Financial Terms Cost-Benefit Analysis

# Definition of Cost-Benefit Analysis

## Cost-Benefit Analysis

The calculation and comparison of the costs and benefits of a policy or project.

# Related Terms:

## cost-benefit analysis the analytical process of comparing the

relative costs and benefits that result from a specific course
of action (such as providing information or investing in a
project)

## Accelerated cost recovery system (ACRS)

Schedule of depreciation rates allowed for tax purposes.

## Accumulated Benefit Obligation (ABO)

An approximate measure of the liability of a plan in the event of a
termination at the date the calculation is performed. Related: projected benefit obligation.

## Agency cost view

The argument that specifies that the various agency costs create a complex environment in
which total agency costs are at a minimum with some, but less than 100%, debt financing.

## Agency costs

The incremental costs of having an agent make decisions for a principal.

## All-in cost

Total costs, explicit and implicit.

## Average cost of capital

A firm's required payout to the bondholders and to the stockholders expressed as a
percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total
required cost of capital by the total amount of contributed capital.

## Bankruptcy cost view

The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.

## BARRA's performance analysis (PERFAN)

A method developed by BARRA, a consulting firm in
Berkeley, Calif. It is commonly used by institutional investors applying performance attribution analysis to
evaluate their money managers' performances.

## Break-even analysis

An analysis of the level of sales at which a project would make zero profit.

## Carring costs

costs that increase with increases in the level of investment in current assets.

## Cluster analysis

A statistical technique that identifies clusters of stocks whose returns are highly correlated
within each cluster and relatively uncorrelated between clusters. Cluster analysis has identified groupings
such as growth, cyclical, stable and energy stocks.

## Common-base-year analysis

The representing of accounting information over multiple years as percentages
of amounts in an initial year.
Common-size analysis The representing of balance sheet items as percentages of assets and of income
statement items as percentages of sales.

## Comparative credit analysis

A method of analysis in which a firm is compared to others that have a desired
target debt rating in order to infer an appropriate financial ratio target.

## Cost company arrangement

Arrangement whereby the shareholders of a project receive output free of
charge but agree to pay all operating and financing charges of the project.

## Cost of capital

The required return for a capital budgeting project.

## Cost of carry

Related: Net financing cost

## Cost of funds

Interest rate associated with borrowing money.

## Cost of lease financing

A lease's internal rate of return.

## Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.

## Cost-benefit ratio

The net present value of an investment divided by the investment's initial cost. Also called
the profitability index.

## Credit analysis

The process of analyzing information on companies and bond issues in order to estimate the
ability of the issuer to live up to its future contractual obligations. Related: default risk

## Defined benefit plan

A pension plan in which the sponsor agrees to make specified dollar payments to
qualifying employees. The pension obligations are effectively the debt obligation of the plan sponsor.
Related: defined contribution plan

## Discriminant analysis

A statistical process that links the probability of default to a specified set of financial ratios.

## Equivalent annual benefit

The equivalent annual annuity for the net present value of an investment project.

## Equivalent annual cost

The equivalent cost per year of owning an asset over its entire life.

## Execution costs

The difference between the execution price of a security and the price that would have
existed in the absence of a trade, which can be further divided into market impact costs and market timing
costs.

## Factor analysis

A statistical procedure that seeks to explain a certain phenomenon, such as the return on a
common stock, in terms of the behavior of a set of predictive factors.

## Financial distress costs

Legal and administrative costs of liquidation or reorganization. Also includes
implied costs associated with impaired ability to do business (indirect costs).

## Fixed cost

A cost that is fixed in total for a given period of time and for given production levels.

## Flat benefit formula

Method used to determine a participant's benefits in a defined benefit plan by
multiplying months of service by a flat monthly benefit.

## Friction costs

costs, both implied and direct, associated with a transaction. Such costs include time, effort,
money, and associated tax effects of gathering information and making a transaction.

## Fundamental analysis

Security analysis that seeks to detect misvalued securities by an analysis of the firm's
business prospects. Research analysis often focuses on earnings, dividend prospects, expectations for future
interest rates, and risk evaluation of the firm.

