COST BENEFIT ANALYSIS

Meaning

Cost-Benefit Analysis (CBA )  is done to determine how well, or how poorly, a planned action will turn out. Although a cost benefit analysis can be used for almost anything, it is most commonly done on financial questions. Since the cost benefit analysis relies on the addition of positive factors and the subtraction of negative ones to determine a net result, it is also known as running the numbers.  It estimates and totals up the equivalent money value of the benefits and costs to the community of projects to establish whether they are worthwhile.

                    A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them.

Definition

Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period. The principles of cost-benefit analysis (CBA) are simple:

1. Appraisal of a project: It is an economic technique for project appraisal, widely used in business as well as government spending projects (for example should a business invest in a new information system)
2. Incorporates externalities into the equation: It can, if required, include wider social/environmental impacts as well as ‘private’ economic costs and benefits so that externalities are incorporated into the decision process. In this way, COBA can be used to estimate the social welfare effects of an investment
3. Time matters! COBA can take account of the economics of time – known as discounting. This is important when looking at environmental impacts of a project in the years ahead

Advantages

COBA has traditionally been applied to big public sector projects such as new motorways, by-passes, dams, tunnels, bridges, flood relief schemes and new power stations. Our example later considers some of the social costs and benefits of the new Terminal 5 for Heathrow airport.

Because financial resources are scarce, COBA allows different projects to be ranked according to those that provide the highest expected net gains in social welfare - this is particularly important given the limitations of government spending.

The Main Stages in the Cost Benefit Analysis Approach

At the heart of any investment appraisal decision is this basic question – does a planned project lead to a net increase in social welfare?

• Stage 1(a) Calculation of social costs & social benefits. This would include calculation of:
• Tangible Benefits and Costs (i.e. direct costs and benefits)
• Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)
• This process is very important – it involves trying to identify all of the significant costs & benefits
• Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important question - If you estimate that a possible benefit (or cost) is £x million, how likely is that outcome? If you are reasonably sure that a benefit or cost will ‘occur’ – what is the scale of uncertainty about the actual values of the costs and benefits?
• Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time. Individuals normally prefer to enjoy the benefits now rather than later – so the value of future benefits has to be discounted
• Stage 3: - Comparing the costs and benefits to determine the net social rate of return
• Stage 4: - Comparing net rate of return from different projects – the government may have limited funds at its disposal and therefore faces a choice about which projects should be given the go-ahead

Evaluation: Criticisms of COBA

There are several objections to the use of CBA for environmental impact assessment:

1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult – not least when a project has a significant impact on the environment. The value attached to the destruction of a habitat is to some “priceless” and to others “worthless”. Costs are also subject to change over time – I.e. the construction costs of a new bridge over a river or the introduction of electronic road pricing
2. The CBA may not cover everyone affected (i.e. all third parties) – inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential “stakeholders” who stand to be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders – there is a risk that some groups might be left out of the decision process

1. Future generations – are they included in the analysis?
2. What of “non-human” stakeholders?

1. Distributional consequences: Costs and benefits mean different things to different income groups - benefits to the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument.
2. Social welfare is not the same as individual welfare - What we want individually may not be what we want collectively. Do we attach a different value to those who feel “passionately” about something (for example the building of new housing on greenfield sites) contrasted with those who are more ambivalent?
3. Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of “property rights” over environmental resources? How does one value “nuisance” and “aesthetic values”?
4. Valuing human life: Some measurements of benefits require the valuation of human life – many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project “reducing the risk of death” – and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies.
5. Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically modified foods

1. Precautionary Principle: Assume toxicity until proven safe

1. If in doubt, then regulate

2. Free Market Principle: Assume it is safe until a hazard is identified

1. If in doubt, do not regulate.

Despite these problems, most economists argue that CBA is better than other ways of including the environment in project appraisal.

Discounting the future

Would you rather have £1000 of income today or £1000 of income in the future (say in 3 years?). The answer is probably now, because £1000 in three years time is unlikely to buy as many goods and services as it does now (because of inflation). And also because £1000 put into a savings account today will yield interest.
Discounting is a widely used technique as part of cost benefit analysis. The technique of discounting reflects the following:

The value of a cost or benefit now > the value of a cost or benefit in future years

Discounting reflects this by reducing all future costs and benefits to express them as today’s values. The key question is: How do you choose an ‘interest rate’ for reducing future costs to give them a present value today?

