Difference Between Cost Benefit Analysis and Return on Investment

Key Difference – Cost Benefit Analysis vs Return on Investment
 

There are a number of factors that should be considered when making investments, where returns play an essential role. It is also important to compare the returns in relation to the investment made or the cost incurred. Cost benefit analysis is an analysis tool that compares the costs and benefits of a potential investment decision whereas return on investment calculates the return from an investment as a percentage of the original amount invested. This is the key difference between cost benefit analysis and return on investment.

CONTENTS
1. Overview and Key Difference
2. What is Cost Benefit Analysis
3. What is Return on Investment
4. Side by Side Comparison – Cost Benefit Analysis vs Return on Investment
5. Summary

What is Cost Benefit Analysis?

A cost-benefit analysis is a process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed, and then the costs associated with taking that action are subtracted. Cost benefit analysis is a compromise between the additions of costs and benefits to implement a business decision. The decision-making criteria will be to proceed with the investment if the benefits overweigh the costs.

E.g. DEF Company is a large-scale manufacturing company that presently operate with an in-house recruitment function within the human resource department. Recently, it was pointed out by the production manager that it will be beneficial to the company to outsource the recruitment function to a separate recruitment agency. He believes that it will be less costly, more effective and DEF will be able to improve quality significantly. Such a scenario should be evaluated in terms of both costs and benefits quantitatively and qualitatively before making a decision.

All direct and indirect costs should be considered and care should be taken to not underestimate costs or overestimate benefits. However, it should be noted that Cost benefit analysis is a simpler investment analysis tool and is only suited for small to medium scale investments that span over a limited time period. Due to the complexity and uncertainty of cash flows, this cannot be considered as an appropriate decision tool for large-scale projects that span over an extended time period.

What is Return on Investment

Return on investment (ROI) is a vital investment evaluation technique that can be made by companies to measure performance. ROI can be used to assess a selected investment option or for the company as a whole, as well as for each division in case of a large-scale company. This allows calculating how much returns are made compared to the amount of capital invested. ROI can be calculated using the below formula.

ROI = Earnings Before Interest and Tax (EBIT)/ Capital Employed *100

• EBIT- Net operating profit before deducting interest and tax
• Capital employed- Addition of debt and equity

This is a measure that indicates the level of efficiency of a company and is expressed as a percentage. Higher the ROI, more the value generation for investors. When ROI is calculated for each division, they can be compared to identify how much value they contribute to company’s overall ROI.

ROI is one of the principal ratios that can be calculated by investors as well to measure the gain or loss arrived from an investment relative to the funds invested. This measure is a frequently utilized one by individual investors in assessing the profitability in various investment decisions and can be simply calculated as a percentage,

ROI = (Gain from Investment- Cost of Investment)/ Cost of Investment *100

ROI helps to compare returns from different investments; thus, an investor can select which one to invest in between two or more options.

E.g. An investor has the following options to invest in stocks of two companies

Company A’s stock – cost = $ 1,500, value at the end of one year = $ 1,730

Company B’s stock – cost= $ 548, value at the end of one year=$ 722

The ROI of the two investments are 15% (1,730-1,500/1,500) for Company A’s stock and 32% (722-548/548) for Company B’s stock.

The above investments can be easily compared assuming both are for a period of one year. Even if the time periods are different ROI can be calculated; however, it does not provide an accurate measure. For instance,  if Company B’s stock takes five years to pay off as opposed to one year, then its higher returns may not be attractive for an investor who prefers to make a quick return.

To better understand the usefulness of ROI, it should be compared against ratios of past years and other companies in the same industry. While useful, it should also be noted that ROI is heavily affected by the size of the asset/ investment base; if the asset/investment base is larger, the resulting ROI will be lower.

What is the difference between Cost Benefit Analysis and Return on Investment?

Summary – Cost Benefit Analysis vs Return on Investment

Both cost benefit analysis and return on investment are investment evaluation tools used by businesses. The difference between cost benefit analysis and return on investment are generally attributable to the uses and the type of investments they are used to analyze. While cost benefit analysis may provide a complete analysis since it considers both quantitative and qualitative factors, ROI can be easily used for comparison purposes.

References
1. “Cost-Benefit Analysis.” Investopedia. N.p., 22 May 2015. Web. 16 Mar. 2017.
2. “Cost Benefit Analysis.” Cost Benefit Analysis | Better Evaluation. N.p., n.d. Web. 16 Mar. 2017.
3. “Return On Investment – ROI.” Investopedia. N.p., 03 Mar. 2017. Web. 16 Mar. 2017.
4. “Return on Investment (ROI): Advantages and Disadvantages.” YourArticleLibrary.com: The Next Generation Library. N.p., 13 May 2015. Web. 16 Mar. 2017.

Image Courtesy:
1. “Social Media Marketing ROI Graph” by Alan O’Rourke (CC BY 2.0) via Workcompass.com