What is a Cost Test

A cost test is an analysis applied to a process to determine if the net present value of costs associated with an activity will exceed a benchmark or other limit. Cost tests are often paired with benefit tests when reviewing a business plan and can help a business or government agency decide whether to undertake an activity or project. Put simply, a cost test helps forecast and measure the cost effectiveness of a project or effort.

BREAKING DOWN Cost Test

Businesses and governments must create plans that will not only be viable in the following year but will also make sense in decades. This is especially the case with plans that involve large capital expenditures, such as the building of a factory, an airport or a bridge. The longer the useful life of a plan and its components, the longer the organization has to develop the plan’s successor.

Cost Test Usage

Cost tests are used to determine if the costs of undertaking an action, such as building a new power plant, will be greater than an alternative. In the case of power plants, a regional utility will want to know if the net present value of the cost of providing power through the new plant will exceed the cost of using alternative means to generate power. For example, the utility may balance the cost of generating greater capacity with the cost of energy conservation programs that may reduce the amount of power demanded.

Cost Test Timelines and Variants

Rather than review the net present value of costs over an indefinite horizon, cost test analysts typically choose a timeline over which to compare the costs of different options. For example, a plan may be judged over an estimated life not to exceed 20 years.

Organizations may also look at different variants of the cost test, including the total resource cost test and the societal test. These two tests take into account a wider array of costs, including the cost to the organization, the cost to stakeholders who work with the organization and the cost associated with externalities.

Many states have their own unique versions of cost testing. For example, California has a total resources cost test (TRC) that examines the efficiency of utility projects from the perspective of an entire service territory. It compares the benefits a program gets from avoided supply costs to the costs for administering a program and also the cost of upgrading equipment. Passing such a test means energy services costs for consumers will fall.