Cost Benefit Analysis

Cost-benefit analysis
Cost-benefit analysis is a term that refers both to:
• a formal discipline used to help appraise, or assess, the case for a project or proposal, which itself is a process known as 'project appraisal'; and
• an informal approach to making 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 CBA, or Benefit-cost analysis in the United States.
Closely related, but slightly different, formal techniques include cost-effectiveness analysis and benefit effectiveness analysis.
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 the various risks which could contribute to partial or total project failure; loss of reputation, market penetration, long-term enterprise strategy alignments, 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.
Application
Cost-benefit analysis is mainly, but not exclusively, used to assess the value for money of very large private and public sector projects. This is because such projects tend to include 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, where feasible.
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.
Transport
The most sophisticated application of cost-benefit analysis is in the transport sector.
UK
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 (NATA) was introduced by the then Department for Transport, Environment and the Regions. This brought together cost-benefit results with those from detailed environmental impact assessments and presented them in a balanced way. NATA was first applied to national road schemes in the 1998 Roads Review, but subsequently rolled out to all modes of transport. It is now a cornerstone of transport appraisal in the UK and is maintained and developed by the Department for Transport.
EU
The EU's 'Developing Harmonised European Approaches for Transport Costing and Project Assessment' (HEATCO) project, part of its Sixth Framework Programme, has 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.
US
Much of the early development work on cost-benefit analysis as a discipline was the result of problems faced by the US Army Corps of Engineers in deciding how and where to build bridges in supporting combat operations.
Benefit-cost analysis is now a well established discipline in the US. California's Department of Transportation (Caltrans) provide detailed guidance on how Benefit-Cost analysis should be applied to transport projects.
Accuracy problemsThe accuracy of the outcome of a cost-benefit analysis is dependent on how accurately costs and benefits have been estimated. A peer-reviewed study 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 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 (Flyvbjerg, Bruzelius, and Rothengatter, 2003).
These outcomes (almost always tending to underestimation, unless significant new approaches are overlooked) are to be expected, since such estimates:
1. rely heavily on past like projects (frequently differing markedly in function or size, and certainly in the skill levels of the team members),
2. rely heavily on the project's members to identify (remember from their collective past experiences) the significant cost drivers,
3. rely on very crude heuristics ('rules of thumb') to estimate the money cost of the intangible elements, and
4. are unable to completely dispel the usually (unconscious) biases of the team members (who often have a vested interest in a decision to 'go ahead') and the natural psychological tendency to "think positive" (whatever that involves). Hence, Murphy's Law: "Whatever can go wrong, will."
Another challenge to cost-benefit analysis comes from determining which costs should be included in an analysis (the significant cost drivers). 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 in a rear-impact collision), the Ford company's decision was not to issue a recall. Ford's cost benefit analysis had estimated that: based on the number of cars in use and the probable accident rate, deaths due to the design flaw would run about $49.5 million (the amount Ford would pay out of court to settle wrongful death lawsuits). This was estimated to be less than the cost of issuing a recall ($137.5 million) .In the event, Ford overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (since it led to the recall anyways and to measurable losses in sales).