Cost-benefit analysis

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Cost-benefit analysis (often referred to as CBA, or in the United States as {) is an important technique for project appraisal: the process of 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.

[edit] Theory

The process involves monetary calculations of initial and ongoing expenses vs. expected return. Constructing plausible measures of the costs and benefits of specific actions is often very difficult. In practice, analysts try to estimate costs and benefits either by using survey methods or by drawing inferences from market behaviour. For example, a product manager may compare manufacturing and marketing expenses to projected sales for a proposed product, and only decide to produce it if he expects the revenues to eventually recoup the costs. Cost-benefit analysis attempts to put all relevant costs and benefits on a common temporal footing. A discount rate is chosen, which is then used to compute all relevant future costs and benefits in present-value terms. Most commonly, the discount rate used for present-value calculations is an interest rate taken from financial markets (R.H. Frank 2000).

During cost-benefit analysis, monetary values may also be assigned to less tangible effects such as risk, loss of reputation, market penetration, long-term strategy alignment, etc. This is especially true when governments use the technique, for instance to decide whether to introduce business regulation, build a new road or offer a new drug on the state healthcare. In this case, a value must be put on human life or the environment, often causing great controversy. The cost-benefit principle says, for example, that we should install a guardrail on a dangerous stretch of mountain road if the dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and property damage thus prevented (R.H. Frank 2000).

Cost-benefit calculations typically involve using time value of money formula. This is usually done by converting the future expected streams of costs and benefits to a present value amount.

[edit] Application

Cost-benefit analysis is mainly, but not exclusively, used to assess the value for money of public sector projects. This is because these projects tend to include some costs and benefits that are less amenable to being expressed in financial or monetary terms (e.g. environmental damage), as well as those that can be expressed in monetary terms. Private sector organisations tend to make much more use of other project appraisal techniques, such as rate of return.

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 discount rate between countries.

[edit] United Kingdom

The most sophisticated application of cost-benefit analysis in the UK is in the transport sector. Basic cost-benefit techniques were applied to the development of the motorway network in the 1950s and 60s. An early, and often quoted, more developed application of the technique was made to London Underground's Victoria Line. Over the last 40 years, cost-benefit techniques have gradually developed to the extent that substantial guidance now exists on how transport projects should be appraised in the UK. In 1998 the New Approach to Appraisal was introduced by the then Department for Transport, Environment and the Regions. This was first applied to national road schemes in the 1998 Roads Review, but subsequently rolled out to all modes of transport.

[edit] Accuracy problems

The accuracy of the outcome of a cost-benefit analysis is dependent on how accurately costs and benefits have been estimated. A peer-reviewed study [1] of the accuracy of cost estimates in transportation infrastructure planning found that for rail projects actual costs turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4 percent higher (Flyvbjerg, Holm, and Buhl, 2002). For benefits, another peer-reviewed study [2] found that actual rail ridership was on average 51.4 percent lower than estimated ridership; for roads it was found that for half of all projects estimated traffic was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005). Comparative studies indicate that similar inaccuracies apply to fields other than transportation. These studies indicate that the outcomes of cost-benefit analyses should be treated with caution, because they may be highly inaccurate. In fact, inaccurate cost-benefit analyses may be argued to be a substantial risk in planning, because inaccuracies of the size documented are likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks efficiency ([3] Flyvbjerg, Bruzelius, and Rothengatter, 2003).

Another challenge to cost-benefit analysis comes from determining which costs should be included in an analysis. This is often controversial as organizations or interest groups may feel that some costs should be included or excluded from a study. In the case of the Ford Pinto (where, due to design flaws, the Pinto was liable to burst into flames under a rear-impact collision) and the Ford company's decision not to issue a recall, Ford's cost benefit analysis had estimated that: the number of cars in use x the probabile rate deaths due to the design flaw x the amount Ford would pay out of court to settle wrongful death lawsuts, was less than the cost of issuing a recall ^{[citation needed]}.

[edit] Sources and further reading

Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press, 2003). [4]
Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "Underestimating Costs in Public Works Projects: Error or Lie?" Journal of the American Planning Association, vol. 68, no. 3, Summer 2002, pp. 279-295. [5]
Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "How (In)accurate Are Demand Forecasts in Public Works Projects? The Case of Transportation." Journal of the American Planning Association, vol. 71, no. 2, Spring 2005, pp. 131-146. [6]
Tevfik F. Nas, Cost-Benefit Analysis: Theory and Application (Thousand Oaks, Ca.: Sage, 1996). [7]

[edit] See also

Kaldor-Hicks efficiency - economic principle underlying cost-benefit analysis
Net present value - a similar type of calculation
Optimism bias
Pareto efficiency - alternative economic principle

[edit] External links

CelsiEval - Cost-Benefit Analysis Tool
[8] - The Environmental Valuation & Cost-Benefit Website
[9] - Environmental Valuation & Cost-Benefit News
[10] - Guide to Benefit-Cost Analysis
[11] - Inaccuracy in cost estimates
[12] - Inaccuracy in benefit estimates
Decision Analysis in Health Care George Mason University online course offering lectures and tools for measuring cost-effectiveness in health care scenarios.de:Kosten-Nutzen-Analyse

he:ניתוח עלות-תועלת nl:Kosten-batenanalyse sv:Cost-benefit-analys

This page uses content from the English-language version of Wikipedia'. The original article was at '. The list of authors can be seen in the page history. As with Psychology Wiki, the text of Wikipedia is available under the GNU Free Documentation License.

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