COST BENEFIT ANALYSIS OF A PROJECT

FINANCIAL MANAGEMENT PROJECT

SUBMITTED BY : BIDISHA MAHANTA

A3221510004, IV SEM

BBA LL.B.(H), 2010-15

Contents

INTRODUCTION........................................................................................................................................2

HISTORY OF COST BENEFIT ANALYSIS...............................................................................................3

Public Policy..........................................................................................................................................4

Transportation Investment.....................................................................................................................4

MAIN STAGES OF CBA ANALYSIS.........................................................................................................5

COST BENEFIT ANALYSIS EXAMPLE...................................................................................................7

Running The Numbers Means All The Numbers.............................................................................8

More Costs............................................................................................................................................9

Accurate Cost Benefit Analysis.........................................................................................................10

PRINCIPLES OF COST BENEFIT ANALYSIS........................................................................................11

CONCLUSION............................................................................................................................................16

BIBLIOGRAPHY........................................................................................................................................17

ACKNOWLEDGEMENT

I would sincerely like to thank my Financial Management teacher, Shweta Arora Ma’am, for

giving me this highly extensive and interesting topic and guiding me through its compilation and

completion.

INTRODUCTION

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.

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 that are at the foundation of CBA. But the practical development of CBA

came as a result of the impetus provided by the Federal Navigation Act of 1936. This act

required that the U.S. Corps of Engineers carry out projects for the improvement of the waterway

system when the total benefits of a project to whomsoever they accrue exceed the costs of that

project. Thus, the Corps of Engineers had create systematic methods for measuring such benefits

and costs. The engineers of the Corps did this without much, if any, assistance from the

economics profession. It wasn't 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. Some technical issues of CBA have not been wholly resolved

even now but the fundamental presented in the following are well established.

A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn

out. Although a cost benefit analysis can be used for almost anything, it is most commonly done

on financial questions. Since the cost benefit analysis relies on the addition of positive factors

and the subtraction of negative ones to determine a net result, it is also known as running the

numbers.

A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits.

Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between

the two indicates whether the planned action is advisable. The real trick to doing a cost benefit

analysis well is making sure you include all the costs and all the benefits and properly quantify

them.

Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the

new stamping machine? Will we be better off putting our free cash flow into securities rather

than investing in additional capital equipment? Each of these questions can be answered by

doing a proper cost benefit analysis.

HISTORY OF COST BENEFIT ANALYSIS

CBA has its origins in the water development projects of the U.S. Army Corps of Engineers. The

Corps of Engineers had its orgins in the French engineers hired by George Washington in the

American Revolution. For years the only school of engineering in the United States was the

Military Academy at West Point, New York.

In 1879, Congress created the Mississippi River Commission to "prevent destructive floods."

The Commission included civilians but the president had to be an Army engineer and the Corps

of Engineers always had veto power over any decision by the Commission.

In 1936 Congress passed the Flood Control Act which contained the wording, "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 phrase if the benefits to

whomsoever they may accrue are in excess of the estimated costs established cost-benefit

analysis. Initially the Corps of Engineers developed ad hoc methods for estimating benefits and

costs. It wasn't until the 1950s that academic economists discovered that the Corps had

developed a system for the economic analysis of public investments. Economists have influenced

and improved the Corps' methods since then and cost-benefit analysis has been adapted to most

areas of public decision-making.

Public Policy

The application for broader public policy started from the work of Otto Eckstein, who in 1958

laid out a welfare economics foundation for CBA and its application for water resource

development. Over the 1960’s, 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 first required the application of CBA for

regulatory programs, and 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, Australian guide for regulation and finance, US guide for health care

programs, and US guide for emergency management programs.

Transportation Investment

CBA application for transport investment started in the UK, with the M1 motorway project in

1960. It was later applied on many projects including London Underground's Victoria Line.

Later, the New Approach to Appraisal (NATA) was introduced 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 is to develop guidelines to harmonise 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.

MAIN STAGES OF CBA ANALYSIS

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 – externalities)

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 £x million, 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.

Evaluation: Criticisms of COBA

There are several objections to the use of CBA for environmental impact assessment:

1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such

as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are

more difficult – not least when a project has a significant impact on the environment. The

value attached to the destruction of a habitat is to some “priceless” and to others

“worthless”. Costs are also subject to change over time – I.e. the construction costs of a

new bridge over a river or the introduction of electronic road pricing

2. The CBA may not cover everyone affected (i.e. all third parties) – inevitably with major

construction projects such as a new airport or a new road, there are a huge number of

potential “stakeholders” who stand to be affected (positively or negatively) by the

decision. COBA cannot hope to include all stakeholders – there is a risk that some groups

might be left out of the decision process

a. Future generations – are they included in the analysis?

b. What of “non-human” stakeholders?

