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Cost–benefit analysis

Cost–benefit analysis (CBA), sometimes called benefit costs analysis (BCA), is a systematic approach to estimating the strengths and weaknesses of alternatives (for example, in transactions, activities, and functional business requirements). It is used to determine options which provide the best approach to achieving benefits while preserving savings.[1] A CBA may be used to compare potential (or completed) courses of actions, or to estimate (or evaluate) the value against the cost of a decision, project, or policy. It is commonly used in commercial transactions, business or policy decisions (particularly public policy), and project investments.

CBA has two main applications:

  1. To determine if an investment (or decision) is sound, ascertaining if – and by how much – its benefits outweigh its costs
  2. To provide a basis for comparing investments (or decisions), comparing the total expected cost of each option with its total expected benefits.[2]

CBA is related to cost-effectiveness analysis. Benefits and costs in CBA are expressed in monetary terms and are adjusted for the time value of money; all flows of benefits and costs over time are expressed on a common basis in terms of their net present value, regardless of whether they are incurred at different times. Other related techniques include cost–utility analysis, risk–benefit analysis, economic impact analysis, fiscal impact analysis, and social return on investment (SROI) analysis.


Contents

HistoryEdit

 
French engineer and economist Jules Dupuit, credited with the creation of cost–benefit analysis

The concept of CBA dates back to an 1848 article by Jules Dupuit, and was formalized in subsequent works by Alfred Marshall.[3] The Corps of Engineers initiated the use of CBA in the US, after the Federal Navigation Act of 1936 mandated cost–benefit analysis for proposed federal-waterway infrastructure.[4] The Flood Control Act of 1939 was instrumental in establishing CBA as federal policy, requiring that "the benefits to whomever they accrue [be] in excess of the estimated costs."[5]

Public policyEdit

CBA's application to broader public policy began with the work of Otto Eckstein,[6] who laid out a welfare economics foundation for CBA and its application to water-resource development in 1958. It was applied in the US to water quality,[7] recreational travel,[8] and land conservation during the 1960s,[9] and the concept of option value was developed to represent the non-tangible value of resources such as national parks.[10]

CBA was expanded to address the intangible and tangible benefits of public policies relating to mental illness,[11] substance abuse,[12] college education,[13] and chemical waste.[14] In the US, the National Environmental Policy Act of 1969 required CBA for regulatory programs; since then, other governments have enacted similar rules. Government guidebooks for the application of CBA to public policies include the Canadian guide for regulatory analysis,[15] the Australian guide for regulation and finance,[16] and the US guides for health-care[17] and emergency-management programs.[18]

Transportation investmentEdit

CBA for transport investment began in the UK with the M1 motorway project and was later used for many projects, including the London Underground's Victoria line.[19] The New Approach to Appraisal (NATA) was later introduced by the Department for Transport, Environment and the Regions. This presented balanced cost–benefit results and detailed environmental impact assessments. NATA was first applied to national road schemes in the 1998 Roads Review, and was subsequently rolled out to all transport modes. Maintained and developed by the Department for Transport, it was a cornerstone of UK transport appraisal in 2011.

The European Union's Developing Harmonised European Approaches for Transport Costing and Project Assessment (HEATCO) project, part of the EU's Sixth Framework Programme, reviewed transport appraisal guidance of EU member states and found significant national differences.[20] HEATCO aimed to develop guidelines to harmonise transport appraisal practice across the EU.[21]

Transport Canada promoted CBA for major transport investments with the 1994 publication of its guidebook.[22] US federal and state transport departments commonly apply CBA with a variety of software tools, including HERS, BCA.Net, StatBenCost, Cal-BC, and TREDIS. Guides are available from the Federal Highway Administration,[23][24] Federal Aviation Administration,[25] Minnesota Department of Transportation,[26] California Department of Transportation (Caltrans),[27] and the Transportation Research Board's Transportation Economics Committee.[28]

