Cost breakdown structure
Cost breakdown is very straight forward, but can become extremely complex, depending on the project and its requirements. Transferring costs between work areas, using contractors where payment methods differ and having to record time, for example will add to the process.
The basic process involves allocating costs to each activity from the lowest level of the work breakdown structure upwards. Be aware that each task may have more than one associated cost so you may need to subdivide the task into individual activities. Once the costs have been assigned it is possible to monitor the project in terms of actual, forecasted and earned cost on a task, eg. you’ve spent 80% of the budget allocated to that task, however only 20% of the work has been done. This might be fine if you were expecting the first part of the activity to be expensive, or it could be a signal that the budget is out of control and needs attention.
A cost breakdown structure is the easiest way of ensuring your budget is spent in a controlled and targeted way, this should help reduce over spend or if you do go over budget help you work how and why it happened.
Cost benefits analysis
One of the key items in any business case is an analysis of the cost of a project that includes some consideration of both the cost and the payback (this does not necessarily need to be monetary).
Basic analysis example
| Benefits of proposed product(s) | Evidence |
| Return of investment | Financial analysis of the cash flow associated with the new technology, to show net gain. Simple payback techniques are ok for small projects. |
| Improved performance, eg. lower operating costs, improved quality, better customer service, higher speed or more flexibility | Technical capabilities of the proposed new system showing:
Such information might come from:
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| Better customer service | Information that competitors are already investing in equivalent technology, and therefore not to do so would be to fail to keep up. Customer surveys that demonstrate that the quality/ service improvement predicted will attract and keep customers more effectively than at present. |
Net and gross
Whatever approach is taken, when actual costs are being estimated it is vital to quote things in both net (excluding VAT and overheads) and gross terms (all costs included). The below example will illustrate how this can be adapted for use as appropriate to the projects. Please note that you need to take into account what is a one off cost and what will be a recurring expense.
| Item | Expenditure (£) | Staff cost (£) |
| Item 1 purchase | 10,000 (net) 12,000 (gross) | |
| Item 1 annual maintenance | 1,250 (net) 1,500 (gross) | |
| External consultant | 12,500 (net) 15,000 (gross) | |
| New staff requirement | 35,000 (net) 45,000 (gross) | |
| Training | 1,750 (net) 2,100 (gross) | |
| Installation | 900 (net) 1,080 (gross) | |
| Totals | 13,900 (net) 16,680 (gross) | 47,500 (net) 57,000 (gross) |
| Grand total | 73,680 (gross) |
If you wanted to add a further layer of detail you can add the type of cost, this would typical be used for a slightly larger project were there is a need for a more in-depth costs analysis.
Example
| Financials | Consist of | Options |
| Income |
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| Production cost |
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| Labour costs (could split into academic and non-academic) |
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| Capital costs |
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Types of information
There are various sources of information and you need to think about the balance between the quality of the information (primary is usually better) versus the cost of getting it (secondary is usually cheaper).
| Primary | Secondary |
| Researched information (takes more time and resources) | Existing information within the organisation |
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Internal:
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Internal:
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External:
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External:
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Cost benefit analysis methods
Payback
This is the amount of time required for the cash inflows from a capital investment project to equal the cash outflows.
Payback period= Initial payment/Annual cash inflow
So if 4 million is invested with the aim of earning £500,000 per year (net) the payback period is calculated as:
P= £4,000,000/ £500, 00= 8 years.
However it is unlikely that a project will yield consistent cash flows. Example (with an initial investment in 0 of £4,000,000).
Example
| Year | Cash flow (£000) | Cumulative cash flow (£000) |
| 0 | (4000) | (4000) |
| 1 | 750 | (3250) |
| 2 | 750 | (2500) |
| 3 | 900 | (1600) |
| 4 | 1000 | (600) |
| 5 | 600 | 0 |
| 6 | 400 | 400 |
The payback period for this example is precisely five years.
Using this method means the shorter the payback period equals the better the investment. The main issue with this is that even when the payback period is short there has to be an upfront investment made with no guarantee of a return.
Comparing several proposals
| Year | Project 1 | Project 2 | Project 3 | Project 4 | Project 5 | Project 6 |
| 0 | (50) | (100) | (80) | (100) | (80) | (100) |
| 1 | 5 | 50 | 40 | 40 | 30 | 5 |
| 2 | 10 | 30 | 20 | 35 | 30 | 25 |
| 3 | 15 | 20 | 20 | 20 | 20 | 30 |
| 4 | 20 | 10 | 20 | 20 | 10 | 30 |
| 5 | 5 | 20 | 10 | 5 | 10 | 40 |
| 6 | 10 | 10 | 10 | 40 | 50 | |
| Payback period | 4 | 3 | 3 | 4 | 3 | 5 |
| Total after 6 years | 5 | 40 | 40 | 30 | 60 | 80 |
The payback period for three if the project (2, 3 and 5) is 3 years so you could see them as of being of equal merit. However because there is a time value constraint here, the four projects cannot be viewed as equivalent. Project 2 is better than project 3 because the revenues flow quicker in years one and two. Project 2 is also better than project 5 because of the earlier flows and because the post-payback revenues are concentrated in the early part of that period. When you look at a longer time period, the picture changes again: after 6 years projects 5 and 6 have the best yields, but although project 6 has the best overall yields, you have to wait the longest to get it.
Average rate return
The average rate of return expresses the profits arising from a project as a percentage of the initial capital cost. However the definition of profits and capital cost vary. For instance, the profits may be taken to include deprecation, or they may not. One of the most common approached is as follows:
ARR= (Average annual revenue/initial capital costs) *100.
For example a new system will cost £240,000 and is expected to generate total savings of £45,000 over the projects 5 year life.
ARR= (£45,000/5) / 240,000*100 = 3.75.
Net present value
The net present value (NPV) is a discounted cash flow (DCF) technique. It relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment.
Opportunity cost is the calculation of what is sacrificed or foregone as a result of a particular decision. It is also referred to as the ‘real cost’ of taking action.
Present value is the cash equivalent now of a sum receivable at a later date. If we didn’t spend that money and banked it instead, the opportunity cost includes both the initial sum and the interest earned.
NPV is a technique where cash inflows expected in future years are discounted back to their present value. This is calculated by using a discounted rate equivalent to the interest that would have been received on the sums, has the inflows been saved.
Example
| 0 | 1 | 2 | 3 | ... | n |
| Now | 1 year from now | 2 years from now | 3 years from now | n years from now |
The present value for 0 years is always 1, and this is not included in the present value table.
If you are looking to find the present value of £150,000 which you expect to receive in 5 years’ time, at a rate of interest of 3%, the following steps are taken:
Step one: Use a NPV lookup table and find the relevant number of years (5 years in example)
Step two: Look across the row for relevant rate of interest (3% in this example)
Step three: Take the value you have found from steps 1 and 2 (in this case 0.863 and multiply the present amount (£150,00) = £129,450
Further information
For further advice and guidance, please contact the Finance Office.
