Cost benefit analysis

Diff: 1> Cost-Benefit Analysis (CBA) estimates and totals up the equivalent money value of the

benefits and costs to the community of projects to establish whether they are worthwhile. These

projects may be dams and highways or can be training programs and health care systems.

Diff: 2> Cost benefit analysis is a term that refers both to:

helping to appraise, or assess, the case for a project, programme or policy proposal;

an approach to making economic decisions of any kind.

Under both definitions the process involves, whether explicitly or implicitly, weighing the total

expected costs against the total expected benefits of one or more actions in order to choose the best or

most profitable option. The formal process is often referred to as either CBA (Cost-Benefit Analysis)

or BCA (Benefit-Cost Analysis).

Benefits and costs are often expressed in money 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 “present value”.

Uses of COBA

CBA 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.

The basic principles of CBA can be applied to many other projects or programmes. For example, -

public health programmes (e.g. the mass immunization of children using new drugs), an investment

in a new rail safety systems, or opening a new railway line. Increasingly the principles of cost benefit

analysis are being used to evaluate the returns from investment in environmental projects such as

wind farms and the development of other sources of renewable energy.

Because financial resources are scarce, CBA 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.

Cost–benefit calculations typically involve using time value of money formulas. This is usually done

by converting the future expected streams of costs and benefits into a present value amount.

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?

o Stage 1(a) Calculation of social costs & social benefits. This would include calculation of:

o Tangible Benefits and Costs (i.e. direct costs and benefits)

o Intangible Benefits and Costs (i.e. indirect costs and benefits)

o This process is very important – it involves trying to identify all of the significant costs &

benefits

o Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important question -

If you estimate that a possible benefit (or cost) is money term( $ or Rs.), 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?

o 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

o Stage 3: - Comparing the costs and benefits to determine the net social rate of return

o 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

Application

The practice of cost–benefit analysis differs between countries and between sectors

(e.g., transport, health) within countries. Some of the main differences include the types of impacts

that are included as costs and benefits within appraisals, the extent to which impacts are expressed in

monetary terms, and differences in the discount rate between countries. Agencies across the world

rely on a basic set of key cost–benefit indicators, including the following:

NPV (net present value)

PVB (present value of benefits)

PVC (present value of costs)

BCR (benefit cost ratio = PVB / PVC)

Net benefit (= PVB - PVC)

NPV/k (where k is the level of funds available)

Decision Criteria for Projects

If the discounted present value of the benefits exceeds the discounted present value of the costs then

the project is worthwhile. This is equivalent to the condition that the net benefit must be positive.

Another equivalent condition is that the ratio of the present value of the benefits to the present value

of the costs must be greater than one.

If there are more than one mutually exclusive projects that have positive net present value then there

has to be further analysis. From the set of mutually exclusive projects the one that should be selected

is the one with the highest net present value.

If the funds required to carry out all of the projects with positive net present value are less than the

funds available this means the discount rate used in computing the present values is too low and does

not reflect the true cost of capital. The present values must be recomputed using a higher discount

rate. It may take some trial and error to find a discount rate such that the funds required for the

projects with a positive net present value is no more than the funds available. Sometimes as an

alternative to this procedure people try to select the best projects on the basis of some measure of

goodness such as the internal rate of return or the benefit/cost ratio.