Cost-benefit analysis is the exercise of evaluating a planned action by determining what net value it will have for the company. Basically, a cost-benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real key to doing a successful cost-benefit analysis is making sure to include all the costs and all the benefits and properly quantify them. It is the fundamental assessment behind virtually every business decision, due to the simple fact that business managers do not want to spend money unless the benefits that derive from the expenditure are expected to exceed the costs. As companies increasingly seek to cut costs and improve productivity, cost-benefit analysis has become a valuable tool for evaluating a wide range of business opportunities, such as major purchases, organizational changes, and expansions.
Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (from such things as management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.
Although its name seems simple, there is often a degree of complexity, and subjectivity, to the actual implementation of cost-benefit analysis. This is because not all costs or benefits are obvious upon initial assessment. Take, for example, a situation in which a company is trying to decide if it should make or buy a certain subcomponent of a larger assembly it manufactures. A quick review of the accounting numbers may suggest that the cost to manufacture the component, at $5 per piece, can easily be beaten by an outside vendor who will sell it to the company for only $4. But there are several other factors that need to be considered and quantified (if possible):
- When production of a subcomponent is contracted to an outside vendor, the company's own factory will become less utilized, and therefore its fixed overhead costs have less components over which to be spread. As a result, other parts it continues to manufacture may show an increase in costs, consuming some or possibly all of the apparent gain.
- The labor force may be concerned about outsourcing of work to which they feel an entitlement. Resulting morale problems and labor unrest could quickly cost the company far more than it expected to save.
- The consequences of a loss of control over the subcomponent must be weighed. Once the part is outsourced, the company no longer has direct control over the quality, timeliness, or reliability of the product delivered.
- Unforeseen benefits may be attained. For example, the newly freed factory space may be deployed in a more productive manner, enabling the company to make more of the main assembly or even another product altogether.
This list is not meant to be comprehensive, but rather illustrative of the ripple effect that occurs in response to changes made in a real business setting. The cost-benefit analyst needs to be cognizant of the subtle interactions of other events with the action under consideration in order to fully evaluate its impact. In fact, accuracy in quantifying the costs and benefits in this sort of analysis is essential in producing information useful for the decision-making process.
The time value of money is a central concept in doing a cost-benefit analysis. The reason is that an amount of money received today has greater value than getting that same amount of money in the future. Compensating for this difference between the present value and the future value of money is essential if a cost-benefit analysis is to accurately quantify the costs and benefits of the action being studied.
Capital budgeting is essentially a cost-benefit analysis that extends the evaluation of costs and benefits into a longer timeframe and therefore greater emphasis is placed on considerations of the time value of money. When the inputs and outputs related to a capital expenditure are quantified by year, they can then be discounted to present value to determine the net present value of the opportunity at the time of the decision.
A formal cost-benefit analysis is a multi-step process which includes a preliminary survey, a feasibility study, and a final report. At the conclusion of each step, the party responsible for performing the analysis can decide whether continuing on to the next step is warranted. The preliminary survey is an initial evaluation that involves gathering information on both the opportunity and the existing situation. The feasibility study involves completing the information gathering as needed and evaluating the data to gauge the short- and long-term impact of the opportunity. Finally, the formal cost-benefit analysis report should provide decision makers with all the pertinent information they need to take appropriate action on the opportunity. It should include an executive summary and introduction; information about the scope, purpose, and methodology of the study; recommendations, along with factual justification; and factors concerning implementation.
Cost-benefit analysis is a decision support method used to help answer questions that often start with "what if" or "should we." It is a mathematical method to measure the benefits of a course of action. It is a powerful tool that can be used to thoroughly analyze the likely net effect to a business of buying new equipment, expanding into a new service area, or outsourcing a task now handled internally. Feeling confident that the benefits derived from an action taken will outweigh the costs of implementing that action makes the decision to proceed much easier.
Bhemani, Alnoor. Management Accounting in the Digital Economy. Oxford University Press, 2004.
Campbell, Harry F., and Richard P.C. Brown. Benefit-Cost Analysis, Financial and Economic Appraisal Using Spreadsheets. Cambridge University Press, 2003.
Dmytrenko, April L. "Cost-Benefit Analysis." Records Management Quarterly. January 1997.
Dompere, Kofi K. Cost-Benefit Analysis and the Theory of Fuzzy Decisions. Springer, 2004.
Hoque, Zahirul. Handbook of Cost and Management Accounting. Spiramus Press, Ltd., 2005.
