Background:

Torrens Consulting Company is a privately owned, independent, wholly Australian operated leading specialised consultancy, providing a full range of management consulting services specialising in Human Resource Management, Executive Recruitment, Organisational Development, Organisational Psychology and Training and Development Services.

They are looking at changing their current consulting decision-making system to a new technology and would like to call it consulting business intelligence system. They are deciding whether to develop the system in-house or outsource the development.

Students need to create a cost-benefit analysis of the proposed new system using the spreadsheet.

Cost-Benefit Analysis Overview:

Conducting a Cost-Benefit Analysis

While it is important to provide decision-makers with a range of options, the process of developing and analysing these can be expensive and time consuming. For major investments, it may be necessary to outline various potential options and then to have decision-makers select, after a preliminary screening, a smaller number for detailed appraisal. In any case, an appropriate level of consultation should be undertaken as best practice, either formally or informally, in creating a set of alternatives.

Step 2: Calculate the Net Present Value

In CBA, the net social benefit (NSB), or the excess of total benefit over total cost, is represented by the net present value (NPV) of the proposal.

Before determining the value (or NPV) of a proposal, the costs (C) and benefits (B) need to be quantified for the expected duration of the project. The NSB is calculated by subtracting the cost stream from the benefit stream and is represented as follows:

NSB = B – C

The NPV of a proposal is determined by applying a ‘discount rate’ (discussed below) to the identified costs and benefits. It is necessary to ‘discount’ costs and benefits occurring later relative to those occurring sooner. This is because money received now can be invested and converted into a larger future amount and because people generally prefer to receive income now rather than in the future.

Valuing each alternative by calculating NPVs facilitates comparison between proposals that exhibit different timing of their benefits and costs. Programmes with

positive NPVs generally indicate an efficient use of the community’s resources.

The NPV is calculated as follows:

Where all projected costs and benefits are valued in real terms, they should be discounted by a real discount rate. This can be estimated approximately by

subtracting the expected (or actual) inflation rate from the nominal discount rate. If nominal (current price) values are used for projected costs and benefits, they should be discounted by a nominal discount rate.

The discount rate can also be varied to test the sensitivity of the proposal to changes in this variable and, implicitly, to the phasing of costs and benefits. Sensitivity analysis is discussed in STEP 3 below.

The Internal Rate of Return (IRR) is typically presented as supplementary information to the NPV. The IRR is the discount rate that will result in a NPV of zero. The project’s IRR needs to be above the benchmark discount rate for the project to be considered viable (financially or economically, depending on the nature of the analysis).