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Cost Benefit Analysis

 

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.

 

Step 1: identify all costs and benefits using the principle of opportunity cost

Step 2: measure the benefits and costs using money as a unit of account

Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)

Step 4: 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:

        Private Costs e.g. construction costs, operating costs and maintenance costs

        External 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

        Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid

        External benefits i.e. benefits to non owners e.g. consumer surplus of users; time savings for travellers and fewer accidents

 

 

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

Private benefits 1,000,000 users each paying 1 each = 1,000,000 a year

 

Externalities are more difficult to measure:

        Noise 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

        Time 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

        Fewer accidents. Economists 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 today.

 

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. 

 

General 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:

        noise.

        pollution of atmosphere, rivers etc..

        danger to workers and public.

        congestion.

 

The most common external costs arising from consumption are:

        pollution from motor vehicles.

        litter.

        noise pollution.

        externalities from 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 firms.

        education which leads to an increase in human capital.

        healthcare.

        knowledge.

        employment created.

        arts and sports.

        neighbourhood watch schemes.

 

A range of different projects often attract cost-benefit analysis, e.g.,

        the building of a new road.

        the building of  new airport/runway.

        the expansion of a factory.

        the building of a supermarket.

        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 saved.

        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 person.

        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.

 

It 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.

 

It 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.

 

 

E-mail Steve Margetts