TheoryEdit

Cost–benefit analysis is often used by organizations to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of any alternatives and the status quo. CBA helps predict whether the benefits of a policy outweigh its costs (and by how much), relative to other alternatives. This allows the ranking of alternative policies in terms of a cost–benefit ratio.[29] Generally, accurate cost–benefit analysis identifies choices which increase welfare from a utilitarian perspective. Assuming an accurate CBA, changing the status quo by implementing the alternative with the lowest cost–benefit ratio can improve Pareto efficiency.[30] Although CBA can offer an informed estimate of the best alternative, a perfect appraisal of all present and future costs and benefits is difficult; perfection, in economic efficiency and social welfare, is not guaranteed.[31]

AccuracyEdit

The value of a cost–benefit analysis depends on the accuracy of the individual cost and benefit estimates. Comparative studies indicate that such estimates are often flawed, preventing improvements in Pareto and Kaldor-Hicks efficiency. [32] Interest groups may attempt to include (or exclude) significant costs in an analysis to influence its outcome.[33]

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 company decided 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 cost it about $49.5 million in wrongful death lawsuits; a recall would cost $137.5 million. The company failed to consider the costs of negative publicity, which forced a recall and reduced Ford sales.[34]

In health economics, CBA may be an inadequate measure because willingness-to-pay methods of determining the value of human life can be influenced by income level. Variants, such as cost–utility analysis, QALY and DALY to analyze the effects of health policies, may be more suitable.[35] [36]

For some environmental effects, cost-benefit analysis can be replaced by cost-effectiveness analysis. This is especially true when one type of physical outcome is sought, such as a reduction in energy use by an increase in energy efficiency. Using cost-effectiveness analysis is less laborious and time-consuming, since it does not involve the monetization of outcomes (which can be difficult in some cases).[37]

It has been argued that if modern cost–benefit analyses had been applied to decisions such as whether to mandate the removal of lead from gasoline, block the construction of two proposed dams just above and below the Grand Canyon on the Colorado River, and regulate workers' exposure to vinyl chloride, the measures would not have been implemented (although all are considered highly successful).[38] The US Clean Air Act has been cited in retrospective studies as a case in which benefits exceeded costs, but knowledge of the benefits (attributable largely to the benefits of reducing particulate pollution) was not available until many years later.[38]

ProcessEdit

A generic cost–benefit analysis has the following steps:[39]

  1. Define the goals and objectives of the action.
  2. List alternative actions.
  3. List stakeholders.
  4. Select measurement(s) and measure all cost and benefit elements.
  5. Predict outcome of costs and benefits over the relevant time period.
  6. Convert all costs and benefits into a common currency.
  7. Apply discount rate.
  8. Calculate the net present value of actions under consideration.
  9. Perform sensitivity analysis.
  10. Adopt the recommended course of action.

EvaluationEdit

CBA attempts to measure the positive or negative consequences of a project. A similar approach is used in the environmental analysis of total economic value. Both costs and benefits can be diverse. Costs tend to be most thoroughly represented in cost-benefit analyses due to relatively-abundant market data. The net benefits of a project may incorporate cost savings, public willingness to pay (implying that the public has no legal right to the benefits of the policy), or willingness to accept compensation (implying that the public has a right to the benefits of the policy) for the policy's welfare change. The guiding principle of evaluating benefits is to list all parties affected by an intervention and add the positive or negative value (usually monetary) that they ascribe to its effect on their welfare.

The actual compensation an individual would require to have their welfare unchanged by a policy is inexact at best. Surveys (stated preferences) or market behavior (revealed preferences) are often used to estimate compensation associated with a policy. Stated preferences are a direct way of assessing willingness to pay for an environmental feature, for example.[40] Survey respondents often misreport their true preferences, however, and market behavior does not provide information about important non-market welfare impacts. Revealed preference is an indirect approach to individual willingness to pay. People make market choices of items with different environmental characteristics, for example, revealing the value placed on environmental factors. [41]

The value of human life is controversial when assessing road-safety measures or life-saving medicines. Controversy 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. Road safety can be measured in cost per life saved, without assigning a financial value to the life. However, non-monetary metrics have limited usefulness for evaluating policies with substantially different outcomes. Other benefits may also accrue from a policy, and metrics such as cost per life saved may lead to a substantially-different ranking of alternatives than CBA.

