Benefit-cost ratio (BCR)

Definition

The benefit-cost ratio (BCR) is a financial metric used to evaluate the profitability or viability of an investment or project by comparing the benefits gained from the project to its costs. 

What is a benefit-cost ratio?

The benefit-cost ratio is commonly used as a decision-making tool in project evaluation and investment analysis. However, other factors such as risk, uncertainty, strategic alignment, and qualitative considerations should also be taken into account when making investment decisions.

The formula for calculating the benefit-cost ratio is:

BCR = Total present value of benefits / Total present value of costs

A benefit-cost ratio greater than 1 indicates that the present value of benefits exceeds the present value of costs, suggesting that the project is potentially economically viable or profitable. A BCR of exactly 1 implies that the project’s benefits equal its costs, while a BCR less than 1 indicates that the costs outweigh the benefits, suggesting that the project may not be economically feasible or advisable.

The ratio takes into account the time value of money by discounting both the benefits and costs to their present values. This adjustment reflects the principle that a pound received or spent in the future is worth less than a pound received or spent today.

While the benefit-cost ratio provides valuable insights into the economic viability of projects, it has some limitations. For example, it may not fully capture non-monetary factors such as intangible benefits, social impacts, and environmental considerations. Additionally, the accuracy of BCR calculations depends on the reliability of the data and assumptions used in estimating project benefits and costs.

Example of a benefit-cost ratio

Let’s consider a project to build a new manufacturing facility. The total present value of benefits associated with the project is estimated to be £5 million, while the total present value of costs is estimated to be £3 million.

BCR = £5 million / £3 million = 1.67

In this example, the benefit-cost ratio is calculated as 1.67. This means that for every pound invested in the project, there is an expected return of £1.67 in benefits. Since the BCR is greater than 1, it indicates that the project is potentially economically viable and could generate positive returns.