January 29th, 2012 Cost Benefit Analysis
Cost-benefit analysis is a term that refers both to:
- a formal discipline used to help appraise, or assess, the case for a project or proposal, which itself is a process known as project appraisal; and
- an informal approach to making decisions of any kind.
Under both definitions the process involves, whether explicitly or implicitly, weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option. The formal process is often referred to as CBA, or Cost-Benefit analysis in the United States.
Closely related, but slightly different, formal techniques include cost-effectiveness analysis and benefit effectiveness analysis.
Theory of Cost Benefit Analysis
Cost Benefit Analysis is an economic tool to aid social decision-making, and is typically used by governments to evaluate the desirability of a given intervention in markets. The aim is to gauge the efficiency of the intervention relative to the status quo. The costs and benefits of the impacts of an intervention are evaluated in terms of the public's willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs are typically measured in terms of opportunity costs – the value in their best alternative use. The guiding principle is to list all of the parties affected by an intervention, and place a monetary value of the effect it has on their welfare as it would be valued by them.
The process involves monetary value of initial and ongoing expenses vs. expected return. Constructing plausible measures of the costs and benefits of specific actions is often very difficult. In practice, analysts try to estimate costs and benefits either by using survey methods or by drawing inferences from market behaviour. For example, a product manager may compare manufacturing and marketing expenses to projected sales for a proposed product, and only decide to produce it if he expects the revenues to eventually recoup the costs. Cost-benefit analysis attempts to put all relevant costs and benefits on a common temporal footing. A discount rate is chosen, which is then used to compute all relevant future costs and benefits in present-value terms. Most commonly, the discount rate used for present-value calculations is an interest rate taken from financial markets (R.H. Frank 2000). This can be very controversial – for example, a high discount rate implies a very low value on the welfare of future generations, which may have a huge impact on the desirability of interventions to help the environment, and so on. Empirical studies have suggested that in reality, people's discount rates do decline over time. Because CBA aims to measure the public's true willingness to pay, this feature is typically built into studies.
During cost-benefit analysis, monetary values may also be assigned to less tangible effects such as the various risks which could contribute to partial or total project failure; loss of reputation, market penetration, long-term enterprise strategy alignments, etc. This is especially true when governments use the technique, for instance to decide whether to introduce business regulation, build a new road or offer a new drug on the state healthcare. In this case, a value must be put on human life or the environment, often causing great controversy. The cost-benefit principle says, for example, that we should install a guardrail on a dangerous stretch of mountain road if the dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and property damage thus prevented (R.H. Frank 2000).
Cost-benefit calculations typically involve using time value of money formula. This is usually done by converting the future expected streams of costs and benefits to a present value amount.
Application of Cost Benefit Analysis
Cost-benefit analysis is mainly, but not exclusively, used to assess the value for money of very large private and public sector projects. This is because such projects tend to include costs and benefits that are less amenable to being expressed in financial or monetary terms (e.g. environmental damage), as well as those that can be expressed in monetary terms. Private sector organisations tend to make much more use of other project appraisal techniques, such as rate of return, where feasible.
The practice of cost-benefit analysis differs between countries and between sectors (e.g. transport, health) 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 discount rate between countries.
Cost Benefit Analysis in UK
Basic cost-benefit techniques were applied to the development of the motorway network in the 1950s and 60s. An early, and often quoted, more developed application of the technique was made to London Underground's Victoria Line. 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 the UK. The Department for Transport (DfT) and its agencies have made extensive use of a number of key cost-benefit indicators, including:
- PVB (present value of benefits);
- PVC (present value of costs);
- NPV (PVB less PVC);
- NPV/k (where k is the level of funds available) and
- BCR (benefit cost ratio).
In 1998 the New Approach to Appraisal (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 assessments 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.
Cost Benefit Analysis in EU
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.
Cost Benefit Analysis in US
Much of the early development work on cost-benefit analysis as a discipline was the result of problems faced by the US Army Corps of Engineers in deciding how and where to build bridges in supporting combat operations.
Cost-benefit analysis is now a well established discipline in the US. California's Department of Transportation (Caltrans) provide detailed guidance on how Cost-benefit analysis should be applied to transport projects.
