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Commonly examined as part of a cost-benefit analysis, a benefit cost ratio (BCR) is a formula defined as the monetary benefits of a project or course of action divided by its monetary costs, with all benefits and costs expressed in present values. Analysts attempt to form reasonable estimates of costs and benefits by inferring them from market behavior or surveys. The higher the benefit cost ratio, the better the value of the project is.
A present value is the projected current monetary worth of a revenue or expenditure stream on a given date. A discount rate is typically based on an interest rate taken from financial markets. That rate is applied to all pertinent future costs and benefits to ascertain the present-value terms.
A major inadequacy of the BCR is that it disregards less tangible non-monetary impacts, such as market penetration, loss of reputation, or long-term venture strategic alignments. Another problem with BCRs involves clearly defining and determining the appropriate benefits and costs to include. These can differ depending on the financial organization or interest group involved. Analysis using the benefit cost ratio is not common in large organizations because their projects often include intangible factors that are not easy to quantify monetarily. For example, in analyzing the value of installing a guardrail on a treacherous road, a company has to assign a dollar value to injuries and deaths that can be avoided and weigh it against the actual costs of the guardrail.
Analyses based on a benefit cost ratio must be considered with caution because they can be highly erroneous. Underestimations of costs are common due to their heavy reliance on data from similar projects in the past. Project participants may not accurately recall the crucial costs of a project. The current project may not be directly comparable to the old project, differing in terms of size, function or skill levels of members. Furthermore, the formulae with which analysts assign money values to intangible factors may be arbitrary and subject to bias.
Benefit cost ratios may also be flawed when analysts overestimate benefits.For example, if a company is launching a new product and the projected sales are $60 million US Dollars (USD) per year, actual annual sales of $30 million US Dollars (USD) would represent a benefit shortfall of 50 percent. A general tendency for people to be over-optimistic results in overestimating the probability of positive occurrences and underestimating the probability of adverse occurrences. When benefit shortfalls occur simultaneously with cost overruns, the BCR plummets.