Setting a general discount rate for new projects has important implications for the environment:

1. A low discount rate is often favoured by economists since they argue that investing a high proportion of current income is a good way of providing for the future
2. A high discount rate may also be favoured since it discourages investment (and by implication environmental damage) in the present

Most projects have lifetimes of 20-30 years – with many of the big costs arising early in a project e.g. from construction whereas the stream of benefits from a project occur over a much longer period of time. But for many huge construction projects, some of the costs only become apparent in the long run. Consider the building of a new nuclear power station. Environmentalists would argue that there is a long list of costs from waste management and decommissioning which stretch over 100 years into the future whereas no social benefits exist to offset these costs beyond year 30 or 40 (where the nuclear power station might reasonably be expected to be ready for closure).

The value of decommissioning costs over 100 years away is almost negligible no matter what discount rate we use. This makes discounting difficult to justify

Revealed Preference – Valuing the Benefits from a Project

According to some economists, the valuation of benefits and costs used in COBA should reflect the preferences revealed by choices which have actually been made by individuals and businesses in different markets.

Example:

A sales director is deciding whether to implement a new computer-based contact management and sales processing system. His department has only a few computers, and his salespeople are not computer literate. He is aware that computerized sales forces are able to contact more customers and give a higher quality of reliability and service to those customers. They are more able to meet commitments, and can work more efficiently with fulfillment and delivery staff.

His financial cost/benefit analysis is shown below:

Costs:
New computer equipment:

• 10 network-ready PCs with supporting software @ $2,450 each
• 1 server @ $3,500
• 3 printers @ $1,200 each
• Cabling & Installation @ $4,600
• Sales Support Software @ $15,000

Training costs:

• Computer introduction – 8 people @ $400 each
• Keyboard skills – 8 people @ $400 each
• Sales Support System – 12 people @ $700 each

Other costs:

• Lost time: 40 man days @ $200 / day
• Lost sales through disruption: estimate: $20,000
• Lost sales through inefficiency during first months: estimate: $20,000

Total cost: $114,000

Benefits:

• Tripling of mail shot capacity: estimate: $40,000 / year
• Ability to sustain telesales campaigns: estimate: $20,000 / year
• Improved efficiency and reliability of follow-up: estimate: $50,000 / year
• Improved customer service and retention: estimate: $30,000 / year
• Improved accuracy of customer information: estimate: $10,000 / year
• More ability to manage sales effort: $30,000 / year

Total Benefit: $180,000/year

Payback time: $114,000 / $180,000 = 0.63 of a year = approx. 8 months

Cost benefit analysis normally clarifies the trade-offs between first costs and operating costs.

Unless the owner or designer can assign a monetary value for incremental benefits such as

improved comfort, productivity, or well-being, they are not normally considered.

• Examine economic consequences at all stages, starting with planning, and continuing through

occupancy, maintenance, and demolition.

In order to reach a conclusion as to the desirability of a project all aspects of the project, positive and negative, must be expressed in terms of a common unit; i.e., there must be a "bottom line." The most convenient common unit is money. This means that all benefits and costs of a project should be measured in terms of their equivalent money value. A program may provide benefits which are not directly expressed in terms of Currency but there is some amount of money the recipients of the benefits would consider just as good as the project's benefits. For example, a project may provide for the elderly in an area a free monthly visit to a doctor. The value of that benefit to an elderly recipient is the minimum amount of money that that recipient would take instead of the medical care. This could be less than the market value of the medical care provided. It is assumed that more esoteric benefits such as from preserving open space or historic sites have a finite equivalent money value to the public.

Not only do the benefits and costs of a project have to be expressed in terms of equivalent money value, but they have to be expressed in terms of Currency of a particular time. This is not just due to the differences in the value of Currency at different times because of inflation. A Currency available five years from now is not as good as a Currency available now. This is because a Currency available now can be invested and earn interest for five years and would be worth more than a Currency in five years. If the interest rate is r then a Currency invested for t years will grow to be (1+r)^t. Therefore the amount of money that would have to be deposited now so that it would grow to be one Currency t years in the future is (1+r)^-t. This called the discounted value or present value of a Currency available t years in the future.