Cost-Benefit Analysis for Contractors

Making a sound investment decision is daunting enough without having to be concerned about falling into a fraud trap and being under the guidance of an unethical financial advisor. Having the capability of making one creates a rock-hard foundation for any business venture, particularly in the construction industry. The success of a construction contractor not only hinges on his/her ability to acquire jobs and complete them to the required standards and within the expected budget but also to make a sound investment decision that maximizes the generation of dollars for every dollar spent.

If you are a contractor yourself – which you probably are since you have landed on this page, you should know that managing a construction project necessitates the making of several decisions to keep the wheels turning. Contractors who have excelled in their markets use data and rely on proper analysis – as opposed to their gut instinct – to formulate informed decisions. I am not saying that you should take your instinct out of the equation as you try to make up your mind. A balance has to be struck between using tangible information and human instinct in decision-making, especially when the decision involves a trade-off between two or more investment opportunities.

What is Cost-Benefit Analysis?

Cost-Benefit Analysis (CBA) is a decision-making tool that assists in determining if a project is worth the investment or expenditure is worthwhile. It is a simpler version of investment appraisal – although it can be as complicated as you want it to be, and it involves summing up all the monetary benefits of a project or an investment and then comparing these with the relevant costs.

Many construction contractors have struggled to keep their businesses afloat as they often invested in projects that seemed financially attractive on the surface but eventually did not generate any significant returns. By just scratching the surface, these contractors frequently jump to conclusions about the profitability of projects, making unsound investment decisions. With Cost-Benefit Analysis, you can steer clear of this path and be sure that every dollar you invest will yield the maximum amount of profit in return.

A Real-Life Example

All this reading has probably aroused your curiosity as to how Cost-Benefit Analysis works. There is no better way to explain the usage of an analytical tool than by attempting to solve a real-life problem. Let us suppose that there are three different, short-term projects on the table, and you can only choose one project to proceed with. Let us name these projects: Project A, Project B, and Project C.

Project A is expected to generate a total benefit of $150,000 and cost $100,000 in total. Project B has been estimated to yield a benefit of $130,000 in total and cost a total amount of $70,000. Regarding Project C, it has been computed that the project will provide an overall amount of $300,000 in benefit and cost an amount of $150,000 in total.

Now, considering that you intend to maximize the amount of return you will get for every dollar you invest, which of the three projects will you choose? For each of the projects, we can divide the total benefit with the total cost to ascertain how much a dollar of yours will give you in return – this is basically what Cost-Benefit Analysis is all about.

Project A = $150,000/$100,000 = 1.50
Project B = $130,000/$70,000 = 1.86
Project C = $300,000/250,000 = 1.20

Looking at the calculations, we can conclude that Project B is the most worthwhile investment. For every single dollar you invest, you will get a dollar and 86 cents in return. Project C is the least favorable one. Despite having to fork out $250,000, which is the highest amount of expenditure in comparison with the others, you will only be given a dollar and 20 cents for every dollar you spend.

How is Cost-Benefit Analysis Related to Net Present Value Analysis?

Cost-Benefit Analysis and Net Present Value Analysis are two different methods of investment appraisal. In this article – you should read it if you haven’t already, we talked about the principle of the time value of money and its relation with Net Present Value Analysis. Cost-Benefit Analysis is suited for short-term projects, just like the scenarios we have provided, whereas Net Present Value is best for long-term projects where there is a need to consider the time value of the money invested.

However, in practice, many have used both analytical tools simultaneously to better analyze the profitability of long-term projects. Again, suppose that you are considering whether to proceed with a construction project, and you have already estimated that the project will take 3 years to complete and generate $100,000 in the first year, $120,000 in the second year, and $180,000 in the third year. An inflation rate of 3% shall be used to discount this stream of future monetary benefits, and the project requires a capital investment of $200,000. Let us calculate the present value for the project:

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PV = $100,000/(1+0.03)^1+$120,000/(1+0.03)^2+$180,000/(1+0.03)^3 = $374,924.39

Using the NPV we have calculated, we can find out how worthwhile the investment is by determining how much a dollar you invest will get you in return:

$374,924.39/$200,000 = 1.87

The calculations tell us two things about the profitability of the investment: The future cash inflows are worth $374,924.39, which is $174,924.30 more than the amount of the capital investment, in total in today’s value, and for every dollar you invest, you will get a dollar and 87 cents more. In reality, you should accept with alacrity any project that is similar to this hypothetical one – opportunity knocks but once!