1. Distributional consequences: Costs and benefits mean different things to different income

groups - benefits to the poor are usually worth more (or are they?). Those receiving

benefits and those burdened with the costs of a project may not be the same. Are the

losers to be compensated? To many economists, the equity issue is as important as the

efficiency argument.

2. Social welfare is not the same as individual welfare - What we want individually may not

be what we want collectively. Do we attach a different value to those who feel

“passionately” about something (for example the building of new housing on greenfield

sites) contrasted with those who are more ambivalent?

3. Valuing the environment: How are we to place a value on public goods such as the

environment where there is no market established for the valuation of “property rights”

over environmental resources? How does one value “nuisance” and “aesthetic values”?

4. Valuing human life: Some measurements of benefits require the valuation of human life –

many people are intrinsically opposed to any attempt to do this. This objection can be

partly overcome if we focus instead on the probability of a project “reducing the risk of

death” – and there are insurance markets in existence which tell us something about how

much people value their health and life when they take out insurance policies.

5. Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically modified foods

a. Precautionary Principle: Assume toxicity until proven safe

1. If in doubt, then regulate

b. Free Market Principle: Assume it is safe until a hazard is identified

1. If in doubt, do not regulate.

Despite these problems, most economists argue that CBA is better than other ways of including

the environment in project appraisal.

COST BENEFIT ANALYSIS EXAMPLE

As the Production Manager, you are proposing the purchase of a Rs.1 Million stamping machine

to increase output. Before you can present the proposal to the Vice President, you know you need

some facts to support your suggestion, so you decide to run the numbers and do a cost benefit

analysis.

You itemize the benefits. With the new machine, you can produce 100 more units per hour. The

three workers currently doing the stamping by hand can be replaced. The units will be higher

quality because they will be more uniform. You are convinced these outweigh the costs.

There is a cost to purchase the machine and it will consume some electricity. Any other costs

would be insignificant.

You calculate the selling price of the 100 additional units per hour multiplied by the number of

production hours per month. Add to that two percent for the units that aren't rejected because of

the quality of the machine output. You also add the monthly salaries of the three workers. That's

a pretty good total benefit.

Then you calculate the monthly cost of the machine, by dividing the purchase price by 12

months per year and divide that by the 10 years the machine should last. The manufacturer's

specs tell you what the power consumption of the machine is and you can get power cost

numbers from accounting so you figure the cost of electricity to run the machine and add the

purchase cost to get a total cost figure.

You subtract your total cost figure from your total benefit value and your analysis shows a

healthy profit. All you have to do now is present it to the VP, right? Wrong. You've got the right

idea, but you left out a lot of detail.

Running The Numbers Means All The Numbers

Lets look at the benefits first. Don't use the selling price of the units to calculate the value. Sales

price includes many additional factors that will unnecessarily complicate your analysis if you

include them, not the least of which is profit margin. Instead, get the activity based value of the

units from accounting and use that. You remembered to add the value of the increased quality by

factoring in the average reject rate, but you may want to reduce that a little because even the

machine won't always be perfect. Finally, when calculating the value of replacing three

employees, in addition to their salaries, be sure to add their overhead costs, the costs of their

benefits, etc., which can run 75-100% of their salary. Accounting can give you the exact number

for the workers' "fully burdened" labor rates.

In addition to properly quantifying the benefits, make sure you included all of them. For

instance, you may be able to buy feed stock for the machine in large rolls instead of the

individual sheets needed when the work is done by hand. This should lower the cost of material,

another benefit.

As for the cost of the machine, in addition to it's purchase price and any taxes you will have to

pay on it, you must add the cost of interest on the money spent to purchase it. The company may

purchase it on credit and incur interest charges, or it may buy it outright. However, even if it

buys the machine outright, you will have to include interest charges equivalent to what the

company could have collected in interest if it had not spent the money.

Check with finance on the amortization period. Just because the machine may last 10 years,

doesn't mean the company will keep it on the books that long. It may amortize the purchase over

as little as 4 years if it is considered capital equipment. If the cost of the machine is not enough

to qualify as capital, the full cost will be expensed in one year. Adjust your monthly purchase

cost of the machine to reflect these issues. You have the electricity cost figured out but there are

some cost you missed too.

More Costs

The typical failure of a cost benefit analysis is not including all the costs. In the case of the

stamping machine, here are some of the overlooked costs:

Floor Space

Will the machine fit in the same space currently occupied by the three workers?

Installation

What will it cost to remove the manual stampers and install the new machine? Will you have

to cut a hole in a wall to get it in or will it fit through the door? Will you need special rollers

or machinists with special skills to install it?

Operator?

