Cost–benefit analysis


Cost–benefit analysis

Cost–benefit analysis (CBA), 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. [1]

CBA is related to, but distinct from cost-effectiveness analysis. In CBA, benefits and costs are expressed in money terms, and are adjusted for the time value of money, 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 analysis, cost–utility analysis, economic impact analysis, fiscal impact analysis and Social Return on Investment (SROI) analysis.


Contents

Theory

Cost–benefit analysis is often used by governments and others, e.g. businesses, to evaluate the desirability of a given intervention. It is an analysis of the cost effectiveness of different alternatives in order to see whether the benefits outweigh the costs (i.e. whether it is worth intervening at all), and by how much (i.e. which intervention to choose). The aim is to gauge the efficiency of the interventions relative to each other and the status quo. It is with altering the status quo that pareto efficiency is applied in order to achieve best outcomes.


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

[2]

Valuation

The costs of an intervention are usually financial. The overall benefits of a government intervention are often evaluated in terms of the public's willingness to pay for them, minus their willingness to pay to avoid any adverse effects. 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. Putting actual values on these is often difficult; surveys or inferences from market behavior are often used. 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. Another controversy is the value of the environment, which in the 21st century is sometimes assessed by valuing it as a provider of services to humans, such as water 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 formulas. This is often done by converting the future expected streams of costs and benefits into a present value amount using a suitable discount rate. Empirical studies and a technical framework[3] 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, and thus is a source of controversy. One of the issues arising is the equity premium puzzle, 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 - that is, people usually consider a loss to have a larger impact than an equal gain, so a simple expected return 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, 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.[4]

Application and history

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 the discount rate 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 = 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 and was formalized in subsequent works by Alfred Marshall. The practical application of CBA was initiated in the US by the Corps of Engineers, after the Federal Navigation Act of 1936 effectively required cost–benefit analysis for proposed federal waterway infrastructure.[5] The Flood Control Act of 1939 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.[6]

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'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 many countries around the world.

In the UK, 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.[10]

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.[11][12] [7]

Transport Canada has also promoted the use of CBA for major transport investments since the issuance of its Guidebook in 1994.[8]

More recent guidance has been provided by the United States Department of Transportation 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,[9][10] Federal Aviation Administration,[11] Minnesota Department of Transportation,[12] California Department of Transportation (Caltrans),[13] and the Transportation Research Board Transportation Economics Committee.[14]

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 and Kaldor-Hicks efficiency .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 was developed to increase accuracy in estimates of costs and benefits.[15]

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 (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) [13]. 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.[16] 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.[16]

References

  1. ^ http://www.dot.ca.gov/hq/tpp/offices/ote/benefit_cost/index.html
  2. ^ Boardman, N. E. (2006). Cost-benefit analysis, concepts and practice. (3 ed.). Upper Saddle River, NJ: Prentice Hall
  3. ^ Dunn, William N. "Public Policy Analysis: an Introduction." Longman (2009)
  4. ^ Campbell and Brown (2003) Ch. 9 provides a useful discussion of sensitivity analysis and risk modelling in CBA.
  5. ^ History of Benefit-Cost Analysis, Proceedings of the 2006 Cost Benefit Conference [1]
  6. ^ Google book extract from Cases in Public Policy Analysis By George M. Guess, Paul G. Farnham
  7. ^ Guide to Cost-Benefit Analysis of Investment Projects. Evaluation Unit, DG Regional Policy, European Commission, 2002. [2]
  8. ^ Guide to Benefit-Cost Analysis in Transport Canada. Transport Canada. Economic Evaluation Branch, Transport Canada, Ottawa, 1994 [3]
  9. ^ US Federal Highway Administration: Economic Analysis Primer: Benefit-Cost Analysis 2003 [4]
  10. ^ US Federal Highway Administration: Cost-Benefit Forecasting Toolbox for Highways, Circa 2001 [5]
  11. ^ US Federal Aviation Administration: Airport Benefit-Cost Analysis Guidance, 1999 [6]
  12. ^ Minnesota Department of Transportation: Benefit Cost Analysis. MN DOT Office of Investment Management [7]
  13. ^ California Department of Transportation: Benefit-Cost Analysis Guide for Transportation Planning [8]
  14. ^ Transportation Research Board, Transportation Economics Committee: Transportation Benefit-Cost Analysis [9]
  15. ^ Flyvbjerg, B., 2008, "Curbing Optimism Bias and Strategic Misrepresentation in Planning: Reference Class Forecasting in Practice." European Planning Studies, vol. 16, no. 1, January, pp. 3-21.
  16. ^ a b Ackerman et al. (2005). Applying Cost-Benefit to Past Decisions: Was environmental protection ever a good idea. Administrative Law Review.

Further reading

  • Ascott, Elizabeth. 2006. Benefit Cost Analysis of Wonderworld Drive Overpass in San Marcos, Texas. Applied Research Project. [14], 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. [15]
  • 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. [16]
  • Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press, 2003). [17]
  • Benefit/Cost Analysis: Introduction. Mankato State University. undated. [18]
  • Campbell, Harry and Brown, Richard (2003) Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. Cambridge University Press [19]
  • 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.[20]
  • 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. [21]
  • 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). [22]
  • 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


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