Cost-benefit analysis

Cost-benefit analysis

Overview
Cost–benefit analysis sometimes called benefit–cost analysis (BCA), is a systematic process for calculating and comparing benefits and costs of a project for two purposes: (1) to determine if it is a sound investment (justification/feasibility), (2) to see how it compares with alternate projects (ranking/priority assignment). It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much.
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Encyclopedia
Cost–benefit analysis sometimes called benefit–cost analysis (BCA), is a systematic process for calculating and comparing benefits and costs of a project for two purposes: (1) to determine if it is a sound investment (justification/feasibility), (2) to see how it compares with alternate projects (ranking/priority assignment). It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much.

CBA is related to, but distinct from cost-effectiveness
Cost-effectiveness
Cost-effectiveness analysis is a form of economic analysis that compares the relative costs and outcomes of two or more courses of action. Cost-effectiveness analysis is distinct from cost-benefit analysis, which assigns a monetary value to the measure of effect...

 analysis. In CBA, benefits and costs are expressed in money terms, and are adjusted for the time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

, so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their "present value."

Closely related, but slightly different, formal techniques include cost-effectiveness
Cost-effectiveness
Cost-effectiveness analysis is a form of economic analysis that compares the relative costs and outcomes of two or more courses of action. Cost-effectiveness analysis is distinct from cost-benefit analysis, which assigns a monetary value to the measure of effect...

 analysis, cost–utility analysis, economic impact analysis
Economic impact analysis
Economic impact analysis examines the effect of a policy, program, project, activity or event on the economy of a given area. The area can range from a neighborhood to the entire globe...

, fiscal impact analysis and Social Return on Investment
Social Return on Investment
Social Return on Investment is a principles-based method for measuring extra-financial value relative to resources invested...

 (SROI) analysis.

Theory


Cost–benefit analysis is often used by governments and others, e.g. businesses, to evaluate the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of foregone alternatives(i.e. opportunity cost
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

) in order to predict whether the benefits of a policy outweigh the costs of that policy, and by how much (i.e. one can rank alternate policies in terms of cost-benefit ratios). The aim is to gauge the economic efficiency of alternate policy options relative to each other including consideration of the costs and benefits of the status quo. Under rather heroic assumptions, altering(or maintaining) the status quo through implementation of a project with the highest cost-benefit ratio can lead the distribution of wealth in society towards pareto efficiency
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

, which roughly states that no policy can improve somebody's situation without deleterious effects to another. Generally, cost-benefit analysis will, when all costs are considered, lead to the selection of projects such that society experiences an increase in social welfare from a utilitarian perspective. Otherwise, cost-benefit analysis offers no guarantees of increased economic efficiency or increases of social welfare; generally positive microeconomic theory is moot when it comes to evaluating the impact on social welfare of a policy.

Steps


The following is a list of steps that comprise a generic cost-benefit analysis.
  • 1) Establish alternative projects/programs
  • 2) Compile a list of key players (those with standing or influence)
  • 3) Select measurement and collect all cost and benefits elements
  • 4) Predict outcome of cost and benefits over the duration of the project
  • 5) Put all effects of costs and benefits in dollars
  • 6) Apply discount rate
  • 7) Calculate net present value of project options
  • 8) Sensitivity analysis
  • 9) Recommendation

Valuation


The costs of an intervention are myriad, diverse and generally can only be estimated based on limited and costly information. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to the abundance of market data. The net benefits of a government intervention are often evaluated in terms of the public's willingness to pay
Willingness to pay
In economics, the willingness to pay is the maximum amount a person would be willing to pay, sacrifice or exchange in order to receive a good or to avoid something undesired, such as pollution...

 compensation (implying the public has no legal right to the benefits of the government policy) or willingness to accept
Willingness to accept
Willingness to accept is the amount that а person is willing to accept to abandon a good or to put up with something negative, such as pollution. It is the minimum monetary amount required for sale of a good or acquisition of something undesirable to be accepted by an individual...

 compensation (implying the public has a right to the benefits of the policy) for the change in welfare the results from the policy. The guiding principle of evaluating benefits is to list all parties affected by an intervention and place a value, usually monetary, on the (positive or negative) effect it has on their welfare as it would be valued by them. Estimating the actual compensation an individual would require to have their welfare unchanged by a policy is exceedingly difficult. Surveys (stated preference techniques) or market behavior (revealed preference
Revealed preference
Revealed preference theory, pioneered by American economist Paul Samuelson, is a method by which it is possible to discern the best possible option on the basis of consumer behavior. Essentially, this means that the preferences of consumers can be revealed by their purchasing habits...

