-cost ratio should not be relied on.
More Resources
Thank you for reading CFI’s guide to Benefit-Cost Ratio (BCR). In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
FAQs
The benefit-cost ratio (BCR) is an indicator showing the relationship between the relative costs and benefits of a proposed project, expressed in monetary or qualitative terms. If a project has a BCR greater than 1.0, the project is expected to deliver a positive net present value to a firm and its investors.
What is the benefit cost ratio BCR used for? ›
The benefit-cost ratio (BCR) is a profitability indicator used in cost-benefit analysis to determine the viability of cash flows generated from an asset or project. The BCR compares the present value of all benefits generated from a project/asset to the present value of all costs.
What is BCR costs and benefits? ›
The Benefit-Cost Ratio (BCR) is defined as the net benefits divided by the net costs; as a rule of thumb a BCR greater than two is required for public sector projects, whereas a value greater than 1 is sufficient for private investment decisions.
What is the BCR ratio in insurance? ›
Benefit-Cost Analysis (BCA) is a method that determines the future risk reduction benefits of a hazard mitigation project and compares those benefits to its costs. The result is a Benefit-Cost Ratio (BCR). A project is considered cost-effective when the BCR is 1.0 or greater.
What is the formula for BCR in PMP? ›
BCR formula = PV of Benefit Expected from the Project / PV of the Cost of the Project.
What does a benefit-cost ratio BCR of 2.1 mean? ›
May either be expressed as a ratio (2:1) or a resultant value (2). B/C ratios greater than one indicate that a project is efficient (benefits exceed costs). B/C ratios less than one indicate that a project is inefficient (costs exceed benefits).
Why is BCR better than NPV? ›
In a budget constrained environment, the BCR can be used as a tool to rank and prioritise all projects in the budget pool. For this reason, the BCR is the preferred decision criterion for project economic justification. The other decision criterion that provides decision makers with additional information is the NPV.
What is a good benefit-cost ratio? ›
The higher the BCR the better the investment. The general rule of thumb is that if the benefit is higher than the cost the project is a good investment. The practice of cost–benefit analysis in some countries refers to the BCR as the cost–benefit ratio, but this is still calculated as the ratio of benefits to costs.
What is an example of a benefit-cost ratio? ›
For example, if the total value of benefits is $80,000 and the total cost of program is $13,400, then the benefit-cost ratio would be =($80,000/$13,400) = 5.97:1 That means every dollar spent in this program generates $5.97 in gross benefits.
Why is the benefit-cost ratio important? ›
A cost-benefit ratio is important for the following reasons: Investors can use it to decide if investing in a project would yield a good return on investment (ROI). Businesses can benchmark two or more projects to choose one that is more profitable. Companies can prioritise projects that have a higher return.
Experts in the area of insurance capital standards use numerous acronyms to refer to groups, designations, and requirements. The most-used acronyms include: BCR – basic capital requirement. Framework created by the IAIS that measures a G-SII's assets, and life and non-life insurance activities.
How do you calculate a cost-benefit ratio? ›
The cost-benefit analysis involves comparing the monetary benefits of a project to the costs. The formula to calculate the cost-benefit analysis ratio divides the projected present value (PV) of benefit by the present value (PV) of cost attributable to a project.
What is the benefit cost ratio in PMP? ›
The benefit-cost ratio (BCR) helps summarize the relationship between a project's costs and benefits by expressing the ratio as a decimal. If the ratio is greater than 1.0, the benefits outweigh the costs. If the ratio is less than 1.0, the costs outweigh the benefits.
Which method is also known as benefit-cost ratio? ›
Profitability Index method is also known as the Benefit-Cost Ratio.
What is the difference between NPV and BCR? ›
There are two main criteria used for evaluating projects in Benefit: Cost Analysis (BCA): the Net Present Value (NPV = benefits minus costs) and the Benefit: Cost Ratio (BCR = benefits divided by costs).
What is cost in cost-benefit analysis? ›
A cost-benefit analysis is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action. A cost-benefit analysis involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
What is cost-benefit analysis used for? ›
A cost-benefit analysis (CBA) is a systemized approach used to assess the advantages (benefits) and disadvantages (costs) associated with a particular decision, project, or policy. The goals is to decide if the benefits outweigh the costs, meaning more informed business decision-making.
What is the benefit to cost ratio in PMP? ›
The benefit-cost ratio (BCR) helps summarize the relationship between a project's costs and benefits by expressing the ratio as a decimal. If the ratio is greater than 1.0, the benefits outweigh the costs.
What is the benefit-cost ratio in accounting? ›
A cost-benefit ratio formula is a tool professionals use to measure the total cost of a potential project against its expected profit. By accounting for all related expenses, the formula can help determine whether a project is profitable.
What is the benefit-cost ratio also known as? ›
The Benefit Cost Ratio (BCR), also referred to as Benefit-to-Cost Ratio is an indicator that is typically used within a cost benefit analysis. In project management, the benefit cost ratio can support the cost-benefit analysis of a business case.
