Cost-Benefit Analysis-What It Is-Why We Need It

and Why It is Important -- A Guide for the Layperson

What Is Cost-Benefit Analysis?

All of us do intuitive cost-benefit analyses every day of our lives when we ask, “Should I take a taxi, a bus or a train to my next meeting, or will I not save enough time for it to be worth the dollars spent?" Maybe I should walk or sign up for a bike share and get some exercise and save some money.  Should I buy a generic product and save some money, or does a name brand offer so much quality, safety and durability that it is worth the higher price?  Will the potentially increased lifetime monetary and psychic earnings arising from more education or an expensive private school be worth the costs in time and money?  Should I buy a home or rent, and how big should my residence be?...

Cost-Benefit Analysis (CBA), sometimes called Benefit–Cost analysis (BCA), estimates and totals up the equivalent money value of the benefits and costs to a community or a specified sub-population, of projects, policies and decisions to establish whether they are worthwhile.  It is a systematic approach to estimating the strengths and weaknesses of alternatives and the status quo.


Cost-benefit analysis is a weighing-scale approach to making 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 more wins.  It is a process by which you weigh expected costs against expected benefits to determine the best (or most profitable) course of action.  When it comes to goal setting or deciding on the best plan of attack, working up a cost-benefit analysis will help you decide just which route would be best for you.  CBA identifies choices that increase welfare from a utilitarian perspective. 
In CBA, benefits and costs are expressed in monetary 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 net present value.

The benefits and costs can be evaluated with respect to the world, a nation, a state, a county, a town, a city, a village, a neighborhood, a company, a group or an individual.

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?  What is the value of cleaner air or water?  What is the value of a life that may be saved or lost?

There are usually several competing options.  If a government does not invest in a new road it can put the money into education.   If a company does not invest in a plant in Kansas it can increase capacity at an existing plant, or take over a new business, buy computers, or leave the money in the bank.  If you do not invest in a new car you can take longer more luxurious vacations.



The net benefits of a project may incorporate cost savings or public willingness to pay compensation or willingness to accept compensation for the welfare change resulting from the policy. The guiding principle of evaluating benefits is to list all (categories of) parties affected by an intervention and add the (positive or negative) value, usually monetary, that they ascribe to its effect on their welfare.




Risk associated with project outcomes is usually handled using probability theory. Uncertainty in CBA parameters (as opposed to risk of project failure etc.) can be evaluated using a sensitivity analysis which shows how results respond to parameter changes. Alternatively a more formal risk analysis can be undertaken using Monte Carlo simulations.


Purpose

The purpose of cost benefit analysis is to determine if an investment/decision is sound – verifying whether its benefits outweigh the costs, and by how much.  It provides a basis for comparing projects – which involves comparing the total expected cost of each option against its total expected benefits.


Why Use Cost-Benefit Analysis?

Formal Cost Benefit Analysis is needed because the world is complex and constantly changing. Policies, projects and decisions can have numerous consequences, benefits and costs at different points in time. The consequences are difficult to determine, subject to change and often interdependent. Sometimes, the fifth or sixth highest cost can tip the balance against a project. Cost-Benefit Analysis compels the use of the most systematic accurate analytical tools to evaluate each cost and benefit. 


Behavioral Economics has shown us that we can often block critical information and be subject to a host of errors in our evaluations.  Cost-Benefit Analysis can make sources of bias explicit and open up the possibility for change, though admittedly it can sometimes bind readers and analysts to their fixed ideas.


Cost-Benefit Analysis portrays assumptions, calculations and conclusions, and renders these subject to criticism, revision and improvement.


Cost-Benefit Analysis can help lead to decisions that systematically take into account more factors than individuals or groups using intuition or less formal analyses can.


Liberal environmentalists tend to focus upon the impacts of policies and projects on air quality, on greenhouse gas emissions that warm the globe and on endangered species. They often appear to favor policies that move in the direction of cleaning the air, reducing GHGs and biodiversity regardless of the costs.


Conservative business owners tend to claim that these actions may be too costly -- forcing businesses to cut jobs, or consumers to spend on things they do not want. They seem to oppose all regulations regardless of the potential health and safety benefits.


Often these stances are based upon mere assertions and fixed ideas. Each side fails to recognize the potential validity of the other side. Behavioral Economists, psychologists and political scientists have shown how individuals and groups get locked into irrational positions through numerous processes.