 techniques) are often used to quantitatively estimate the compensation associated with a policy, however there are often strong incentives for survey respondents to misreport their true compensation and market behavior does not provide any information about important non-market welfare impacts.
One source of controversy is placing a monetary value of human life, e.g. when assessing road safety measures or life-saving medicines. However, this can sometimes be avoided by using the related technique of cost-utility analysis, in which benefits are expressed in non-monetary units such as quality-adjusted life years. For example, road safety can be measured in terms of 'cost per life saved', without placing a financial value on the life itself. However, metrics with non-monetary units such as these are limited in their usefulness for evaluating policies with substantially different outcomes. Additionally, many benefits in addition to saving life may accrue as a result of the policy, and metrics such as 'cost per life saved' may lead to a substantially different ranking of alternatives than traditional cost-benefit analysis.
Another controversy is the value of the environment, which in the 21st century is typically assessed by valuing the environment as a provider of services (i.e. ecosystem services
Ecosystem services
Humankind benefits from a multitude of resources and processes that are supplied by natural ecosystems. Collectively, these benefits are known as ecosystem services and include products like clean drinking water and processes such as the decomposition of wastes...

) to humans, such as safe water supply and pollination. Monetary values may also be assigned to other intangible effects such as loss of business reputation, market penetration, or long-term enterprise strategy alignments.

Time and Discounting


CBA usually tries to put all relevant costs and benefits on a common temporal footing using time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

 formulas. This is often done by converting the future expected streams of costs and benefits into a present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...

 amount using a suitable discount rate. Empirical studies and a technical framework suggest that in reality, people do discount the future like this.

There is often no consensus on the appropriate discount rate to use - e.g. whether it should be small (thus putting a similar value on future generations as on ourselves) or larger (e.g. a real interest rate or market rate of return, on the basis that there is a theoretical alternative option of investing the cost in financial markets to get a monetary benefit). The rate chosen usually makes a large difference in the assessment of interventions with long-term effects, such as those affecting climate change
Climate change
Climate change is a significant and lasting change in the statistical distribution of weather patterns over periods ranging from decades to millions of years. It may be a change in average weather conditions or the distribution of events around that average...

, and thus is a source of controversy. One of the issues arising is the equity premium puzzle
Equity premium puzzle
The equity premium puzzle is a term coined in 1985 by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher returns of stocks compared to government bonds in the United States, individuals must have implausibly high risk aversion...

, that actual long-term financial returns on equities may be rather higher than they should be; if so then arguably these rates of return should not be used to determine a discount rate, as doing so would have the effect of largely ignoring the distant future (e.g. climate change)

Risk and uncertainty


Risk associated with the outcome of projects is also usually taken into account using probability theory. This can be factored into the discount rate (to have uncertainty increasing over time), but is usually considered separately. Particular consideration is often given to risk aversion
Risk aversion
Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....

 - that is, people usually consider a loss to have a larger impact than an equal gain, so a simple expected return
Expected return
The expected return is the weighted-average outcome in gambling, probability theory, economics or finance.It isthe average of a probability distribution of possible returns, calculated by using the following formula:...

 may not take into account the detrimental effect of uncertainty.

Uncertainty in the CBA parameters (as opposed to risk of project failure etc.) is often evaluated using a sensitivity analysis
Sensitivity analysis
Sensitivity analysis is the study of how the variation in the output of a statistical model can be attributed to different variations in the inputs of the model. Put another way, it is a technique for systematically changing variables in a model to determine the effects of such changes.In any...

, which shows how the results are affected by changes in the parameters. Alternatively a more formal risk analysis can be undertaken using spreadsheet-based Monte Carlo simulations with add-in software such as @RISK or Crystal Ball.

Application and history


The practice of cost–benefit analysis differs between countries and between sectors (e.g., transport
Transport
Transport or transportation is the movement of people, cattle, animals and goods from one location to another. Modes of transport include air, rail, road, water, cable, pipeline, and space. The field can be divided into infrastructure, vehicles, and operations...

, health
Health
Health is the level of functional or metabolic efficiency of a living being. In humans, it is the general condition of a person's mind, body and spirit, usually meaning to be free from illness, injury or pain...

