Benefit-Cost Ratio PMP® Exam Guide
Resource limitations may require you to decide if a project is worth pursuing or which project to choose from multiple viable options. Using benefit-cost ratios can help ensure you are using your resources in the best way possible. Your team at Project Management Academy has put together this guide outlining everything you need to know about the benefit-cost ratio for the PMP exam.
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Define Benefit-Cost Ratio
Cost-benefit analysis is a systemic approach to evaluating and comparing the costs and benefits of different project proposals. A benefit-cost ratio is a tool you can use when performing a cost-benefit analysis to evaluate what projects to undertake or what value a project can bring.
The benefit-cost ratio (BCR) helps summarize the relationship between a project’s costs and benefits by expressing the ratio as a decimal. If the ratio is greater than 1.0, the benefits outweigh the costs. If the ratio is less than 1.0, the costs outweigh the benefits.
It’s easy to assume the project with the largest BCR is the best option. This assumption is not always accurate! Let’s start by looking at the BCR formula used to calculate the ratio.
Benefit-Cost Ratio Formula for the PMP Exam
Comparing the costs and benefits of a potential project begins with identifying them. What is the cost of investing in a project, such as equipment, labor, or even electricity and other utilities? What about benefits, such as profit, labor savings, or better quality products?
Next, assign and calculate monetary values for the costs and benefits. This step can be tricky for many reasons, including the fact that monetary values change over time. You need to consider inflation when calculating a project’s benefit-cost ratio, which means you need to understand the concept of Present Value (PV).
PV helps PMP credential holders conceptualize the expected or future values of projects by adjusting today’s money for inflation. For example, $1,000 today will not have the same purchasing power in five years. When you adjust that $1,000 for inflation, you get the PV.
More than likely, you will not have to calculate PV for the PMP exam. However, you should understand the benefit-cost ratio is the PV of the benefits divided by the PV of the costs.
Benefit-cost ratio = (PV of benefits)/(PV of costs)
As mentioned previously, the benefit-cost ratio is expressed as a decimal. Here’s an example of how to calculate and understand this ratio:
- PV of benefits = $200,000
- PV of costs = $100,000
- Benefit-cost ratio = 200,000/100,000
- The ratio is 2.0, which is greater than 1.0, so the benefits outweigh the costs.
Let’s review some of the advantages of BCRs in the project selection process.
Benefit-cost ratio advantages
Suppose you had four potential projects to pursue but only enough resources to choose one. Knowing the benefit-cost ratio for each project can help you compare, select, and justify the best option. For example:
- Project 1: BCR = 1.2
- Project 2: BCR = 0.7
- Project 3: BCR = 1.5
- Project 4: BCR = 1.0
You can eliminate Project 2 because its BCR is less than 1.0, meaning its costs outweigh the benefits. You are left with Projects 1, 3, and 4. Since Project 3 has the highest BCR, it will likely earn the highest profit, so it seems like the best choice. However, benefit-cost ratios also have some limitations and should not be the sole basis of your decision.
BCR PMP Limitations
Although benefit-cost ratios can be helpful, they also simplify projects down to a single number. As you have most likely experienced, projects are usually much more complicated! Here are some limitations you should keep in mind when using BCRs.
BCRs only show relative profitability.
Consider the following projects:
- A mini project with $10 in costs and $100 in benefits; BCR = 10.0
- A large project with $10,000 in costs and $30,000 in benefits; BCR = 3.0
- A risky project with $500,000 in costs and $5,000,000 in benefits; BCR = 10.0
If you only compare the ratios, the mini project or risky project may seem like the more obvious choices. However, pursuing only high-profit projects may expose you to unnecessary risks. Likewise, pursuing only high-BCR projects may cause you to miss out on some profitable ventures your stakeholders would value.
Keeping costs low to increase the BCR may force you to sacrifice quality.
Sacrificing quality in a project, even if the project still meets minimum requirements, can create potential problems later on. For example, using cheaper materials to create a deliverable may result in more customer complaints.
Calculating BCRs may not always be accurate.
The BCR formula includes assumptions about PV that are more accurate for smaller, shorter projects. Your calculations become more complicated and less reliable as the project’s size and duration increase. It is also challenging to estimate costs and benefits if their monetary values are intangible or hard to quantify.
In addition, BCRs may not be accurate for comparing related projects. If a project depends on deliverables for another project, comparing their ratios is unhelpful. Similarly, if a project’s benefits fluctuate depending on another project’s success, its BCR may change as well.
Benefit-cost ratios are a helpful tool, but the success or failure of a project depends on many factors. Make sure you use BCRs along with other tools and types of analyses to inform your project decisions.