Somebody has to operate the machine. Does this person need special training? What will the

operator's salary, including overhead, cost?

* Environment

Will the new machine be so noisy that you have to build soundproofing around it? Will the

new machine increase the insurance premiums for the company?

Accurate Cost Benefit Analysis

Once you have collected ALL the positive and negative factors and have quantified them you

can put them together into an accurate cost benefit analysis.

Some people like to total up all the positive factors (benefits), total up all the negative factors

(costs), and find the difference between the two. I prefer to group the factors together. It makes it

easier for you, and for anyone reviewing your work, to see that you have include all the factors

on both sides of the issues that make up the cost benefit analysis. For the example above, our

cost benefit analysis might look something like this:

Cost Benefit Analysis - Purchase of New Stamping Machine

(Costs shown are per month and amortized over four years)

1. Purchase of Machine .................... -Rs.20,000

includes interest and taxes

2. Installation of Machine ..................... -3,125

including screens & removal of existing stampers

3. Increased Revenue .......................... 27,520

net value of additional 100 units per hour, 1 shift/day, 5 days/week

4. Quality Increase Revenue ..................... 358

calculated at 75% of current reject rate

5. Reduced material costs ...................... 1,128

purchase of bulk supply reduces cost by Rs.0.82 per hundred

6. Reduced Labor Costs ....................... 18,585

3 operators salary plus labor o/h

7. New Operator ................................. -8,321

salary plus overhead. Includes training

8. Utilities ............................................ -250

power consumption increase for new machine

9. Insurance ......................................... -180

premiums increase

10. Square footage ...................................... 0

no additional floor space is required

Net Savings per Month ........................... Rs.15,715

Your cost benefit analysis clearly shows the purchase of the stamping machine is justified. The

machine will save your company over Rs.15,000 per month, almost Rs.190,000 a year.

This is just one example of how you can use cost benefit analysis determine the advisability of a

course of action and then to support it once you propose the action.

PRINCIPLES OF COST BENEFIT ANALYSIS

One of the problems of CBA is that the computation of many components of benefits and costs is

intuitively obvious but that there are others for which intuition fails to suggest methods of

measurement. Therefore some basic principles are needed as a guide.

There Must Be a Common Unit of Measurement

In order to reach a conclusion as to the desirability of a project all aspects of the project, positive

and negative, must be expressed in terms of a common unit; i.e., there must be a "bottom line."

The most convenient common unit is money. This means that all benefits and costs of a project

should be measured in terms of their equivalent money value. A program may provide benefits

which are not directly expressed in terms of dollars but there is some amount of money the

recipients of the benefits would consider just as good as the project's benefits. For example, a

project may provide for the elderly in an area a free monthly visit to a doctor. The value of that

benefit to an elderly recipient is the minimum amount of money that that recipient would take

instead of the medical care. This could be less than the market value of the medical care

provided. It is assumed that more esoteric benefits such as from preserving open space or historic

sites have a finite equivalent money value to the public.

Not only do the benefits and costs of a project have to be expressed in terms of equivalent money

value, but they have to be expressed in terms of dollars of a particular time. This is not just due

to the differences in the value of dollars at different times because of inflation. A dollar available

five years from now is not as good as a dollar available now. This is because a dollar available

now can be invested and earn interest for five years and would be worth more than a dollar in

five years. If the interest rate is r then a dollar invested for t years will grow to be (1+r)t.

Therefore the amount of money that would have to be deposited now so that it would grow to be

one dollar t years in the future is (1+r)-t. This called the discounted value or present value of a

dollar available t years in the future.

When the dollar value of benefits at some time in the future is multiplied by the discounted value

of one dollar at that time in the future the result is discounted present value of that benefit of the

project. The same thing applies to costs. The net benefit of the projects is just the sum of the

present value of the benefits less the present value of the costs.

The choice of the appropriate interest rate to use for the discounting is a separate issue that will

be treated later in this paper.

CBA Valuations Should Represent Consumers or Producers

Valuations As Revealed by Their Actual Behavior

The valuation of benefits and costs should reflect preferences revealed by choices which have

been made. For example, improvements in transportation frequently involve saving time. The

question is how to measure the money value of that time saved. The value should not be merely

what transportation planners think time should be worth or even what people say their time is

worth. The value of time should be that which the public reveals their time is worth through

choices involving tradeoffs between time and money. If people have a choice of parking close to

their destination for a fee of 50 cents or parking farther away and spending 5 minutes more

walking and they always choose to spend the money and save the time and effort then they have

revealed that their time is more valuable to them than 10 cents per minute. If they were

indifferent between the two choices they would have revealed that the value of their time to them

was exactly 10 cents per minute.