) within countries. Some of the main differences include the types of impacts that are included as costs and benefits within appraisals, the extent to which impacts are expressed in monetary terms, and differences in the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

 between countries. Agencies across the world rely on a basic set of key cost–benefit indicators, including the following:
  • NPV (net present value)
  • PVB (present value of benefits)
  • PVC (present value of costs)
  • BCR (benefit cost ratio
    Benefit-cost ratio
    A benefit-cost ratio is an indicator, used in the formal discipline of cost-benefit analysis, that attempts to summarize the overall value for money of a project or proposal. A BCR is the ratio of the benefits of a project or proposal, expressed in monetary terms, relative to its costs, also...

     = PVB / PVC)
  • Net benefit (= PVB - PVC)
  • NPV/k (where k is the level of funds available)


The concept of CBA dates back to an 1848 article by Jules Dupuit
Jules Dupuit
Jules Dupuit was an Italian-born French civil engineer and economist.He was born in Fossano, Italy then under the rule of Napoleon Bonaparte. At the age of ten he emigrated to France with his family where he studied in Versailles — winning a Physics prize at graduation. He then studied in the...

 and was formalized in subsequent works by Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...

. The practical application of CBA was initiated in the US by the Corps of Engineers
United States Army Corps of Engineers
The United States Army Corps of Engineers is a federal agency and a major Army command made up of some 38,000 civilian and military personnel, making it the world's largest public engineering, design and construction management agency...

, after the Federal Navigation Act of 1936 effectively required cost–benefit analysis for proposed federal waterway infrastructure. The Flood Control Act of 1939
Flood Control Act of 1939
Flood Control Act of 1939 , enacted on August 11, 1939 by the 76th Congress, is U.S. legislation that authorized construction of flood control projects across the United States...

 was instrumental in establishing CBA as federal policy. It specified the standard that "the benefits to whomever they accrue [be] in excess of the estimated costs.

Subsequently, cost–benefit techniques were applied to the development of highway and motorway investments in the US and UK in the 1950s and 1960s. An early and often-quoted, more developed application of the technique was made to London Underground
London Underground
The London Underground is a rapid transit system serving a large part of Greater London and some parts of Buckinghamshire, Hertfordshire and Essex in England...

's Victoria Line
Victoria Line
The Victoria line is a deep-level London Underground line running from the south to the north-east of London. It is coloured light blue on the Tube map...

. Over the last 40 years, cost–benefit techniques have gradually developed to the extent that substantial guidance now exists on how transport projects should be appraised in many countries around the world.

In the UK, the New Approach to Appraisal
New Approach to Appraisal
The New Approach to Appraisal was the name given to a multi-criteria decision framework used to appraise transport projects and proposals in the United Kingdom...

 (NATA) was introduced by the then Department for Transport, Environment and the Regions. This brought together cost–benefit results with those from detailed environmental impact assessment
Environmental impact assessment
An environmental impact assessment is an assessment of the possible positive or negative impact that a proposed project may have on the environment, together consisting of the natural, social and economic aspects....

s and presented them in a balanced way. NATA was first applied to national road schemes in the 1998 Roads Review but subsequently rolled out to all modes of transport. It is now a cornerstone of transport appraisal in the UK and is maintained and developed by the Department for Transport.http://www.webtag.org.uk/topics/costbenefitanalysis.htm

The EU's 'Developing Harmonised European Approaches for Transport Costing and Project Assessment' (HEATCO) project, part of its Sixth Framework Programme, has reviewed transport appraisal guidance across EU member states and found that significant differences exist between countries. HEATCO's aim is to develop guidelines to harmonise transport appraisal practice across the EU.http://heatco.ier.uni-stuttgart.dehttp://ec.europa.eu/regional_policy/sources/docgener/guides/cost/pdf/3_full_en.pdf

Transport Canada
Transport Canada
Transport Canada is the department within the government of Canada which is responsible for developing regulations, policies and services of transportation in Canada. It is part of the Transportation, Infrastructure and Communities portfolio...

 has also promoted the use of CBA for major transport investments since the issuance of its Guidebook in 1994.