Another metric is valuing the environment, which in the 21st century is typically assessed by valuing ecosystem services to humans (such as air and water quality and pollution).[42] Monetary values may also be assigned to other intangible effects such as business reputation, market penetration, or long-term enterprise strategy alignment.

Time and discountingEdit

CBA generally attempts to put all relevant costs and benefits on a common temporal footing, using time value of money calculations. This is often done by converting the future expected streams of costs and benefits into a present value amount with a discount rate.

The selection of a discount rate for this calculation is subjective. A smaller rate values the current generation and future generations equally. Larger rates (a market rate of return, for example) reflects human present bias or hyperbolic discounting: valuing money which they will receive in the near future more than money they will receive in the distant future. Empirical studies suggest that people discount future benefits in a way similar to these calculations.[43] The choice makes a large difference in assessing interventions with long-term effects. An example is the equity premium puzzle, which suggests that long-term returns on equities may be higher than they should be after controlling for risk and uncertainty. If so, market rates of return should not be used to determine the discount rate because they would undervalue the distant future.[44]

Risk and uncertaintyEdit

Risk associated with project outcomes is usually handled with probability theory. Although it can be factored into the discount rate (to have uncertainty increasing over time), it is usually considered separately. Particular consideration is often given to agent risk aversion: preferring a situation with less uncertainty to one with greater uncertainty, even if the latter has a higher expected return.

Uncertainty in CBA parameters can be evaluated with a sensitivity analysis, which indicates how results respond to parameter changes. A more formal risk analysis may also be undertaken with the Monte Carlo method.[45] However, even a low parameter of uncertainty does not guarantee the success of a project.


CBA under US administrationsEdit

The increased use of CBA in the US regulatory process is often associated with President Ronald Reagan's administration. Although CBA in US policy-making dates back several decades, Reagan's Executive Order 12291 mandated its use in the regulatory process. After campaigning on a deregulation platform, he issued the 1981 EO authorizing the Office of Information and Regulatory Affairs (OIRA) to review agency regulations and requiring federal agencies to produce regulatory impact analyses when the estimated annual impact exceeded $100 million. During the 1980s, academic and institutional critiques of CBA emerged. The three main criticisms were:[46]

  1. That CBA could be used for political goals. Debates on the merits of cost and benefit comparisons can be used to sidestep political or philosophical goals, rules and regulations.
  2. That CBA is inherently anti-regulatory, and therefore a biased tool. The monetization of policy impacts is an inappropriate tool for assessing mortality risks and distributional impacts.
  3. That the length of time necessary to complete CBA can create significant delays, which can impede policy regulation.

These criticisms continued under the Clinton administration during the 1990s. Clinton furthered the anti-regulatory environment with his Executive Order 12866.[47] The order changed some of Reagan's language, requiring benefits to justify (rather than exceeding) costs and adding "reduction of discrimination or bias" as a benefit to be analyzed. Criticisms of CBA (including uncertainty valuations, discounting future values, and the calculation of risk) were used to argue that it should play no part in the regulatory process.[48] The use of CBA in the regulatory process continued under the Obama administration, along with the debate about its practical and objective value. Some analysts oppose the use of CBA in policy-making, and those in favor of it support improvements in analysis and calculations.


