Cost and Benefit Analysis (Cba)

COST AND BENEFIT ANALYSIS (CBA)

ABSTRACT

Cost Benefit Analysis is typically used by governments

to evaluate the desirability of a given intervention. The

aim is to gauge the efficiency of the intervention

relative to the status quo. The costs and benefits of the

impacts of an intervention are evaluated in terms of the

public's willingness to pay for them (benefits) or

willingness to pay to avoid them (costs). Inputs are

typically measured in terms of opportunity costs - the

value in their best alternative use. The guiding

principle is to list all of the parties affected by an

intervention, and place a monetary value of the effect it

has on their welfare as it would be valued by them.

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, longterm

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.

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.

KEYWORDS

Cost-benefit analysis, Financial analysis, Externalities,

Shadow prices,

1. INTRODUCTION TO COST AND

BENEFIT ANALYSIS

Cost and benefit analysis has been a very active field of

research and study since at least the early 1960s. It

development has had much to do with the evaluation of

public sector investment projects. This type of analysis

is frequently recommended to public sector agencies

use it regularly in the course of their operations. The

practical importance of CBA is not of course confined

to project evaluation. In one form or another, it also

bears on such areas as investment planning,

commercial policy and development policy broadly

defined.

1.1. The particular cost-benefit model

The basic idea behind the model is to: (a) take the

benefits and costs and disaggregate them into their

constituent parts, and then (b) apply unequal weights to

those component that have a different social

significance from others. The level of complexity

involved is equivalent to using a weighted average

rather than an unweighted average to summarize the

typical affect in statistics.

1.2. Some general issues

The principles of economic analysis of project are

exactly the same as the principles of analysis in other

branches of applied welfare economics. The

distinguishing features of project analysis are twofold:

first, project analysis is typically carried out in greater

detail and specificity than analysis of sectoral or

economy wide issues; and second, it involves a

sequential process within the special context of the

project cycle.

Economic analysis is not a one-shot affair at the

appraisal stage, which immediately precedes the

commitment of financial resources to the project. If, as

in some cases, it is limited to the appraisal stage, then it

can serve only as a final check on the overall soundness

of the project proposal. But many of the early decisions

made in developing the project may not enter the

analysis at the appraisal stage.

1.3. Basic approaches

Economic benefits and costs of a project can be defined

only by the effect of the project on some fundamental

objectives of the economy. Given the choice of a

fundamental objective, and the precise manner in which

it is defined, one obtains a measuring rod or a common

yardstick, to assess the various effect of a project.

There is no analytic distinction between benefits and

cost. Cost is simply the benefit forgone by not using the

project resources in other ways. By measuring both

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benefits and costs with the yardstick, one can indicate

in project analysis the net impact on the chosen

objective. If the net impact is positive, or at least not

negative, the indication is that the project resources

cannot be used in better ways from the point of view of

that objective.

2. STEPS IN COST-BENEFIT ANALYSIS

Basically cost-benefit analysis is made up of three

parts:

- a technical-engineering part in which the context and

technical characteristics of the project are identified;

- a financial analysis that represents the starting point

for the CBA and that leads the analysis from the point

of view of the private investor;

- an economic analysis, the true core of CBA, which,

starting with the financial analysis that serves to

identify all the income and expenditure items and the

relative market prices, applies a series of corrections

that allow us to pass from the point of view of the

private investor to that of the public operator.

2.1. Identification of the project

The first step serves to place the project in its

implemental context. Obviously it is necessary to

identify the object of the evaluation, the unit of analysis

to which the cost-benefit analysis is applied. This is

particularly important for groups of projects or for parts

or phases of a larger project that have their own

planning autonomy.

The technical analysis is carried out to ensure the

feasibility of the projected work from a technical point

of view. This involves aspects of an engineering,

management, localization, marketing and

organisational nature. The proposed project must show

that it is the best of the possible alternatives. For each

project at least three alternatives may be considered:

- the do nothing alternative

- the do minimum alternative

- the do something alternative.

2.2. Financial analysis

The financial analysis is the starting point for the

subsequent economic analysis. It provides all the

necessary data regarding input, output, their relative

prices and how they are distributed over time. It serves

to:

- formulate the tables for the analysis of the cash-flows

(selection of the important cost and revenue items)

- evaluate the financial feasibility (verification of

sustainability)

- evaluate the financial benefit by calculating the return

from the private investor’s (financial return of the

project and the capital) point of view.

Financial feasibility is an essential condition for the

viability of the project, but financial convenience is not

necessary: On the contrary, if a project is extremely

convenient for a private investor then there is less need

to decide on the convenience of public financing. The

financial analysis is carried out using the discounted

cash flow method. The choice of the discount rate is

crucial to the assessment of the costs weighted against

the benefits over a longer period of time. The discount

rate is the rate by which benefits that accrue in some

future time period must be adjusted so that they can be

compared with values in the present. This method

considers only the real monetary income and

expenditure of the project and does not include

accounting conventions such as depreciation, reserves

and so on.

The monetary income and expenditure are recorded at

the time they effectively occur. Thus it is necessary to

define a time horizon that is coherent with the project’s

life cycle, and to estimate not only the income and

expenditure, but how they are expected to break down

over the entire time horizon.