Cost Benefit Analysis leads to empirical evaluation of each potential effect, and then tallies as many of the potential effects as possible in common (dollar) terms. The aim is to determine overall effects, according the most significant effects the greatest weight.


For example green roofs or other green building features can be more expensive to install and maintain, but they can reduce last longer, absorb stormwater, save energy, reduce greenhouse gases, air pollution and noise, enhance biodiversity, produce local food, and provide aesthetic benefits. To rationally evaluate the desirability of incurring some extra costs it is necessary to quantify the benefits in common units such as dollars.


It should be noted than many environmentally measures do not sacrifice jobs or force consumers, businesses or taxpayers to spend more. These situations can be made more explicit via cost benefit analysis.


Although the use of cost-benefit analysis is increasing in many sectors too often policies are based on fixed ideas or intuitions.


We believe that it is better to fight with comprehensive spreadsheets backed by solid models and deep empirical evidence than with fixed ideas, slogans, harsh rhetoric, vicious attacks, tweets and bullets.


We believe it can be applied to many areas where it is not currently utilized frequently such as tallying up the social costs and benefits of real estate projects, zoning regulations, smart growth policies, smart cities technology investments, construction of bike lanes and many other areas rather than subject these decisions to arbitrary rules


A complex, warming more crowded urbanizing planet needs to make better decisions with respect to land uses, policies, taxes, building codes, transportation systems, projects, affordable housing, social programs and technologies at international, national and local levels. Only by comprehensively evaluating the costs and benefits of these decisions can choices be optimized. Cost-Benefit analysis is need to avoid waste and maximize utility. New data, analytical tools and technologies make these calculations more feasible and useful.


Today land use decisions are often suboptimal, determined by static outdated flawed zoning codes, political power, and the most vocal NIMBY-driven opponents. Current zoning codes often render infill, downtown, transit-oriented, live-work, residential over retail, other mixed-use and affordable development that can enhance vitality, walkability, and convenience difficult. Cost-benefit analysis can and performance or form-based codes can help promote modern affordable housing and optimize transit and other infrastructures.


There is a broad scope for potential expansion of the use of cost-benefit analysis in key decisions.

Why CBA Is Important?

Despite significant advances, too many policy decisions are still based upon rigid adherence to fixed ideas, limited information, political power, and irrational emotions. Cost-Benefit Analysis has the potential to overcome these difficulties and produce rational, optimal decisions.


It can eliminate arguments based on fixed ideas with evidence, and can potentially reconcile conflicts.


Uses

Cost-benefit analysis can help answer questions such as: 
  • Should we subsidize the sale of things like unleaded petrol and solar panels?
  • Shall we turn this busy urban street into a pedestrian zone?
  • What are the benefits to human health of reducing the levels of lead in the atmosphere? And what are the savings from medical facilities that will not be required as a result of the better health of the population?
It can help:
  • Decide whether to hire new team members.
  • Evaluate a new project or change initiative.
  • Determine the feasibility of a capital purchase.
CBA can assist with decisions regarding:

  • dams
  • highways
  • training programs
  • health care systems.
  • investing in marketing ideas, 
  • product development, 
  • infrastructure enhancements 
  • operational changes. 
  • finance, health care programs, 
  • emergency management programs.
  • transport investments
  • information technology (IT) Expenditures
CBA has been applied to policies and programs with respect to water quality, recreation travel, and land conservation, mental illness, substance abuse, college education, and chemical waste policies.


History

Informal cost-benefit analyses were conducted in the African savannas two million years ago, and by more primitive beings well before then.  There is an extensive biological literature investigating cost-benefit analyses in all forms of life -- from singled celled organisms to supposedly more advanced creatures on the evolutionary chain, including the following articles:



Some point to Benjamin Franklin, the brilliant multi-talented inventor of the lightning conductor and co-author of the American Declaration of Independence as an early practitioner. In 1772, 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 French engineer and economist Jules Dupuit is generally credited as the creator of formal cost–benefit analysis. His 1844 article "De la mesure de l’utilité des travaux publics" appeared in the Annales des ponts et chaussées and was translated by R.H. Barback as "On the measurement of the utility of public works" in International Economic Papers, 1952.  The British economist, Alfred Marshall, subsequently formulated many of the concepts that are the foundation of CBA.

