Cost-budget analysis (CBA) is a framework for evaluating the social costs
and benefits of an investment project. This
involves identifying, measuring and comparing the private costs and negative
externalities of a scheme with its private benefits and positive
externalities, using money as a measure of value.
identify all costs and benefits using the principle of opportunity cost
measure the benefits and costs using money as a unit of account
consider the likelihood of the cost or benefit occurring (i.e. sensitivity
take account of the timing of the cost and benefit (i.e. discounting). A £1,000
benefit now is worth more than £1,000 benefit in 10 years time
Identify All Costs And Benefits
A firm deciding on an investment project will only take account of its
own private costs and benefits e.g. total cost and total revenue. Firms
ignore externalities. CBA will
take account of both private and external costs and benefits.
Consider a project to build a bridge over a river:
Costs e.g. construction
costs, operating costs and maintenance costs
Costs i.e. costs incurred
by non owners (a) monetary e.g. loss of profits to competitors e.g. to ferry
owner and (b) non monetary e.g. noise, loss of countryside, inconvenience
benefits direct the
amount consumers are prepared to pay e.g. the tolls paid
benefits i.e. benefits to
non owners e.g. consumer surplus of users; time savings for travellers and
Measure The Benefits And Costs
Benefits and costs can be valued using money. Private costs and benefits
are relatively easy to measure in monetary terms
Total costs and total revenue.
Private costs Build
the bridge: £5,000, 000 to operate it £200,000 a year, to repair and
maintain £ 50,000
1,000,000 users each paying £1 each = £1,000,000 a year
more difficult to measure:
or loss of countryside.
What value do people place on these? By how much do those who suffer need to
be compensated Ask them using a questionnaire! If 50,000 affected people
value the annual loss of countryside at £5 then cost = £250,000
savings. What value do we
place on work time saved or leisure time saved? Is the time saved worth the
same to everyone? If 100,000 hours re saved and valued at £4 per hour,
benefit = £400,000
value human life using money. One life = £750,000. If the bridge saves on
life a year, annual benefit is £750,000
Likelihood Of The Cost Or Benefit
If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000
The Timing Of The Cost And Benefit
The major costs of the project occurs straight away. The benefits occur
over the life of the project. The bridge may cost £5m to build but consumers
benefit by £1m a year. If the expected life of the bridge is 25 years then
economists use discounting to value now the £1m of benefit in 25 years time.
Commonly the rate of interest or inflation is used to discount the
future earnings as the £1m in 25 years time will be worth substantially less
Is A Project Worth Undertaking?
Yes if discounted benefits
outweigh discounted costs. If the
government has to choose between competing projects then the ones with the
highest positive net present value should be undertaken.
Points Regarding CBA
Here are some common examples that can be applied to many CBAs they will
hopefully assist you in answering any question.
The most common external costs arising from production are:
atmosphere, rivers etc..
danger to workers and
The most common external costs arising from consumption are:
pollution from motor
smoking and drinking alcohol.
External benefits from production and consumption are often grouped
together, the following are the most commonly used examples:
industrial training by
education which leads
to an increase in human capital.
arts and sports.
A range of different projects often attract cost-benefit analysis, e.g.,
the building of a new
the building of
the expansion of a
the building of a
the provision of a
public or merit good.
There are a number of problems with cost-benefit analysis:
if the project leads
to a time saving, it can often be difficult to place a value on the time
Lives maybe saved,
again what value do we place on a life?
How do we place a
monetary value on an eyesore, pollution or illness?
These require a level of judgement that may vary from person to
Over time the value of
the benefits will fall as inflation erodes the value of the pound.
Any future benefits would have to be discounted.
is accepted that cost-benefit analysis can be an imprecise, however it is
deemed to be better than making no attempt to recognise the externalities at
all. Due to the amount of
judgement involved when coming to the figures and discount rate the results
should be viewed with caution. All of the assumptions made in the cost-benefit analysis
should be explicitly stated.
is important to note who is carrying out the cost-benefit analysis and do
they have a particular agenda, i.e., do they want the project in question to
be approved/turned down. Depending
upon their stance will affect what data they choose to include and their
methods of interpreting it.