Cost-benefit analysis is a weighing-scale approach to making business decisions: all the pluses (the benefits) are put on one side of the balance and all the minuses (the costs) are put on the other. Whichever weighs the heavier wins. A company considering whether to buy new computer systems, for example, might put on the cost side things like:
• the price of the computers themselves;
• the cost of hiring people to install them;
• the cost of training staff to use them.
On the benefits side would be things like:
• greater speed in carrying out the company's operations;
• greater efficiency in organising data;
• a boost to staff morale from using the latest equipment.
All of us do intuitive cost-benefit analyses every day of our lives, at such times as when we ask, “Shall I take a taxi to my next meeting or will I not save enough time for it to be worth my while?”
Benjamin Franklin, inventor of the lightning conductor and co-author of the American Declaration of Independence, was an early practitioner. In , he wrote:
When difficult cases occur, they are difficult chiefly because while we have them under consideration, all the reasons pro and con are not present to the mind at the same time … To get over this, my way is to divide half a sheet of paper by a line into two columns; writing over the one “Pro”, and the other “Con”. Then … I put down under the different heads short hints of the different motives … for and against the measure … I endeavour to estimate their respective weights; where I find one on each side that seem equal, I strike them both out. If I find a reason pro equal to two reasons con, I strike out three … and thus proceeding I find at length where the balance lies … And, though the weight of reasons cannot be taken with the precision of algebraic quantities, yet when each is thus considered, separately and comparatively, and the whole lies before me, I think I can judge better, and am less liable to take a rash step.
Franklin hints that this comparatively simple idea has complicated ramifications. The pluses and minuses are not all immediately obvious, and many of them are not easily measurable in monetary terms. How, for instance, do you quantify an increase in staff morale?
Moreover, decisions cannot be made in isolation. There are usually several competing options: if you do not invest in a new plant in west Africa you can increase capacity at your existing plant, or you can take over a new business, or you can just leave the money in the bank. An analysis has to be done for each of the options.
In recent years, cost-benefit analysis has been widely used for analysing public-sector projects, as a tool to help answer questions such as: “Should we subsidise the sale of things like unleaded petrol and solar panels?” or “Shall we turn this busy urban street into a pedestrian zone?” In these examples, the social costs are the most important ones. What are the benefits to human health of reducing the levels of lead in the atmosphere? And can you measure this—in terms, for example, of the medical facilities that will not be required as a result of the better health of the population?
Boardman, A., Greenberg, D., Vining, A. and Weimer, D., “Cost Benefit Analysis: Concepts and Practice”, Prentice Hall, ; 3rd edn,
Layard, R. and Glaister, S., “Cost-Benefit Analysis”, 2nd edn, Cambridge University Press,
Roy, A., “Cost-Benefit Analysis: Theory and Application”, Johns Hopkins University Press,
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- Definition: This is a technique designed to determine whether a project should go ahead -Do the benefits outweigh the costs?
- CBA not only included private monetary costs but also EXTERNALITIES and NON MONETARY costs
Procedure of Cost Benefit Analysis
- ALL costs and benefits are identified. These include external and non monetary
- A monetary value is assigned to each costs and benefit. A common value must be used, this is difficult for putting a value on noise, pollution
- Account is taken of future costs and benefits; these will also be discounted, for example, £ now is worth more than £ in the future
- Some costs may have a probability of occurring e.g. accident has a 10% chance of occurring but would cost £6, Therefore the cost is * £6, = £
Whether the project should occur
- Simplest method is whether total benefits > total costs
- Pareto approach. This means that everybody has to benefit from the project. It is possible that originally some people will lose out, but these could be compensated by those who gain
- Allow the project to go ahead with regulation
Identifying the COSTS and BENEFITS
- Direct (private) monetary costs
- Monetary, e.g. a new road may mean less money for train companies
- Non- monetary e.g. poll, spoiling landscape, noise
These are hard to measure you could:
Ask a questionnare as to how much people wanted to be compensated but there are problems
You could ask people who already have suffered
What is cost of overcoming it?
- e.g. cost of double-glazing but this can not be done with landscape
- What price a human life: one could give a monetary value on a human life but this is not satisfactory
- Direct benefits, this is revenue from firm operating, however these may fluctuate. It is also difficult to forecast demand in the future
- Consumer surplus
- Time saved from a new road Could be given a value from hourly rate
Discounting in cost –benefit Analysis
- Work out costs and benefits for each year of the project
- Subtract costs from the benefits for each year to give a net benefit for each year
- Discount each year’s net benefit to give it a present value
- Add all these up to give a NPV
- Choose the discount rate, This will reflect society’s preference for present benefits over future ones
Q. What are the problems with using a COST-Benefit Analysis?
- Converting into commensurates
- Agreeing on the benefits of landscape, noise, cost of human life
- the Unpredictable, e.g. Chernobyl
- Planning takes a long time benefits and costs may change frequently e.g. Wembley stadium now £1 billion
- Choosing a discount rate for future benefits and costs
- Deciding on distributional effects