The Federal Navigation Act of 1936 and the Flood Control Act brought cost-benefit analysis to the U.S. federal government and the regulatory and legal infrastructures, stating that "the Federal Government should improve or participate in the improvement of navigable waters or their tributaries, including watersheds thereof, for flood-control purposes if the benefits to whomsoever they may accrue are in excess of the estimated costs."  The U.S. Corps of Engineers was tasked with carrying out these projects and these acts and the Corps created systematic, though somewhat ad hoc, methods for measuring such benefits and costs. The engineers of the Corps did this without much, if any, assistance from the economics profession.

Otto Eckstein, laid out a welfare economics foundation for CBA and its application for water resource development and wider application for public policy in 1958. In the early 1960s, CBA was applied in the US for water quality, recreation travel, and land conservation. During this period, the concept of option value was developed to represent the non-tangible value of preserving resources such as national parks.

CBA was later expanded to address both intangible and tangible benefits of public policies relating to mental illness, substance abuse, college education, and chemical waste policies. In the US, the National Environmental Policy Act of 1969 required the application of CBA for regulatory programs, and since then, other governments have enacted similar rules.

The application of CBA to transport investments started in the UK with the M1 motorway project, which opened in 1959 but was conceived in 1923, and was later applied on many projects including London Underground's Victoria line. Later, the New Approach to Appraisal (NATA) was introduced in 1998 by the then Department for Transport, Environment and the Regions. This presented cost–benefit results and detailed environmental impact assessments in a balanced way. NATA was first applied to national road schemes in the 1998 Roads Review but subsequently rolled out to all transport modes. As of 2011 it was a cornerstone of transport appraisal in the UK and is maintained and developed by the Department for Transport.

The EU's 'Developing Harmonised European Approaches for Transport Costing and Project Assessment' (HEATCO) project, part of its Sixth Framework Programme, reviewed transport appraisal guidance across EU member states and found that significant differences exist between countries. HEATCO's aim was to develop guidelines to harmonize transport appraisal practice across the EU.

Transport Canada promoted the use of CBA for major transport investments with the 1994 issuance of its Guidebook.

In the US, both federal and state transport departments commonly apply CBA, using a variety of available software tools including HERS, BCA.Net, StatBenCost, Cal-BC, and TREDIS. Guides are available from the Federal Highway Administration, Federal Aviation Administration, Minnesota Department of Transportation, California Department of Transportation (Caltrans), and the Transportation Research Board Transportation Economics Committee.

The increased usage of CBA in the US regulatory process is often associated with President Ronald Reagan's administration. Though the use of CBA in US policy-making dates back many decades, Reagan's Executive Order 12291 mandated the use of CBA in the regulatory process. Reagan campaigned on a deregulation platform, and once he took office in 1981 quickly issued this EO, which vested the Office of Information and Regulatory Affairs (OIRA) with the authority to review agency regulations and required federal agencies to produce regulatory impact analyses when the annual impact could be estimated to be over $100M.

Shortly thereafter, in the 1980s, academic and institutional critiques of CBA started to emerge.  Some technical issues of CBA remain unresolved.

Under the Clinton administration Executive Order 12866 changed some of Reagan's language, requiring benefits to justify, rather than exceed costs, and added "reduction of discrimination or bias" as one of the benefits to be analyzed.


Process

The following is a list of steps that comprise a generic cost–benefit analysis.
  • List alternative projects/programs.
  • List stakeholders.
  • Select measurement(s) and measure all cost/benefit elements.
  • Predict outcome of cost and benefits over relevant time period.
  • Convert all costs and benefits into a common currency.
  • Apply discount rate.
  • Calculate net present value of project options.
  • Perform sensitivity analysis.
  • Adopt recommended choice.
  • Evaluation
The first section of a cost-benefit analysis is a statement of purpose. This explains the project or purchase under consideration and the goal of the cost-benefit analysis. In some cases, it is necessary to analyze alternatives as well.

Usually, a CBA measures literal cost in terms of money, but, in cases where money is not an issue, CBAs can measure cost in terms of time, energy usage, and more.
The next section is a detailed listing of costs. Include both tangible and intangible costs such as (1) the cost of personnel planning the project, (2) materials, (3) services, (4) computing, (5) training, (6) hiring of additional personnel, (7) facilities costs (8) equipment, (9) insurance, (10) taxes, (11) utilities and (11) the future value of the total money expected to be spent. If applied to the creation of a new product line, include additional costs such as (12) research and development, (13) design, (14) manufacturing, (15) marketing and sales, (16) fulfillment and (17) transaction costs.