See alsoEdit

ReferencesEdit

  1. ^ David, Rodreck; Ngulube, Patrick; Dube, Adock (16 July 2013). "A cost-benefit analysis of document management strategies used at a financial institution in Zimbabwe: A case study". SA Journal of Information Management. 15 (2). doi:10.4102/sajim.v15i2.540.
  2. ^ [1] Archived October 16, 2008, at the Wayback Machine
  3. ^ Wiener, Jonathan B. (2013). "The Diffusion of Regulatory Oversight". In Livermore, Michael A.; Revesz, Richard L. The Globalization of Cost-Benefit Analysis in Environmental Policy. New York: Oxford University Press. ISBN 978-0-199-93438-6.
  4. ^ "History of Benefit-Cost Analysis" (PDF). Proceedings of the 2006 Cost Benefit Conference. Archived from the original (PDF) on 2006-06-16.
  5. ^ Guess, George M.; Farnham, Paul G. (2000). Cases in Public Policy Analysis. Washington, DC: Georgetown University Press. pp. 304–308. ISBN 978-0-87840-768-2.
  6. ^ Eckstein, Otto (1958). Water Resource Development: The Economics of Project Evaluation. Cambridge: Harvard University Press.
  7. ^ Kneese, A. V. (1964). The Economics of Regional Water Quality Management. Baltimore: Johns Hopkins Press.
  8. ^ Clawson, M.; Knetsch, J. L. (1966). Economics of Outdoor Recreation. Baltimore: Johns Hopkins Press.
  9. ^ Krutilla, J. V. (1967). "Conservation Reconsidered". American Economic Review. 57 (4): 777–786. JSTOR 1815368.
  10. ^ Weisbrod, Burton A. (1964). "Collective-Consumption Services of Individual-Consumption Goods". Quarterly Journal of Economics. 78 (3): 471–477. doi:10.2307/1879478. JSTOR 1879478.
  11. ^ Weisbrod, Burton A. (1981). "Benefit-Cost Analysis of a Controlled Experiment: Treating the Mentally Ill". Journal of Human Resources. 16 (4): 523–548. doi:10.2307/145235. JSTOR 145235.
  12. ^ Plotnick, Robert D. (1994). "Applying Benefit-Cost Analysis to Substance Abuse Prevention Programs". International Journal of the Addictions. 29 (3): 339–359. doi:10.3109/10826089409047385.
  13. ^ Weisbrod, Burton A.; Hansen, W. Lee (1969). Benefits, Costs, and Finance of Public Higher Education. Markham.
  14. ^ Moll, K. S.; et al. (1975). Hazardous wastes: A Risk-Benefit Framework Applied to Cadmium and Asbestos. Menlo Park, CA: Stanford Research Institute.
  15. ^ Canadian Cost–Benefit Guide: Regulatory Proposals, Treasury Canada, 2007. [2]
  16. ^ Australian Government, 2006. Introduction to Cost–Benefit Analysis and Alternative Evaluation Methodologies and Handbook of Cost–Benefit Analysis, Finance Circular 2006/01. http://www.finance.gov.au/publications/finance-circulars/2006/01.html
  17. ^ US Department of Health and Human Services, 1993. Feasibility, Alternatives, And Cost/Benefit Analysis Guide, Administration for Children and Families, and Health Care Finance Administration. http://www.acf.hhs.gov/programs/cb/systems/sacwis/cbaguide/index.htm
  18. ^ Federal Emergency Management Administration, 1022. Guide to Benefit Cost Analysis. http://www.fema.gov/government/grant/bca.shtm
  19. ^ Hugh Coombs; Ellis Jenkins; David Hobbs (18 April 2005). Management Accounting: Principles and Applications. SAGE Publications. pp. 278–. ISBN 978-1-84787-711-6.
  20. ^ "HEATCO project site". Heatco.ier.uni-stuttgart.de. Retrieved 2013-04-21.
  21. ^ [3] Guide to Cost-Benefit Analysis of Major Projects. Evaluation Unit, DG Regional Policy, European Commission, 2008.
  22. ^ Guide to Benefit-Cost Analysis in Transport Canada. Transport Canada. Economic Evaluation Branch, Transport Canada, Ottawa, 1994 [4]
  23. ^ US Federal Highway Administration: Economic Analysis Primer: Benefit-Cost Analysis 2003 [5]
  24. ^ US Federal Highway Administration: Cost-Benefit Forecasting Toolbox for Highways, Circa 2001 [6]
  25. ^ US Federal Aviation Administration: Airport Benefit-Cost Analysis Guidance, 1999 [7] [8]