## Horizon analysis

An analysis of returns using total return to assess performance over some investment horizon.

## Horizontal analysis

The process of dividing each expense item of a given year by the same expense item in
the base year. This allows for the exploration of changes in the relative importance of expense items over time
and the behavior of expense items as sales change.

## Incremental costs and benefits

costs and benefits that would occur if a particular course of action were
taken compared to those that would occur if that course of action were not taken.

## Information costs

Transaction costs that include the assessment of the investment merits of a financial asset.
Related: search costs.

## Market impact costs

Also called price impact costs, the result of a bid/ask spread and a dealer's price concession.

## Market timing costs

costs that arise from price movement of the stock during the time of the transaction
which is attributed to other activity in the stock.

## Mean-variance analysis

Evaluation of risky prospects based on the expected value and variance of possible outcomes.

## Multiple-discriminant analysis (MDA)

Statistical technique for distinguishing between two groups on the
basis of their observed characteristics.

## Net benefit to leverage factor

A linear approximation of a factor, T*, that enables one to operationalize the
total impact of leverage on firm value in the capital market imperfections view of capital structure.

## Net financing cost

Also called the cost of carry or, simply, carry, the difference between the cost of financing
the purchase of an asset and the asset's cash yield. Positive carry means that the yield earned is greater than
the financing cost; negative carry means that the financing cost exceeds the yield earned.

## Opportunity cost of capital

Expected return that is foregone by investing in a project rather than in
comparable financial securities.

## Opportunity costs

The difference in the performance of an actual investment and a desired investment
adjusted for fixed costs and execution costs. The performance differential is a consequence of not being able
to implement all desired trades. Most valuable alternative that is given up.

## Pension Benefit Guaranty Corporation (PBGC)

A federal agency that insures the vested benefits of
pension plan participants (established in 1974 by the ERISA legislation).

The decomposition of a money manager's performance results to explain
the reasons why those results were achieved. This analysis seeks to answer the following questions: (1) What
were the major sources of added value? (2) Was short-term factor timing statistically significant? (3) Was
market timing statistically significant? And (4), Was security selection statistically significant?

## Price impact costs

Related: market impact costs

## Pro forma capital structure analysis

A method of analyzing the impact of alternative capital structure
choices on a firm's credit statistics and reported financial results, especially to determine whether the firm will
be able to use projected tax shield benefits fully.

## Regression analysis

A statistical technique that can be used to estimate relationships between variables.

## Replacement cost

cost to replace a firm's assets.

## Round-trip transactions costs

costs of completing a transaction, including commissions, market impact
costs, and taxes.

## Scenario analysis

The use of horizon analysis to project bond total returns under different reinvestment rates
and future market yields.

## Search costs

costs associated with locating a counterparty to a trade, including explicit costs (such as
advertising) and implicit costs (such as the value of time). Related:information costs.

## Sensitivity analysis

analysis of the effect on a project's profitability due to changes in sales, cost, and so on.

## Shortage cost

costs that fall with increases in the level of investment in current assets.

## Sunk costs

costs that have been incurred and cannot be reversed.

## Technical analysis

Security analysis that seeks to detect and interpret patterns in past security prices.

costs of buying and selling marketable securities and borrowing. Trading costs include

## Transactions costs

The time, effort, and money necessary, including such things as commission fees and the
cost of physically moving the asset from seller to buyer. Related: Round-trip transaction costs, Information
costs, search costs.

## True interest cost

For a security such as commercial paper that is sold on a discount basis, the coupon rate
required to provide an identical return assuming a coupon-bearing instrument of like maturity that pays
interest in arrears.

## Unit benefit formula

Method used to determine a participant's benefits in a defined benefit plan by
multiplying years of service by the percentage of salary.

## Variable cost

A cost that is directly proportional to the volume of output produced. When production is zero,
the variable cost is equal to zero.

