Cost Benefit Analysis
Cost Benefit Analysis
Cost benefit analysis (CBA) is a tool which is used for the determination of the worth of a project, programme or policy. Its principles and practice are well established and widely used. Organizational management normally uses this tool to appraise a project before taking an investment decision. The decision to conduct a CBA for the project alternatives and the manner in which it is to be conducted is usually taken since it helps the management in making judgments and appraising available options.
CBA is a systematic approach for the estimation of the strengths and weaknesses of alternatives and is used to determine options which provide the best approach to achieve benefits from the project. It is the comparison of costs and benefits of the project to decide whether it can be undertaken. In CBA both the tangible and intangible costs as well as tangible and intangible benefits are considered.
CBA is a term that refers both to (i) a formal discipline used to help appraise, or assess, the case for a project, which itself is a process known as project appraisal, and (ii) an informal approach to making decisions. Under both definitions the process involves, whether explicitly or implicitly, weighing the total expected costs against the total expected benefits of the project or its alternatives in order to choose the best option.
The idea of this economic accounting originated with Jules Dupuit, a French engineer whose 1848 article is still worth reading. The British economist, Alfred Marshall, formulated some of the formal concepts which are at the foundation of CBA. But the practical development of CBA came in 1936 when the regulatory act required US Corps of Engineers to take up only those projects for the improvement of the waterway system in which the total benefits of the project exceed the costs of the project. Thus, the Corps of Engineers had created systematic methods for measuring such benefits and costs. They did this without much, if any, assistance from the economics profession. It was not until about twenty years later in the 1950’s that economists tried to provide a rigorous, consistent set of methods for measuring benefits and costs and deciding whether a project is worthwhile.
CBA is carried out to determine how well, or how poorly, a project will turn out. It finds, quantifies, and adds all the positive factors which are the benefits. Then it identifies, quantifies, and subtracts all the negative factors which are the costs. The difference between the two indicates whether to take up the project is advisable. In CBA, it is necessary to ensure that all the costs and all the benefits are included and properly quantified. Benefits of the project are most often received over time. Hence, in CBA, this effect of time is built up into analysis by calculating a payback period. This is the time it takes for the benefits of a change to repay its costs. Sometimes, payback on projects is expected over a specified period of time.
CBA is a quantitative analytical tool to aid decision making. It helps management in the efficient allocation of resources for the project. It identifies and attempts to quantify the costs and benefits of a project and converts available data into manageable information. The strength of the method is that it provides a framework for analyzing data in a logical and consistent way. CBA helps management to know (i) whether the project proposal provides a net benefit to the organization, (ii) whether the proposed project is to be undertaken, (iii) whether the project is to be continued, (iv) which of various alternatives of the project is to be undertaken.
CBA adds rigour to the project evaluation because, among other things, it makes explicit the links between inputs and outcomes, clarifies the underlying assumptions, and points to gaps in information. By attempting to express outcomes (benefits) and inputs (costs) in monetary terms, it facilitates comparisons across different alternatives available for the project.
Generally there are two main purposes of CBA. These are as below.
- To determine if the decision of investment in the project is sound. This is done normally with proper justification through a feasibility studies which verify whether the benefits of the project outweigh the costs, and by how much.
- To provide a basis for comparing projects. This is generally done by comparing the total expected cost of each option against its total expected benefits.
CBA is related to, but different from cost effectiveness analysis. 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.
CBA is also frequently being used by management to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of foregone alternatives and maintaining the status quo. CBA helps predict whether the benefits of the policy outweigh its costs, and by how much relative to other alternatives, so that the different alternatives can be ranked in terms of the cost benefit ratio. While CBA can offer a well-educated estimate of the best alternative – perfect appraisal of all present and future costs and benefits is difficult. Hence, accuracy of the CBA is dependent on the assumptions taken for the analysis.
The basic steps in the process of CBA (Fig 1) are given below.
- To define the boundaries of the project and the base level.
- To determine the level of details needed.
- To select the measurement required to be done for the CBA.
- To measure all cost/benefit elements of the selected measurements.
- To predict the outcome of cost and benefits over relevant time period.
- To convert all costs and benefits into a common base.
- To apply discount rate and to calculate net present value (NPV) of the project alternatives.
- To carry out the sensitivity analysis.
- To make recommendations for the best alternative for the project.
Fig 1 Basic steps in the process of CBA
Risk associated with project outcomes is usually handled using probability theory. This can be factored into the discount rate (to have uncertainty increasing over time), but is usually considered separately. Uncertainty in CBA parameters (as opposed to risk of project failure etc.) is generally evaluated using a sensitivity analysis, which shows how results respond to parameter changes.
CBA is a useful tool in the evaluation of a project. It examines whether a particular use of resources generates net returns. A particular use of funds may be effective in terms of achieving the objectives of the project, but may still generate a negative net return to the organization if the benefits from these objectives are judged not to be worth the costs involved. Alternatively, an investment can achieve a positive return for the organization but fall short of achieving the objectives of the project.
CBA needs careful consideration of the project life cycle (generally measured in years). A project is generally be appraised over its projected life. When conducting CBA, all of the benefits and costs of the project are normally be discounted over the life of the project. It is necessary to discount costs and benefits occurring later relative to those occurring sooner since money has an opportunity cost. While discounting costs and benefits is integral to conducting a CBA, a critical consideration is the discount rate used.