  26. ^ Minnesota Department of Transportation: Benefit Cost Analysis. MN DOT Office of Investment Management [9]
  27. ^ California Department of Transportation: Benefit-Cost Analysis Guide for Transportation Planning [10]
  28. ^ Transportation Research Board, Transportation Economics Committee: Transportation Benefit-Cost Analysis [11]
  29. ^ Cellini, Stephanie Riegg; Kee, James Edwin. "Cost-Effectiveness and Cost-Benefit Analysis" (PDF).
  30. ^ http://www.finance.gov.au/obpr/docs/Decision-Rules.pdf
  31. ^ Weimer, D.; Vining, A. (2005). Policy Analysis: Concepts and Practice (Fourth ed.). Upper Saddle River, NJ: Pearson Prentice Hall. ISBN 978-0-13-183001-1.
  32. ^ Pamela, Misuraca (2014). "The Effectiveness of a Costs and Benefits Analysis in Making Federal Government Decisions: A Literature Review" (PDF). Center for National Security. The MITRE Corporation.
  33. ^ Huesemann, Michael H., and Joyce A. Huesemann (2011). Technofix: Why Technology Won’t Save Us or the Environment, Chapter 8, “The Positive Biases of Technology Assessments and Cost Benefit Analyses”, New Society Publishers, Gabriola Island, British Columbia, Canada, ISBN 0865717044, 464 pp.
  34. ^ "Ford Fuel Fires". Archived from the original on July 15, 2011. Retrieved 29 December 2011.
  35. ^ Phelps, Charles (2009). Health Economics (4th ed.). New York: Pearson/Addison-Wesley. ISBN 978-0-321-59457-0.
  36. ^ Buekers, J (2015). "Health impact model for modal shift from car use to cycling or walking in Flanders: application to two bicycle highways". Journal of Transport and Health. 2 (4): 549–562. doi:10.1016/j.jth.2015.08.003.
  37. ^ Tuominen, Pekka; Reda, Francesco; Dawoud, Waled; Elboshy, Bahaa; Elshafei, Ghada; Negm, Abdelazim (2015). "Economic Appraisal of Energy Efficiency in Buildings Using Cost-effectiveness Assessment". Procedia Economics and Finance. 21: 422–430. doi:10.1016/S2212-5671(15)00195-1.
  38. ^ a b Ackerman; et al. (2005). "Applying Cost-Benefit to Past Decisions: Was Environmental Protection Ever a Good Idea?". Administrative Law Review. 57: 155.
  39. ^ Boardman, N. E. (2006). Cost-benefit Analysis: Concepts and Practice (3rd ed.). Upper Saddle River, NJ: Prentice Hall. ISBN 978-0-13-143583-4.
  40. ^ Field, Barry C; Field, Martha K (2016). ENVIRONMENTAL ECONOMICS: AN INTRODUCTION, SEVENTH EDITION. America: McGraw-Hill. p. 144. ISBN 978-0-07-802189-3.
  41. ^ Field, Barry C; Field, Martha K (2016). ENVIRONMENTAL ECONOMICS: AN INTRODUCTION, SEVENTH EDITION. America: McGraw-Hill. p. 138. ISBN 978-0-07-802189-3.
  42. ^ Campbell, Harry F.; Brown, Richard (2003). "Valuing Traded and Non-Traded Commodities in Benefit-Cost Analysis". Benefit-Cost Analysis: Financial and Economic Appraisal using Spreadsheets. Cambridge: Cambridge University Press. ISBN 978-0-521-52898-6. Ch. 8 provides a useful discussion of non-market valuation methods for CBA.
  43. ^ Dunn, William N. (2009). Public Policy Analysis: An Introduction. New York: Longman. ISBN 978-0-13-615554-6.
  44. ^ Newell, R. G. (2003). "Discounting the Distant Future: How Much Do Uncertain Rates Increase Valuations?". Journal of Environmental Economics and Management. 46 (1): 52–71. doi:10.1016/S0095-0696(02)00031-1.
  45. ^ Campbell, Harry F.; Brown, Richard (2003). "Incorporating Risk in Benefit-Cost Analysis". Benefit-Cost Analysis: Financial and Economic Appraisal using Spreadsheets. Cambridge: Cambridge University Press. ISBN 978-0-521-52898-6. Ch. 9 provides a useful discussion of sensitivity analysis and risk modelling in cost benefits analysis. CBA.
  46. ^ http://regulation.huji.ac.il/papers/jp5.pdf
  47. ^ "Executive Order 12866: Regulatory Planning and Review". govinfo.library.unt.edu.
  48. ^ Heinzerling, L. (2000), "The Rights of Statistical People", Harvard Environmental Law Review 24, 189-208.

