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Costbenefit Evaluation Techniques
We would consider proceeding with a project only where the benefits outweigh the costs. However, in order to choose among projects, we need to take into
Costbenefit Evaluation Techniques
Last Updated on Fri, 23 Dec 2022
We would consider proceeding with a project only where the benefits outweigh the costs. However, in order to choose among projects, we need to take into account the timing of the costs and benefits as well as the benefits relative to the size of the investment.
In the following sections we will take a brief look at some common methods for comparing projects on the basis of their cash flow forecasts.
The net profit of a project is the difference between the total costs and the total income over the life of the project. Project 2 in Table 3.2 shows the greatest net profit but this is at the expense of a large investment. Indeed, if we had £lm to invest, we might undertake all of the other three projects and obtain an even greater net profit. Note also, that all projects contain an element of risk and we might not be prepared to risk £1 m. We shall look at the effects of risk and investment later in this chapter.
Moreover, the simple net profit takes no account of the timing of the cash flows. Projects 1 and 3 each have a net profit of £50,000 and therefore, according to this selection criterion, would be equally preferable. The bulk of the income occurs late in the life of project 1, whereas project 3 returns a steady income throughout its life. Having to wait for a return has the disadvantage that the investment must be funded for longer. Add to that the fact that, other things being equal, estimates in the more distant future are less reliable that short-term estimates and we can see that the two projects are not equally preferable.
The payback period is the time taken to break even or pay back the initial investment. Normally, the project with the shortest payback period will be chosen on the basis that an organization will wish to minimize the time that a project is 'in debt'.
The advantage of the payback period is that it is simple to calculate and is not particularly sensitive to small forecasting errors. Its disadvantage as a selection technique is that it ignores the overall profitability of the project - in fact, it totally ignores any income (or expenditure) once the project has broken even. Thus the fact that projects 2 and 4 are, overall, more profitable than project 3 is ignored.
Return on investment
The return on investment (ROI), also known as the accounting rate of return (ARR), provides a way of comparing the net profitability to the investment required. There are some variations on the formula used to calculate the return on investment but a straightforward common version is
The main difficulty with NPV for deciding between projects is selecting an appropriate discount rate. Some organizations have a standard rate but, where this is not the case, then the discount rate should be chosen to reflect available interest rates (borrowing costs where the project must be funded from loans) plus some premium to reflect the fact that software projects are inherently more risky than lending money to a bank. The exact discount rate is normally less important than ensuring that the same discount rate is used for all projects being compared. However, it is important to check that the ranking of projects is not sensitive to small changes in the discount rate - have a look at the following exercise.
Internal rate of return
One disadvantage of NPV as a measure of profitability is that, although it may be used to compare projects, it might not be directly comparable with earnings from other investments or the costs of borrowing capital. Such costs are usually quoted
The IRR may be estimated by plotting a series of guesses:
For a particular project, a discount rate of 8% gives a positive NPV of £7,898; a discount rate of 12% gives a negative NPV of -£5,829. The IRR is therefore somewhere between these two values. Plotting the two values on a chart and joining the points with a straight line suggests that the IRR is about 10.25%. The true IRR (calculated with a spreadsheet) is 10.167%. as a percentage interest rate. The internal rate of return (IRR) attempts to provide a profitability measure as a percentage return that is directly comparable with interest rates. Thus, a project that showed an estimated IRR of 10% would be worthwhile if the capital could be borrowed for less than 10% or if the capital could not be invested elsewhere for a return greater than 10%.
The IRR is calculated as that percentage discount rate that would produce an NPV of zero. It is most easily calculated using a spreadsheet or other computer program that provides functions for calculating the IRR. Microsoft Excel and Lotus, for example, both provide IRR functions which, provided with an initial guess or seed value (which may be zero), will search for and return an IRR.
Manually, it must be calculated by trial-and-error or estimated using the technique illustrated in Figure 3.3. This technique consists of guessing two values
Continue reading here: Risk Management in Software Development
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Before starting a project, determine if the benefits outweigh the costs with a cost-benefit analysis. Here's a step-by-step process to use it.
When managing a project, one is required to make a lot of key decisions. Project managers strive to control costs while getting the highest return on investment and other benefits for their business or organization. A cost-benefit analysis (CBA) is just what they need to help them do that.
In a project, there is always something that needs executing, and every task has a cost and expected benefits. Because of the high stakes, good project managers don’t just make decisions based on gut instinct. They prefer to minimize risk to the best of their ability and act only when there is more certainty than uncertainty.
But how can you accomplish that in a world with myriad variables and constantly shifting economics? The answer: consult hard data collected with project management software, reporting tools, charts and spreadsheets. You can then use that data to evaluate your decisions with a process called cost-benefit analysis (CBA). Intelligent use of cost-benefit analysis will help you make cost-effective decisions and maximize gains both for your project and your organization.
Before we explain how to do a cost-benefit analysis, let’s briefly define what it is.
What Is a Cost-Benefit Analysis?
