What is a 'Benefit Cost Ratio - BCR'

A benefit cost ratio (BCR) attempts to identify the relationship between the cost and benefits of a proposed project. Benefit cost ratios are most often used in corporate finance to detail the relationship between possible benefits and costs, both quantitative and qualitative, of undertaking new projects or replacing old ones.

BREAKING DOWN 'Benefit Cost Ratio - BCR'

The ratio is used to measure both the quantitative and the qualitative factors, since sometimes the benefits and the costs cannot be measured exclusively in financial terms. When possible, the qualitative factors should be translated into quantitative terms for the results to be easily understandable and tangible.

Benefit Cost Ratio Calculation

The BCR is calculated by dividing the total discounted value of the benefits by the total discounted value of the costs. To calculate the discounted values of each, use the net present value (NPV) formula, in which the values are divided by the sum of 1 and the discount rate raised to the number of periods.

For example, assume company ABC wishes to assess the profitability of a project that involves renovating an apartment building that the company owns, over the next year. The company decides to lease the equipment needed for the project for $50,000, rather than purchasing the equipment. The inflation rate is 2%, and the renovations are expected to increase the company's annual profit by $100,000 for the next three years.

The NPV of the total cost of the lease does not need to be discounted, because the initial cost of $50,000 is paid up front. The NPV of the projected benefits is $288,388, or ($100,000 / (1 + 0.02)^1) + ($100,000 / (1 + 0.02)^2) + ($100,00 / (1 + 0.02)^3). Consequently, the BCR is 5.77, or $288,388 divided by $50,000.

Interpretation

If a project has a BCR that is greater than 1, it indicates that the NPV of the project benefits outweigh the NPV of the costs. Therefore, the project should be considered if the value is significantly greater than 1. If the BCR is equal to 1, the ratio indicates that the NPV of expected profits equal the costs. If a project's BCR is less than 1, the project's costs outweigh the benefits and it should not be considered.

In the previous example, company ABC had a BCR of 5.77, which indicates that the project's benefits significantly outweigh its costs. Moreover, company ABC could expect $5.77 in benefits for each $1 of its cost.

RELATED TERMS
  1. Profitability Index

    An index that attempts to identify the relationship between the ...
  2. Net Present Value Rule

    The net present value rule (NPV) states an investment should ...
  3. Quantitative Analysis

    A business or financial analysis technique that seeks to understand ...
  4. Progress Billings

    A series of invoices prepared at different stages in the process ...
  5. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  6. Accounting Ratio

    A way of expressing the relationship between one accounting result ...
Related Articles
  1. Investing

    Ratio Analysis Tutorial

    If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
  2. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  3. Investing

    6 Basic Financial Ratios And What They Reveal

    These formulas can help you pick better stocks for your portfolio once you learn how to use them.
  4. Investing

    Key Financial Ratios for Manufacturing Companies

    An investor can utilize these financial ratios to determine whether a manufacturing company is efficient, profitable and a good long-term investment option.
  5. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  6. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  7. Investing

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  8. Investing

    5 Must-Have Metrics for Value Investors

    These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
RELATED FAQS
  1. How do I take qualitative factors into consideration when using fundamental analysis?

    Fundamental analysis is the method of analyzing companies based on factors that affect their intrinsic value. Find out how ... Read Answer >>
  2. How do you use discounted cash flow to calculate a capital budget?

    Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >>
  3. How do you use DCF for real estate valuation?

    Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>
  4. How do you use internal rate of return to calculate a capital budget?

    Learn about how the internal rate of return is used in the creation of a capital budget along with net present value and ... Read Answer >>
Hot Definitions
  1. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  2. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  3. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  4. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  5. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  6. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
Trading Center