Benefit-cost ratio PMP exam tips
Knowledge about benefit-cost ratios plays directly into the Business Environment domain in the PMP Exam Content Outline, making it fair game for some questions on the PMP Exam. Besides understanding how to compare BCRs and how they fit into project management, here are a few related PMP exam concepts and calculations you should know.
Understanding Present Value (PV) and Net Present Value (NPV) allows PMP credential holders to consider the expected values of projects over time. A project with a larger NPV is more profitable. However, due to limited resources, choosing to pursue one project usually means giving up other potentially viable alternatives.
Opportunity cost is a concept describing the cost of pursuing one project and rejecting other options. It is equal to the value of the single best alternative, not the sum of the values of all alternatives. When it comes to opportunity cost, calculating a BCR helps you understand the benefit of your chosen project compared to the cost of the next best alternative.
Let’s say you have three project options:
- Project 1: NPV = $300,000
- Project 2: NPV = $350,000
- Project 3: NPV = $500,000
If you choose Project 3, the next best alternative is Project 2.
- Your opportunity cost is $350,000 (the NPV of the next best alternative)
- Your opportunity cost is NOT the sum of the NPV of Projects 1 and 2.
- The BCR is 1.4, or the benefit (Project 3) divided by the cost (Project 2).
As an active PMP credential holder, staying aware of opportunity costs can help you counter the limitations of relative profitability.
When calculating the Present Value of your project’s benefits, inflation is not the only change in value over time you should consider. Your assets may also depreciate, or lose value, over time.
You can calculate depreciation in three ways:
- Straight Line Depreciation: this is the simplest method. It describes when the asset will decrease in value by the same amount each year.
- Sum of Year Depreciation: this is a type of accelerated depreciation. It describes when an asset’s depreciation is higher at first, but lower in later years.
- Double-Declining Balance: this is another form of accelerated depreciation. It describes when the asset is more useful in its early years and works similarly to, but faster than, the sum of year depreciation.
Depreciation can occur for many reasons, including degradation of materials, loss of efficiency, or new models of an asset being developed. It’s necessary to facture depreciation into NPV calculations.
Sunk costs in project management are any costs that have already been irreversibly spent, such as purchasing non-refundable materials for a project that ended up being canceled. Sunk costs can include the following:
- Fixed cost describes any scheduled or recurring costs that stay the same over time, such as the cost of subscribing to a program needed to execute a project.
- Variable cost can be any costs that fluctuate based on usage, such as the cost of utilities used to power machines during a project.
- Direct costs include expenses directly billed to the project, such as the cost of materials or labor.
- Indirect costs are typically shared between multiple projects, such as software that benefits more than one project.
As you study for the PMP exam, remember sunk cost shouldn’t influence whether or not you pursue a project. Those decisions should be made based on the NPV, BCR, and other similar factors.
Benefit-cost ratio formula PMP Exam sample questions
Ready to put your BCR knowledge to the test? Try out these sample questions to practice applying this concept and related calculations. Answers are at the bottom of the page.
|You are working with potential sponsors to determine which project your company will pursue. Based on the benefit-to-cost (BCR) ratios, which of the following four projects should you recommend?||Project A, which has a BCR of 5:2||Project B, which has a BCR of 5:4||Project C, which has a BCR of 3:1||Project D, which has a BCR of 2:1|
|There are multiple software implementation projects in the company pipeline under consideration. Knowing that you will be the project manager on the project that is selected, you are curious to get a sense of which project they might select even before the decision is made by the executives. In an effort to get a heads-up, you ask the PMO for the BCR scores of each of the projects that are being considered. The BCR for one of the projects is calculated at 1.8. What does this tell you?||Revenue from the project is 1.8 times the cost||Cost of the project is 1.8 times the profit||Revenue from the project equal 1.8 times the profit||Cost of the project is 1.8 times the payback on the project|
Studying for the PMP Exam?
A benefit-cost ratio helps project managers address whether or not a project should be pursued, or in some cases, which project presents the best option. It is a valuable and necessary tool for cost-benefit analysis and project selection. However, it comes with some limitations and should therefore be used alongside other tools and processes.
Do you have more questions about mastering benefit-cost ratio and other PMP exam concepts? Your Project Management Academy experts are here to help. Get in touch with us or check out our PMP Certification Training courses to get started.
Sample Question Answers
- C. When you’re asked to use benefit-to-cost (BCR) ratios to select a project on the PMP exam, choose the project with the highest BCR because that’s the project that gives you the most benefit for the least cost. An easy way to do it is to divide: Project A has a BCR of 5:2, and 5 / 2 is 2.5. Do that with all four projects, and you find that project C has the highest BCR.
- A. BCR stands for benefit-cost ratio and it measures the benefits (revenue) against the cost of implementing the project.
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