Further readingEdit

  • Campbell, Harry; Brown, Richard (2003). Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. Cambridge University Press. ISBN 978-0-521-82146-9.
  • Chakravarty, Sukhamoy (1987). "Cost-benefit analysis". The New Palgrave: A Dictionary of Economics. 1. London: Macmillan. pp. 687–690. ISBN 978-0-333-37235-7.
  • David, R., Ngulube, P. & Dube, A., 2013, ‘A cost-benefit analysis of document management strategies used at a financial institution in Zimbabwe: A case study’, SA Journal of Information Management 15(2), Art. #540, 10 pages. http://www.sajim.co.za/index.php/SAJIM/article/view/540/640
  • Dupuit, Jules (1969). "On the Measurement of the Utility of Public Works". In Arrow, Kenneth J.; Scitovsky, Tibor. Readings in Welfare Economics. London: Allen and Unwin. ISBN 978-0-04-338038-3.
  • Eckstein, Otto (1958). Water-resource Development: The Economics of Project Evaluation. Cambridge: Harvard University Press.
  • Folland, Sherman; Goodman, Allen C.; Stano, Miron (2007). The Economics of Health and Health Care (Fifth ed.). New Jersey: Pearson Prentice Hall. pp. 83–84. ISBN 978-0-13-227942-0.
  • 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. ISBN 978-0-415-56821-0.
  • Frank, Robert H. (2000). "Why is Cost-Benefit Analysis so Controversial?". Journal of Legal Studies. 29 (S2): 913–930. doi:10.1086/468099.
  • Hirshleifer, Jack (1960). Water Supply: Economics, Technology, and Policy. Chicago: University of Chicago Press.
  • Huesemann, Michael H., and Joyce A. Huesemann (2011). Technofix: Why Technology Won’t Save Us or the Environment, Chapter 8, “The Positive Biases of Technology Assessments and Cost Benefit Analyses”, New Society Publishers, Gabriola Island, British Columbia, Canada, ISBN 0865717044, 464 pp.
  • Maass, Arthur, ed. (1962). Design of Water-resource Systems: New Techniques for Relating Economic Objectives, Engineering Analysis, and Governmental Planning. Cambridge: Harvard University Press.
  • McKean, Roland N. (1958). Efficiency in Government through Systems Analysis: With Emphasis on Water Resources Development. New York: Wiley.
  • Nas, Tevfik F. (1996). Cost-Benefit Analysis: Theory and Application. Thousand Oaks, CA: Sage. ISBN 978-0-8039-7133-2.
  • Richardson, Henry S. (2000). "The Stupidity of the Cost-Benefit Analysis". Journal of Legal Studies. 29 (S2): 971–1003. doi:10.1086/468102.
  • Quigley, John; Walls, Lesley (2003). "Cost-Benefit Modelling for Reliability Growth". Journal of the Operational Research Society. 54 (12): 1234–1241. doi:10.1057/palgrave.jors.2601633.
  • Sen, Amartya (2000). "The Discipline of Cost-Benefit Analysis". Journal of Legal Studies. 29 (S2): 931–952. doi:10.1086/468100.

External linksEdit