Intangible costs include (1) the cost of the time spent on a project - i.e., the money that could be made if this time was spent doing something else, (2) the cost of the energy spent on a project, (3) the cost of adjusting an established routine, (4) the cost of any possible lost business during the implementation of the projected venture, and (5) the risk factor value of intangibles like safety and customer loyalty

The benefit section of the analysis comes next. Benefits are often not as easily quantified as costs. For businesses benefits consist of increased revenues or lower costs for maintenance, labor time, and intangible benefits such as an improvement in company image.


Variables that impact results much be considered including changes in the economy that can result in either inflation or deflation, higher or lower demand, and new technologies that render a company's products obsolete. Best case, worst case and most likely scenarios should be evaluated.

The future value of money takes into account the purchasing power of costs and benefits given assumptions of future economic inflation or deflation.



The last section of your cost-benefit analysis compares the cost associated with the proposal to the value of the benefits derived. It also can include an analysis of whether the alternative to the proposed project or purchase presents a loss of opportunity.


Examples

A company considering whether to buy new computer systems 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.
Our cost-benefit analysis of green roofs is available on the National Park Service website on pages 41-52 (51-62 of the PDF) at

https://www.nps.gov/tps/sustainability/greendocs/rosenzweig-sm.pdf


A simple application to transport is available at


and from our Environmental Valuation and Cost-Benefit News:



Classic comprehensive, highly scrutinized analyses of the Clean Air Act from 1970 to 2020 are available at:

https://www.epa.gov/clean-air-act-overview/benefits-and-costs-clean-air-act

Other examples are at

Critiques

The three main criticisms of CBA have been:
  • 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.
  • That CBA is inherently anti-regulatory, therefore not a neutral analysis tool. This is an ethical argument: that the monetization of policy impacts is an inappropriate tool for assessing things such as mortality risks and distributional impacts.
  • That the length of time necessary to complete CBA can create significant delays, which can impede policy regulations.
Criticisms of aspects of CBA, including uncertainly valuations, discounting future values, and the calculation of risk, were used to argue that CBA should play no part in the regulatory process.

Some technical issues of CBA continue to be unresolved though much is accepted.

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. Causes of these inaccuracies include:
  • Overreliance on data from past projects (often differing markedly in function or size and the skill levels of the team members)
  • Use of subjective impressions in assessment
  • Inappropriate use of heuristics to derive money cost of the intangible elements
  • Confirmation bias among project supporters (looking for reasons to proceed).
  • Interest groups may attempt to include or exclude significant costs from an analysis to influence the outcome.
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'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 cost it about $49.5 million to settle wrongful death lawsuits versus recall costs of $137.5 million. Ford overlooked (or considered insignificant) the costs of the negative publicity that would result, which forced a recall and damaged sales.

In 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 influenced by income level. They support use of variants such as cost–utility analysis and quality-adjusted life year to analyze the effects of health policies.

For some environmental effects cost-benefit analysis can be substituted with cost-effectiveness analysis. This is especially true when there is only one type of physical outcome that is sought, such as the reduction of energy use by increasing energy efficiency. Using cost-effectiveness analysis is less laborious and time-consuming as it does not involve the monetization of outcomes, which can be difficult in some cases.

In environmental and occupational health regulation, it has been argued that if modern cost–benefit analyses had been applied prospectively 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, these measures would not have been implemented even though they are considered to be highly successful in retrospect.  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.



The actual compensation an individual would require to have their welfare unchanged by a policy is inexact at best. Surveys (stated preference techniques) or market behavior (revealed preference techniques) are often used to estimate the compensation associated with a policy. Stated preference technique is a direct way of assessing willingness to pay. Because it involves asking people directly to indicate their willingness to pay for some environmental feature, or some outcome that is closely connected to the state of the environment. However, survey respondents often have strong incentives to misreport their true preferences and market behavior does not provide any information about important non-market welfare impacts. Revealed preference technique is an indirect approach to individual willingness to pay. People make market choices among certain items that have different characteristics related to the environment, they reveal the value they place on these environmental factors.