More recent guidance has been provided by the United States Department of Transportation
United States Department of Transportation
The United States Department of Transportation is a federal Cabinet department of the United States government concerned with transportation. It was established by an act of Congress on October 15, 1966, and began operation on April 1, 1967...

 http://www.dot.ca.gov/hq/tpp/offices/ote/benefit_cost/models/index.html and several state transportation departments, with discussion of available software tools for application of CBA in transportation, including HERS, BCA.Net, StatBenCost, Cal-BC, and TREDIS. Available guides are provided by the Federal Highway Administration
Federal Highway Administration
The Federal Highway Administration is a division of the United States Department of Transportation that specializes in highway transportation. The agency's major activities are grouped into two "programs," the Federal-aid Highway Program and the Federal Lands Highway Program...

, Federal Aviation Administration
Federal Aviation Administration
The Federal Aviation Administration is the national aviation authority of the United States. An agency of the United States Department of Transportation, it has authority to regulate and oversee all aspects of civil aviation in the U.S...

, Minnesota Department of Transportation
Minnesota Department of Transportation
The Minnesota Department of Transportation oversees transportation by land, water, and air in the U.S. state of Minnesota. The cabinet-level agency is responsible for maintaining the state's trunk highway system The Minnesota Department of Transportation (Mn/DOT, pronounced "min-dot") oversees...

, California Department of Transportation
California Department of Transportation
The California Department of Transportation is a government department in the U.S. state of California. Its mission is to improve mobility across the state. It manages the state highway system and is actively involved with public transportation systems throughout the state...

 (Caltrans), and the Transportation Research Board
Transportation Research Board
The Transportation Research Board is a division of the National Research Council, which serves as an independent adviser to the President, the Congress and federal agencies on scientific and technical questions of national importance...

 Transportation Economics Committee.

Accuracy problems


The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs and benefits have been estimated. The public interest is an ever moving target containing a highly varied and complex set of interest based on the individual standing and/or stake holder role.

Comparative studies indicate that similar inaccuracies apply to fields other than transportation. These studies indicate that the outcomes of cost–benefit analyses should be treated with caution because they may be highly inaccurate. Inaccurate cost–benefit analyses likely to lead to inefficient decisions, as defined by Pareto
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

 and Kaldor-Hicks efficiency
Kaldor-Hicks efficiency
Kaldor–Hicks efficiency, named for Nicholas Kaldor and John Hicks, also known as Kaldor–Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, but has less stringent criteria and is hence applicable to more circumstances...

  .These outcomes (almost always tending to underestimation unless significant new approaches are overlooked) are to be expected because such estimates:
  1. Rely heavily on past like projects (often differing markedly in function or size and certainly in the skill levels of the team members)
  2. Rely heavily on the project's members to identify (remember from their collective past experiences) the significant cost drivers
  3. Rely on very crude heuristics to estimate the money cost of the intangible elements
  4. Are unable to completely dispel the usually unconscious biases of the team members (who often have a vested interest in a decision to go ahead) and the natural psychological tendency to "think positive" (whatever that involves)


Reference class forecasting
Reference class forecasting
Reference class forecasting is the method of predicting the future, through looking at similar past situations and their outcomes.Reference class forcasting predicts the outcome of a planned action based on actual outcomes in a reference class of similar actions to that being forecast. The theories...

 was developed to increase accuracy in estimates of costs and benefits.

Another challenge to cost–benefit analysis comes from determining which costs should be included in an analysis (the significant cost drivers). This is often controversial because organizations or interest groups may think that some costs should be included or excluded from a study.

In the case of the Ford Pinto
Ford Pinto
The Ford Pinto is a subcompact car produced by the Ford Motor Company for the model years 1971–1980. The car's name derives from the Pinto horse. Initially offered as a two-door sedan, Ford offered "Runabout" hatchback and wagon models the following year, competing in the U.S. market with the AMC...

 (where, because of design flaws, the Pinto was liable to burst into flames in a rear-impact collision), the Ford company's decision was not to issue a recall. Ford's cost–benefit analysis had estimated that based on the number of cars in use and the probable accident rate, deaths due to the design flaw would run about $49.5 million (the amount Ford would pay out of court to settle wrongful death lawsuits). This was estimated to be less than the cost of issuing a recall ($137.5 million) http://www.safetyforum.com/fordfuelfires/. In the event, Ford overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (because it led to the recall anyway and to measurable losses in sales).

In the field of health economics, some analysts think cost–benefit analysis can be an inadequate measure because willingness-to-pay methods of determining the value of human life can be subject to bias according to income inequity. They support use of variants such as cost–utility analysis and quality-adjusted life year to analyze the effects of health policies.