The most challenging part of CBA is finding past choices which reveal the tradeoffs and

equivalencies in preferences. For example, the valuation of the benefit of cleaner air could be

established by finding how much less people paid for housing in more polluted areas which

otherwise was identical in characteristics and location to housing in less polluted areas.

Generally the value of cleaner air to people as revealed by the hard market choices seems to be

less than their rhetorical valuation of clean air.

Benefits Are Usually Measured by Market Choices

When consumers make purchases at market prices they reveal that the things they buy are at least

as beneficial to them as the money they relinquish. Consumers will increase their consumption of

any commodity up to the point where the benefit of an additional unit (marginal benefit) is equal

to the marginal cost to them of that unit, the market price. Therefore for any consumer buying

some of a commodity, the marginal benefit is equal to the market price. The marginal benefit

will decline with the amount consumed just as the market price has to decline to get consumers

to consume a greater quantity of the commodity. The relationship between the market price and

the quantity consumed is called the demand schedule. Thus the demand schedule provides the

information about marginal benefit that is needed to place a money value on an increase in

consumption.

Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve

The increase in benefits reulting from an increase in consumption is the sum of the marginal

benefit times each incremental increase in consumption. As the incremental increases considered

are taken as smaller and smaller the sum goes to the area under the marginal benefit curve. But

the marginal benefit curve is the same as the demand curve so the increase in benefits is the area

under the demand curve. As shown in Figure 1 the area is over the range from the lower limit of

consumption before the increase to consumption after the increase.

Figure 1

When the increase in consumption is small compared to the total consumption the gross benefit

is adequately approximated, as is shown in a welfare analysis, by the market value of the increased

consumption; i.e., market price times the increase in consumption.

Some Measurements of Benefits Require the Valuation of Human Life

It is sometimes necessary in CBA to evaluate the benefit of saving human lives. There is

considerable antipathy in the general public to the idea of placing a dollar value on human life.

Economists recognize that it is impossible to fund every project which promises to save a human

life and that some rational basis is needed to select which projects are approved and which are

turned down. The controversy is defused when it is recognized that the benefit of such projects is

in reducing the risk of death. There are many cases in which people voluntarily accept increased

risks in return for higher pay, such as in the oil fields or mining, or for time savings in higher

speed in automobile travel. These choices can be used to estimate the personal cost people place

on increased risk and thus the value to them of reduced risk. This computation is equivalent to

placing an economic value on the expected number of lives saved.

The Analysis of a Project Should Involve a With Versus Without Comparison

The impact of a project is the difference between what the situation in the study area would be

with and without the project. This that when a project is being evaluated the analysis must

estimate not only what the situation would be with the project but also what it would be without

the project. For example, in determining the impact of a fixed guideway rapid transit system such

as the Bay Area Rapid Transit (BART) in the San Francisco Bay Area the number of rides that

would have been taken on an expansion of the bus system should be deducted from the rides

provided by BART and likewise the additional costs of such an expanded bus system would be

deducted from the costs of BART. In other words, the alternative to the project must be explicitly

specified and considered in the evaluation of the project. Note that the with-and-without

comparison is not the same as a before-and-after comparison.

Another example shows the importance of considering the impacts of a project and a with-and-

without comparison. Suppose an irrigation project proposes to increase cotton production in

Arizona. If the United States Department of Agriculture limits the cotton production in the U.S.

by a system of quotas then expanded cotton production in Arizona might be offset by a reduction

in the cotton production quota for Mississippi. Thus the impact of the project on cotton

production in the U.S. might be zero rather than being the amount of cotton produced by the

project.

CONCLUSION

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:

1. Overreliance on data from past projects (often differing markedly in function or size and

the skill levels of the team members)

2. Use of subjective impressions by assessment team members

3. Inappropriate use of heuristics to derive money cost of the intangible elements

4. Confirmation bias among project supporters (looking for reasons to proceed)

Reference class forecasting was developed to increase accuracy in estimates of costs and

benefits.

Interest groups may attempt to include or exclude significant costs from an analysis to influence

the outcome.

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.

In environmental and occupational health regulation, it has been argued that if modern cost-

benefit analyses had been applied prospectively to decisions such as removing lead from

gasoline, building Hoover Dam in the Grand Canyon and regulating workers' exposure to vinyl

chloride, they 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.

BIBLIOGRAPHY

1. http://www.sjsu.edu/faculty/watkins/cba.htm

2. http://management.about.com/cs/money/a/CostBenefit_2.htm

3. http://tutor2u.net/economics/revision-notes/a2-micro-cost-benefit-analysis.html

4. www.sjsu.edu/faculty/watkins/cba.htm - United States

5. www.investopedia.com/terms/c/cost-benefitanalysis.asp

6. FINANCIAL MANAGEMENT, I M PANDEY