One controversy is valuing a 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 formally placing a financial value on the life. However, such non-monetary metrics have limited usefulness for evaluating policies with substantially different outcomes. Additionally, many other benefits may accrue from the policy, and metrics such as 'cost per life saved' may lead to a substantially different ranking of alternatives than traditional cost–benefit analysis.

Another controversy 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.[9] Monetary values may also be assigned to other intangible effects such as business reputation, market penetration, or long-term enterprise strategy alignment.

CBA usually tries 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 using a discount rate. Empirical studies and a technical framework suggest that in reality, people do discount the future like this.

A smaller rate values future generations equally with the current generation. Larger rates (e.g. a market rate of return) reflects humans' attraction to time inconsistency—valuing money that they receive today more than money they get in the future. The choice makes a large difference in assessing interventions with long-term effects. One issue is the equity premium puzzle, in which long-term returns on equities may be rather higher than they should be. If so then arguably market rates of return should not be used to determine a discount rate, as doing so would have the effect of undervaluing the distant future (e.g. climate change).


Particular consideration is often given to risk aversion—the preference for avoiding loss over achieving gain. Expected return calculations do not account for the detrimental effect of uncertainty


A January 2017 articles by Cass R. Sunstein entitled "Is Cost-Benefit Analysis a Foreign Language?"
Forthcoming in the Quarterly Journal of Experimental Psychology, at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2893401 begins by discussing an experiment, conducted in late 2016 with 204 Americans. Using Amazon’s Mechanical Turk, he began by noting that “people debate how the government should go about reducing risks that come from air pollution, unsafe food, and potentially unsafe working conditions.” He then asked respondents to state their agreement or disagreement, on a five-point scale (from “strongly agree” to “strongly disagree”), with the following proposition: The government should assign a dollar value to each human life – perhaps $9 million – and weigh the costs of regulation against the benefits of regulation.  As it happens, the U.S. government routinely does exactly that. Within both Republican and Democratic administrations, the proposition is not even controversial (though there are occasional debates over the exact value).1 And yet respondents were deeply skeptical. The most common answer was “strongly disagree,” with 68 votes. The second most common was “somewhat disagree,” with 52 votes. Only four strongly agreed. Just 37 somewhat agreed; 42 were neutral. The overwhelming majority of American respondents refused to embrace a proposition that most executive branch officials in the United States find self-evidently correct 

Some people find the very idea of assigning a monetary value to lifesaving or to quality of life, which is an essential element of cost-benefit analysis, meaningless and ethically wrong. Human life, it is argued, is not a commodity that can be traded against other goods. It should therefore not carry a price tag. However, the purpose of assigning a monetary value to human life is not to engage in trading in the usual sense of that term. It is simply to provide a guideline with respect to the amount of resources we would like to spend on the prevention of accidents or injuries, given the fact that not all of our resources can be spent for this purpose. Some form of economic reasoning – that is some form of thinking that recognises the fact that resources are limited and can be put to very many alternative uses – is simply inevitable, given the following basic facts:
  • A limited amount of resources is at our disposal for the prevention of accidents or injuries, or indeed for catering to any human need.
  • Human needs and value systems are complex and multi-dimensional. While safety is certainly one of the more basic human needs, it is not the only one, and no society would ever be able to spend more than a fraction of disposable resources on the prevention of accidents or injuries.
  • How much to spend on the prevention of accidents or injuries will depend, and ought to depend, on how important people think this good is, seen in relation to all other goods they would like to see produced.
  • It is, in principle, possible both to provide too little safety and to provide too much of it. The objective of cost-benefit analysis is to help us find the right balance between safety and other goods.
  • If these basic observations are accepted as a fair description of the choices we are facing, then some kind of cost-benefit reasoning, although not necessarily formalised, is simply inevitable: We engage in this sort of thinking whether we are conscious of it our not.
The main reason for doing cost-benefit analyses of road safety measures is to help develop policies that make the most efficient use of resources, i.e. that produce the largest possible benefits for a given cost. Cost-benefit analysis seeks to identify the cheapest way of improving road safety. While one can think of arguments for choosing expensive solutions, one should never forget the fact that once resources have been committed to an expensive solution to a problem, they are no longer available for alternative, and possibly more beneficial, uses.


Why CBA Is Important?

Many elements of a social cost-benefit analysis are difficult to quantify. The following tools and concepts can be useful
and many more






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copyright 2017 Ken Acks

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