In the case of environmental and occupational health regulation, it has been argued that if modern cost-benefit analyses had been applied prospectively to proposed regulations such as removing lead from gasoline, not turning the Grand Canyon into a hydroelectric dam, and regulating workers' exposure to vinyl chloride, these regulations would not have been implemented even though they are considered to be highly successful in retrospect. The Clean Air Act has been cited in retrospective studies as a case where benefits exceeded costs, but the knowledge of the benefits (attributable largely to the benefits of reducing particulate pollution) was not available until many years later.

Further reading

  • Ascott, Elizabeth. 2006. Benefit Cost Analysis of Wonderworld Drive Overpass in San Marcos, Texas. Applied Research Project. http://ecommons.txstate.edu/arp/104/, Texas State University
  • Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "Underestimating Costs in Public Works Projects: Error or Lie?" Journal of the American Planning Association, vol. 68, no. 3, Summer 2002, pp. 279–295. http://flyvbjerg.plan.aau.dk/JAPAASPUBLISHED.pdf
  • Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "How (In)accurate Are Demand Forecasts in Public Works Projects? The Case of Transportation." Journal of the American Planning Association, vol. 71, no. 2, Spring 2005, pp. 131–146. http://flyvbjerg.plan.aau.dk/Traffic91PRINTJAPA.pdf
  • Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press
    Cambridge University Press
    Cambridge University Press is the publishing business of the University of Cambridge. Granted letters patent by Henry VIII in 1534, it is the world's oldest publishing house, and the second largest university press in the world...

    , 2003). http://books.google.com/books?vid=ISBN0521009464&id=RAV5P-50UjEC&printsec=toc&dq=flyvbjerg
  • Benefit/Cost Analysis: Introduction. Mankato State University. undated. http://krypton.mankato.msus.edu/~tony/courses/604/bencost.html
  • Campbell, Harry and Brown, Richard (2003) Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. Cambridge University Press http://www.uq.edu.au/economics/bca
  • Chakravarty, Sukhamoy (1987). "cost-benefit analysis," The New Palgrave: A Dictionary of Economics, v. 1, pp. 687–90.
  • Dupuit, Jules. "On the Measurement of the Utility of Public Works" in Readings in Welfare Economics, ed. Kenneth J. Arrow and Tibor Scitovsky (1969)
  • Eckstein, Otto. Water-resource Development: The Economics Of Project Evaluation. Cambridge : Harvard University Press, 1958.
  • Folland, Sherman, Allen C. Goodman and Miron Stano. The Economics of Heath and Health Care. Fifth ed. Pearson Prentice Hall: New Jersey, 2007. pg 83, 84.
  • Ferrara, A. (2010) Cost-Benefit Analysis of Multi-Level Government: The Case of EU Cohesion Policy and US Federal Investment Policies, London and New York: Routledge.http://www.routledge.com/books/details/9780415568210/
  • Hirshleifer, Jack. Water Supply: Economics, Technology, And Policy. Chicago: University Of Chicago Press 1960.
  • Maass, Arthur., eds. Design Of Water-resource Systems: New Techniques For Relating Economic Objectives, Engineering Analysis, And Governmental Planning. Cambridge: Harvard University Press, 1962.
  • McKean, Roland N. Efficiency In Government Through Systems Analysis: With Emphasis On Water Resources Development. New York: Wiley 1958.
  • Portney, Paul R., Benefit-Cost Analysis, in The Library Of Economics and Liberty. http://www.econlib.org/library/Enc/BenefitCostAnalysis.html
  • Proposed Practices For Economic Analysis Of River Basin Projects. Washington: [U.S. Govt. Print. Off.], 1950.
  • Tevfik F. Nas, Cost-Benefit Analysis: Theory and Application (Thousand Oaks, Ca.: Sage, 1996). http://books.google.com/books?vid=ISBN0803971338&id=wttV6nAtdMkC&pg=PP1&lpg=PP7&dq=%22cost+benefit+analysis%22&sig=oA2-XuXSydPNvjjM29YvgxACil8
  • Kosub, Jeffry, (2010) "Transitioning to a Greener Fleet: A Cost-Benefit Analysis of a Vehicle Fleet Program at the Texas General Land Office in Austin, Texas" (2010). Applied Research Projects. Texas State University. Paper 329. http://ecommons.txstate.edu/arp/329

External links