A cost-benefit analysis (CBA) is a process that is used to estimate the costs and benefits of decisions in order to find the most cost-effective alternative. A CBA is a versatile method that is often used for the business, project and public policy decisions. An effective CBA evaluates the following costs and benefits:Costs
Direct costs Indirect costs Intangible costs Opportunity costs
Costs of potential risksBenefits
Direct Indirect Total benefits Net benefits
Our free cost-benefit analysis template can help you manage and analyze all these project details. Download yours today.
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Cost Benefit Analysis Template
Use this free Cost Benefit Analysis Template for Excel to manage your projects better.
Cost-Benefit Analysis in Project Management
In project management, a cost-benefit analysis is used to evaluate the cost versus the benefits in your project proposal and business case. It begins with a list, as so many processes do.
There’s a list of every project expense and what the expected benefits will be after successfully executing the project. From that, you can calculate the cost-benefit ratio (CBR), return on investment (ROI), internal rate of return (IRR), net present value (NPV) and the payback period (PBP).
Whether the benefits outweigh the costs or not will determine if action is warranted or not. In most cases, if the cost is 50 percent of the benefits and the payback period is not more than a year, then the action is worth taking.
The Purpose of Cost-Benefit Analysis
The purpose of cost-benefit analysis in project management is to have a systemic approach to figure out the pluses and minuses of various paths through a project, including transactions, tasks, business requirements and investments. The cost-benefit analysis gives you options, and it offers the best approach to achieve your goal while saving on investment.
There are two main purposes in using CBA:
To determine if the project business case is sound, justifiable and feasible by figuring out if its benefits outweigh costs.
To offer a baseline for comparing projects by determining which project’s benefits are greater than its costs.
Keeping track of all these figures is made easier with project management software. For example, ProjectManager has a sheet view, which is exactly like a Gantt but without a visual timeline. You can switch back and forth from the Gantt to the sheet view when you want to just look at your costs in a spreadsheet. You can add as many columns as you like and filter the sheet to capture only the relevant data. Keeping track of your costs and benefits is what brings in a successful project. Use our tool to get the control you need by taking this free trial.
Track costs alongside your project schedule in ProjectManager. Learn more
How to Do a Cost-Benefit Analysis
According to the Economist, CBA has been around for a long time. In 1772, Benjamin Franklin wrote of its use. But the concept of CBA as we know it dates to Jules Dupuit, a French engineer, who outlined the process in an article in 1848.
Since then, the CBA process has greatly evolved. Let’s go through this checklist to learn how to do a cost-benefit analysis:
1. What Are the Goals and Objectives of the Project?
Create a business case for your project and state its goals and objectives.
2. What Are the Alternatives?
Before you can know if the project is right, you need to compare it to similar past projects to see which is the best path forward. You can quickly check their success metrics such as their return on investment, internal rate of return, payback period and benefit-cost ratio.
3. Who Are the Stakeholders?
List all stakeholders in the project. They’re the ones affected by the costs and benefits. Describe which of them are decision-makers.
4. How Will You Measure Costs and Benefits?
Common Methods For Cost Benefit Evaluation
The common methods for Cost-Benefit Evaluation are:-Payback Method, Present Value Method, Net Present Method, Net Benefit Method, Break Even Method...
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Common Methods For Cost Benefit Evaluation
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on Common Methods For Cost Benefit EvaluationCost-Benefit Evaluation:-The primary objective of cost-benefit analysis is to find out whether it is economically worthwhile to invest in the proposed project. If the return on investment is high, the project is considered economically worthwhile.
The common methods for Cost-Benefit Evaluation are:-
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Present Value Method
Net Present Method Net Benefit Method Break Even Method Cash Flow Analysis
Payback analysis defines the time required to recover the money spent on a project.Formula
Payback Time=Overall cost outlay/ Annual cash return+ installation period.
Present Value Method
The payback method has certain drawbacks. The value of today’s money& tomorrow’s money is not the same. In the payback method, today’s cost is compared with tomorrow’s benefits & thus the time value of money is not considered.
The present value method compared the present value to future values by considering the time value of invested money. The present value analysis determines how much money it is worthwhile investing now, in order to receive a given return in some year’s time.
Where P is the present value
F is the future value
r is the rate of interest
n is the number of years
Net Present Value Method
This method takes into consideration the time value of money & attempts to calculate the return on investment by introducing the factor of the time element.
The net present values of all inflows& outflows of cash occurring during the entire life of the project are determined separately for each year by discounting these flows by the firm’s cost of capital.
Net Benefit Method
In this method, the net benefit is calculated by subtracting the total estimated cost from the total estimated benefit.
Break Even Method
In the Break-Even Method, the costs of current & new systems are compared to find the time when both are equal. This point is called a break-even point. The breakeven point is the time at which the cost of the new system equals the cost of the current one.
Cash Flow Analysis
Cash flow is a procedure designed to keep track of accumulated saving and expenditure on a regular basis. In cash flow analysis method, projected expenditure& costs are identified & totaled. The difference between the incoming savings& outgoing expenses is the cash flow.