## Vertical analysis

The process of dividing each expense item in the income statement of a given year by net
sales to identify expense items that rise faster or slower than a change in sales.

## Weighted average cost of capital

Expected return on a portfolio of all the firm's securities. Used as a hurdle
rate for capital investment.

## Cost basis

An assetâ€™s purchase price, plus costs associated with the purchase, like installation fees, taxes, etc.

## Cost of goods sold

The cost of merchandise that a company sold this year. For manufacturing companies, the cost of raw
materials, components, labor and other things that went into producing an item.

## MACRS (Modified Accelerated Cost Recovery System)

A depreciation method created by the IRS under the Tax Reform Act of 1986. Companies must use it to depreciate all plant and equipment assets installed after December 31, 1986 (for tax purposes).

## VERTICAL ANALYSIS

A financial analysis technique that relates key amounts on the income statement and balance sheet to a 100 percent or base figure for the present and previous year.
It shows the percentage change from last year to this year, making it easier to spot problems that require analysis.

## Absorption costing

A method of costing in which all fixed and variable production costs are charged to products or services using an allocation base.

## Activity-based costing

A method of costing that uses cost pools to accumulate the cost of significant business activities and then assigns the costs from the cost pools to products or services based on cost drivers.

## Avoidable costs

costs that are identifiable with and able to be influenced by decisions made at the business
unit (e.g. division) level.

## Cash cost

The amount of cash expended.

## Cost

A resource sacrificed or forgone to achieve a specific objective (Horngren et al.), defined
typically in monetary terms.

## Cost behaviour

The idea that fixed costs and variable costs react differently to changes in the volume of
products/services produced.

## Cost centre

A division or unit of an organization that is responsible for controlling costs.

## Cost control

The process of either reducing costs while maintaining the same level of productivity or maintaining costs while increasing productivity.

## Cost driver

The most significant cause of the cost of an activity, a measure of the demand for an activity
by each product/service enabling the cost of activities to be assigned from cost pools to products/services.

## Cost object

Anything for which a measurement of cost is required â€“ inputs, processes, outputs or responsibility centres.

## Cost of capital

The costs incurred by an organization to fund all its investments, comprising the risk-adjusted
cost of equity and debt weighted by the mix of equity and debt.

## Cost of goods sold

See cost of sales.

## Cost of manufacture

The cost of goods manufactured for subsequent sale.

## Cost of quality

The difference between the actual costs of production, selling and service and the costs that would be incurred if there were no failures during production or usage of products or services.

## Cost of sales

The manufacture or purchase price of goods sold in a period or the cost of providing a service.

## Cost-plus pricing

A method of pricing in which a mark-up is added to the total product/service cost.

## Cost pool

The costs of (cross-functional) business processes, irrespective of the organizational structure of the business.

## Costâ€“volumeâ€“profit analysis (CVP)

A method for understanding the relationship between revenue, cost and sales volume.

## Direct costs

costs that are readily traceable to particular products or services.

## Fixed costs

costs that do not change with increases or decreases in the volume of goods or services
produced, within the relevant range.

## Full cost

The cost of a product/service that includes an allocation of all the (production and

## Indirect costs

costs that are necessary to produce a product/service but are not readily traceable to particular products or services â€“ see overhead.

## Job costing

A method of accounting that accumulates the costs of a product/service that is produced either
customized to meet a customerâ€™s specification or in a batch of identical product/services.

## Labour oncost

The non-salary or wage costs that follow from the payment of salaries or wages, e.g. National
Insurance and pension contributions.

## Lifecycle costing

An approach to costing that estimates and accumulates the costs of a product/service over
its entire lifecycle, i.e. from inception to abandonment.

## Marginal cost

The cost of producing one extra unit.

## Opportunity cost

The lost opportunity of not doing something, which may be financial or non-financial, e.g. time.

## Period costs

The costs that relate to a period of time.

## Prime cost

The total of all direct costs.

## Process costing

A method of costing for continuous manufacture in which costs for an accounting compared are compared with production for the same period to determine a cost per unit produced.