Evolutionary Biology of Cost Benefit Analysis
Cost-benefit analysis is used in evolutionary biology to assess the fitness costs and benefits of traits. For example, a behavioral ecologist may use the cost benefit approach to explain the evolution of play behavior in young animals. Costs would include injury and increased vulnerability of predation, while benefits may include improvement of a certain skill important in future success. Deviation from predictions based on the cost-benefit approach may highlight factors not considered by the researcher.
Accuracy Problems in Cost Benefit Analysis
The accuracy of the outcome of a cost-benefit analysis is dependent on how accurately costs and benefits have been estimated. A peer-reviewed study of the accuracy of cost estimates in transportation infrastructureplanning found that for rail projects actual costs turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4 percent higher (Flyvbjerg, Holm, and Buhl, 2002). For benefits, another peer-reviewed study found that actual rail ridership was on average 51.4 percent lower than estimated ridership; for roads it was found that for half of all projects estimated traffic was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005). 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. In fact, inaccurate cost-benefit analyses may be argued to be a substantial risk in planning, because inaccuracies of the size documented are likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks efficiency ( Flyvbjerg, Bruzelius, and Rothengatter, 2003).
These outcomes (almost always tending to underestimation, unless significant new approaches are overlooked) are to be expected, since such estimates:
1. rely heavily on past like projects (frequently 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 ('rules of thumb') to estimate the money cost of the intangible elements, and
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).
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 as organizations or interest groups may feel that some costs should be included or excluded from a study.
In the case of the Ford Pinto (where, due to 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). In the event, Ford overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (since it led to the recall anyways and to measurable losses in sales).
Specifically in the field of Health Economics, cost-benefit analysis is viewed as an inadequate measure by extra-welfarists, as willingness-to-pay methods of determining the value of human life are subject to bias according to income inequity. This is due to the inherent nature of "ability to pay," which weighs heavily in the willingness-to-pay question (i.e. one's willingness-to-pay is constrained by one's ability-to-pay). For this reason, extra-welfaristscost-utility analysis and the QALY to analyze the effects of health policies. support use of
Sources and further reading about Cost Benefit Analysis
- Sukhamoy Chakravarty (1987). "cost-benefit analysis," The New Palgrave: A Dictionary of Economics, v. 1, pp. 687-90.
- Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press, 2003).
- Bent Flyvbjerg, Mette K. Skamris Holm, and Sï¿½ren 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.
- Bent Flyvbjerg, Mette K. Skamris Holm, and Sï¿½ren 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.
- Tevfik F. Nas, Cost-Benefit Analysis: Theory and Application (Thousand Oaks, Ca.: Sage, 1996).
- 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.
- Ascott, Elizabeth. 2006. Benefit Cost Analysis of Wonderworld Drive Overpass in San Marcos, Texas. Applied Research Project. Texas State University. http://ecommons.txstate.edu/arp/104/
Weighing-scale approach to decision-making Cost-Benefit Analysis
Cost-benefit analysis (CBA) is the weighing-scale approach to decision-making. All the plusses (cash-flows and other intangible benefits) are put on one side of the balance and all the minuses (the costs and disadvantages) are put on the other. Whichever weighs the heavier wins.
Example of a Cost Benefit Analysis (CBA):
A company that would like to buy new software to improve its business might conduct a CBA to decide and make up its mind.
On the minus (cost) side would be:
- the price of the software,
- the cost of consultants to install and implement the software, and
- the cost of training for the users of the software.
However on the plus (benefits) side would be:
- improved business processes (leading to an annual cost decrease),
- due to better available information, being able to take better decisions (leading to additional cash-flows), and
- increased staff moral from using the state of the art tools for running the business.
A frequently made mistake in the CBA method is to use non-discounted amounts for calculating the costs and benefits. A method like NPV or Economic Value Added or CFROI is strongly recommended, because all of these account for the time value of money.
A frequent problem with CBA is that typically the cost are tangible, hard and financial, while the benefits are hard and tangible, but also soft and intangible. Caution should be taken here against people who claim that "if you can't measure it does not exist / it has no value". Especially in more strategic investments, frequently the intangible benefits clearly outweigh the financial benefits