The financial analysis is made up of three tables that

summarize the basic data and three tables for the

calculation of important indicators. The initial three

tables are:

-investment costs and residual value; this includes the

value of the fixed assets, (land, buildings, extraordinary

maintenance), pre-production expenses (licences,

patents, etc.), variations in working capital (cash,

clients, stocks, current liabilities) and residual value,

which appears as a single positive item in the last year

of the time horizon.

operating costs and revenue; this includes all the

operating costs (raw materials, labour, electricity,

maintenance) and any possible revenue items (tariff and

non-tariff income)

sources of financing; this includes private equity, all

public contributions (local, national, community level),

loans and other sources of financing.

2.3. Correction for the fiscal effect

In the financial analysis carried out from the point of

view of the private investor some items are included,

like for example taxes on profits, that represent neither

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a social benefit not a cost, but rather a transfer from one

social group to another. Other examples of fiscal effects

can be found in subsidies, in welfare contributions

considered in the cost of labour and the effects of duties

on the prices of inputs and outputs.

2.4. Calculation of the positive and

negative externalities

In evaluating the convenience the public operator also

considers the externalities generated by the project. The

externalities are social costs or benefits that manifest

themselves beyond the realms of the project and

influence the welfare of third parties without any

monetary compensation. As such they are not captured

by market mechanisms and are not monetised, since

their effects are transmitted through real variables that

influence the welfare of individuals and not through

price mechanisms. Such effects, which influence the

welfare of the social group involved, must be quantified

and then monetised in order to be included in the

analysis as a true item of input or output.

The external effects generated by a project may be easy

to identify, but are often difficult to quantify. After

quantifying in physical terms, a monetary value must

be attributed to the quantified benefit; this operation

requires a lot of approximations and recourse to some

standard practices that have been consolidated at an

international level. This, for example, is the case of any

calculation of the value of time or of human lives. In

these cases one tries to artificially reconstruct the

market mechanism to measure the preferences of

individuals via the declared preferences method (the

willingness to pay method) or the revealed preferences

method (the value is approximated by calculating the

savings in spending, as in the health field, or the price

of equivalent goods and services). Importantly, to

provide a broader understanding of the implications of

a project or programme, social, environmental and

gender impacts, must also be evaluated. To assist in

determining these impacts, tools such as environmental

impact assessments and gender impact assessments can

be conducted.

2.5. From market prices to shadow prices

The last correction is made through the calculation of

opportune conversion factors which, multiplied by the

market price, give the value of the shadow prices. This

correction is necessary because the markets are

imperfect and market prices don’t always reflect the

opportunity cost of a good. If prices are distorted they

are not a suitable indicator of welfare.

In order to correct the market prices of inputs and

outputs the following are used:

- the marginal cost, for non-marketed goods such as

the land, local transport services, etc.;

- the border price, for marketed goods;

- the standard conversion factor for minor nonmarketed

goods.

As far as salaries are concerned, the two alternative

methods of calculating the conversion factor are:

- using a conversion factor lower than one if faced with

high unemployment (by reducing the labour costs the

net economic value of the project rises compared to the

financial analysis);

- calculating an income multiplier that captures the

positive external value of creating jobs.

Since the reference price in the economic analysis is the

opportunity cost (that is the best alternative use of a

specific resource) it is obvious that if faced with high

unemployment (as is mainly the case with development

projects) the conversion factor will be less than one (the

alternative use of the labour resource would be

unemployment). If the contrary is true, the conversion

factor is greater than one, which means that probably

the project diverts labour resources from more

productive occupations.

2.6. Calculation of the economic return of

the project

Having made the three corrections we have built a table

of the economic analysis that combines the items

contained in the first and second initial tables duly

corrected with the elimination of the fiscal effects, and

the addition of the external effects and the correction of

the prices using discount coefficients. In order to

measure the economic convenience, after having timediscounted

with a social discount rate (generally

different from the financial one), it is now necessary to

calculate the net present value and the economic

internal rate of return, following the methodology

already adopted for the financial analysis.

The economic internal rate of return is expected to be

higher than the rate of financial return. If this is not so,

then the project would be more convenient for a private

investor than for a public operator (unless there are

considerable social benefits that are not monetisable).

The calculation of the economic indicators allows for

the creation of a ranking of projects and helps in the

selection of more than one alternative intervention.

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3. STRENGTH AND LIMITATION

3.1. Strength

Cost-benefit analysis:

- enables us to express an opinion on the economicsocial

convenience of a project;

- enables us to create rankings among projects;

- encourages the practice of identifying the economic

benefits and costs, even of they are not immediately

monetisable.

3.2. Limitation

Cost-benefit analysis:

- does not take redistributive effects into consideration

(for these one can use a multicriteria analysis);

- does not consider the effect on the economic return of

non-monetisable benefits or costs;

- sometimes uses discretional criteria for the

monetisation of the costs and benefits for which no

market exists.

4. EXAMPLE COST - BENEFIT ANALYSIS

As the Production Manager, you are proposing the

purchase of a $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.