Various decision rules are widely used in the CBA of projects. The NPV is the preferred selection criterion because of its simplicity, generality and intuitive appeal. The NPV of the project must be greater than zero. There are, however, other common rules in addition to NPV such as the IRR and the Benefit-Cost Ratio (BCR). The IRR is the discount rate at which the NPV of the project is zero. The decision-maker is implicitly asked to make a judgment as to whether this rate of return is ‘acceptable’ or not. If the recommended discount rate is 8 % (in real terms) then projects having an IRR greater than 8 % is regarded as ‘acceptable’. The IRR criterion is commonly used for steel projects. The BCR can be estimated in two ways. One method is to calculate the present value of benefits to the present value of costs. Another method is to calculate the ratio of the present value of net recurrent benefits to the present value of capital costs. An advantage of the latter is that it indicates the return on capital employed. However the former is possibly used more often. In either case, a ratio of greater than 1 shows that there is net benefit to a particular project having considered the present values of the costs and benefits. The BCR should always be greater than 1 in order for the benefits of a project to exceed the associated costs.
It is important to note the distinction between outputs and outcomes in the context of a project. Outputs are physical deliverables over which managers have a high degree of control whereas outcomes reflect the real impacts or benefits. If outcomes cannot be quantified in monetary terms, it is not possible to undertake a formal CBA. However, there are ways to attach monetary values to benefits so they can be measured on the same basis as costs, thus allowing comparisons of different project alternatives to be useful to the management. However, while useful, the estimation of monetary values in such circumstances often involves a significant degree of judgment and imprecision.
CBA is different from a financial evaluation (or ‘investment evaluation’) which is generally conducted from the perspective the organization without considering the stakeholders. Financial evaluation is essentially concerned with assessing the impact of the project alternatives on the financial performance of the organization. A financial evaluation is used to answer the question of whether the project offers an acceptable return from an organizational perspective. Financial evaluations normally determine cash flows in and out of the organization. On the other hand CBA is primarily focused on evaluating the all the aspects of the project alternatives since it includes impact of the project on all the stake holders.
CBA is also different from the ‘cost effectiveness analysis (CEA) which is aimed at determining the cost of achieving a specific physical target. CEA studies are usually undertaken from an organizational perspective. It differs from CBA in that benefits are expressed in physical units rather than in monetary units. Costs, as in CBA, are expressed in monetary terms. Since the approach towards benefits measurement is relaxed in CEA, its usefulness for decision making gets reduced.
CBA is generally the preferred method when markets or prices do not adequately reflect all the costs and benefits of the project. When markets are competitive and most costs and benefits are reflected in market prices, financial evaluation can provide an adequate guide to the total viability of the project. Financial evaluation is also important when the organization has financial objectives. CEA is useful most often when the benefits of a proposal are difficult to quantify in monetary terms but the management wishes to know which option will achieve organizational objectives most cost effectively.
CBA is normally undertaken to determine whether the net impact of the project is positive or negative. Some of the key benefits of undertaking a CBA are as given below.
- CBA facilitates meaningful comparisons. It aims to quantify the net benefits of the project expressed in monetary value, percentage return or ratio. This provides a common basis for comparison for project alternatives since each alternative is assessed on uniform basis with a common framework of assumptions. Hence, the method is a very useful aid for the management for taking decision.
- CBA is conducive to good project management. The basic idea of CBA is that it reflects the value of the project. During the CBA, monetary value of various aspects of the project becomes available which helps in the useful monitoring and the management of the project.
- CBA has distributional impact. It is a key advantage of CBA since it provides a quantitative measure of the net benefit of an investment, allowing direct comparisons between various alternatives of the project often dissimilar alternatives. CBA estimates the impact of the alternatives of the project on different organizational stakeholders. The cost-benefit process implicitly estimates the size of gains and losses for affected stakeholders. This information is important in decision-making and is to be made explicit because it is important to identify those who stand to gain and lose from the project.
- CBA encourages clear thinking about the true ‘value added’. CBA provides an estimate of the worth of a project relative to an accompanying estimate of what would happen in the absence of the project. The difference between these values can be viewed as the ‘value added’ with the implementation of the project.
- CBA is integral to an evaluation strategy. It is a rigorous evaluation process which is based on multiple lines of evidence. The conclusions are more robust and more credible since the evaluation process involves a number of discrete analyses. Since CBA emphasize on the quantification of costs and benefits on a comparable basis, it is a useful technique to add to an evaluation strategy which includes other methods as well.
- CBA can help to meet regulatory requirements in a project since during CBA various impacts of the project such as impact on environment, impact on different stakeholders of the organization are studied to determine the cost or benefits due to these impacts. If there is net benefit then the implementation of the project is generally considered efficient.
The value of CBA depends on the accuracy of the individual cost and benefit estimates. Causes of these inaccuracies include the following.
- Over reliance 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.
Project evaluation is essentially an assessment of a project, or part of it, in order to aid judgments about its appropriateness, efficiency and effectiveness. Project evaluations encompass policy/project reviews, efficiency (or process) and effectiveness (or impact) evaluations, post-implementation reviews, major enquiries and some audits. Here ‘appropriateness’ refers to the extent to which the project meets the policy and priorities and the stakeholder needs. ‘Efficiency’ is concerned with the net impact on the stake holder and defined in terms of how well outputs are maximized for a given level of resource inputs, or resources minimized for a given level of output. ‘Effectiveness’ is concerned with the extent to which project alternative outcomes achieve stated objectives.
CBA is a useful tool in programme evaluation. It examines whether a particular use of resources generates net returns. A particular use of funds may be effective in terms of achieving the objectives of the project, but may still generate a negative net return to the skate holders if the benefits from these objectives are judged not to be worth the costs involved. Alternatively, an investment can achieve a positive return for the skate holders but fall short of achieving the objectives. It is important to note the distinction between outputs and outcomes in a project. Outputs are physical deliverables over which management has a high degree of control whereas outcomes reflect the real programme impacts or benefits.