| Cost Benefit Analysis must be carried out to | | | | |
| accepted principles. If not, your reputation | | | | Critical Item #3. Price Changes Due to |
| and the company could suffer. There are some | | | | Inflation |
| elements that should never be included in | | | | |
| Cost Benefit Analysis. Some of these are | | | | The Discount Rate used in the model is |
| listed in this article. | | | | designed to take account of inflation during |
| | | | the life of the project. The Discount Rate |
| Let's start, shall we? | | | | reduces the value of the costs and benefits |
| | | | as time progresses, just as inflation does. |
| Critical Item #1. Sunk Costs | | | | If inflation-based price changes were |
| | | | included in the analysis, then they would be |
| Irrecoverable cash outlays that occurred | | | | double-counted. |
| prior to the evaluation of the project are | | | | |
| excluded, only the present and future costs | | | | Critical Item #4. Book Gains or Losses |
| benefits are assessed. You cannot go back in | | | | |
| time to add in past costs, only deal in the | | | | Accountants use this method to take account |
| current and the future, as best you can. | | | | of the fact that the value of the asset at |
| | | | time of disposal is not equal to the |
| Critical Item #2. Arbitrary Accounting Cost | | | | depreciated value in the company's books. |
| Income Allocations | | | | This often happens, since it is not always |
| | | | possible to accurately predict the selling |
| Depreciation - Depreciation is not a cash | | | | price or disposal value at the time of |
| item. It relates to cash expended on capital | | | | purchase when the life of the asset is longer |
| purchases in previous periods. It is intended | | | | than a year or two. |
| to show the decreasing value of the asset as | | | | |
| time passes and as the asset ages through use | | | | However, in Cost Benefit Analysis models the |
| or obsolescence. | | | | purchase price and the selling price are |
| | | | always clearly stated, so there is no need to |
| To include depreciation in Cost Benefit | | | | adjust. |
| Analysis, would be to double-count the | | | | |
| expenditure. The decreasing value of the | | | | Critical Item #5. Loan Repayments |
| asset is shown by the difference in the | | | | |
| purchase price and the eventual disposal or | | | | The use of the Discount Rate is designed to |
| sales price at the end of its life. | | | | take account of the cost of financing the |
| | | | project whether in terms of interest rate (if |
| Accruals - Accruals are an accounting method | | | | the funds are borrowed) or return on equity |
| of moving costs and income to different years | | | | (if the funds are provided by shareholders). |
| as compared to when the transaction actually | | | | The actual cash repayments on the loan have |
| occurred. In Cost Benefit Analysis, we are | | | | no place in this analysis. Neither does the |
| dealing only in cash transactions in the year | | | | interest component of the repayments. |
| they occurred. Accruals have no role here. | | | | |