Shein, Esther. "Formula for ROI." PC Week. 28 September 1998.
Hillstrom, Northern Lights
updated by Magee, ECDI
The process of cost-benefit analysis, or CBA, enables analysts to exploit a set of analytical economic and econometrics tools to evaluate project investments and policy options. It has been made a legal prerequisite for public policy decisions in most countries. In the United States, for example, Executive Order 12991, signed by President Ronald Reagan in 1981, codified CBA as a requirement for agencies when conducting risk assessments in health, safety, and environmental regulation.
There is a large body of literature available dealing with CBA, some of which dates back to the 1920s, when large-scale engineering projects in the United States required some type of project evaluation. Although CBA is not itself a self-contained field of economics—sitting somewhat uneasily between several scholarly discourses, including philosophy, psychology and politics—the central procedures of CBA have been predominantly defined by economists. The standard introductory textbook was written by an economist, Edward J. Mishan. Originally published in 1971, the fourth edition of Mishan’s Cost-Benefit Analysis appeared in 1988. While the original purpose of CBA was to capture the costs and benefits accruing to a single enterprise, its scope was soon expanded to evaluate policy options applicable to the wellbeing of society as a whole, and most literature in the social sciences now refers to CBA in this context.
A cost-benefit analysis can be seen as proceeding through a number of stages. First, for any proposal under consideration, including the option of doing nothing, a qualitative statement of its expected costs and benefits is to be provided. Second, each cost and benefit should be rendered in quantitative form, usually as a monetary value. Third, the expected costs or benefits should be aggregated. Finally, a decision should be taken on the basis of which proposal produces the greatest sum of benefits over costs. The first stage seems essential to any rational decision-making process, but each further stage is highly contested on conceptual, economic, and philosophical grounds. Three issue areas in particular are worth pointing out: (1) monetary valuation, (2) aggregation, and (3) the subordination of other values.
In order for CBA not to be arbitrary or fetishistic, some connection between the currency of the economic analysis and human well-being must be established. The monetary value of goods is usually chosen for this purpose, because it is said to reflect the strength of individuals’ preferences for that good, which in turn is a measure of the well-being provided by it. Yet various objections have been raised regarding this approach. First, some goods and services—such as most ecosystem services—are not traded in markets at all, and therefore no monetary value can be ascertained. The social sciences have developed various surrogate methods to rectify this deficiency, and “contingent valuation” (CV) has been particularly influential. Through CV, economists seek to create hypothetical markets by eliciting people’s “willingness to pay” (WTP) for the satisfaction of a preference if there was a market. However, WTP has been criticized as an inadequate proxy for market prices because of the ambiguity and limited reliability of the stated preferences used in CV (as opposed to those revealed in the market). There is also some doubt as to whether coherent preferences on policy issues are actually susceptible to valuation and extractable through interviews or questionnaires.
Second, preferences conceal well-known facts about human nature, and they are therefore not always a suitable basis for policy decisions. For example, individuals may adjust their aspirations to their perceptions of possibilities; preferences may be misinformed or malformed, and they may therefore cause individuals to inflict harm on themselves (e.g., the addict; the gambler) or on others (e.g., the murderer); and preference satisfaction fails to accord the proper moral status to those beings that are incapable of expressing a preference—whether human (e.g., children) or nonhuman (e.g., animals).
Finally, where monetary valuation in a market is possible, that value may not be a valid indicator of the wellbeing the good provides to society because of the conceptual difference between a good’s monetary “exchange value” and its “use value.” Gold, for example, has a high exchange value but a low value in actual use. The use value of the air we breathe, by contrast, is infinite (it being a physical necessity for our lives), while its exchange value is zero.
Once attributes of well-being have been valued, CBA requires that they be aggregated into a single standard. They need to be compared across lives, so that an increase in well-being for individual A in one dimension can be weighed against the foregone improvement individual B would have experienced in another. This is no easy task. It may be possible to make comparisons of well-being in an ordinal sense—in the case of, say, health care, one person may be able to stipulate that he or she feels better than someone who is in great physical pain—but not in a cardinal sense. That is to say, a person cannot know exactly how much better he or she is. Cardinality presupposes two characteristics of the currency used: (1) a number must be attached to the outcome that represents the strength of the preference relative to others, so that a health state of, say, 0.6 is three times better than one of 0.2; and (2) the scale must have an equal interval property where equal differences at different points along the scale are equally meaningful, so that boosting a patient from, say, 0.1 to 0.2 on that scale is of equal benefit to raising someone from 0.8 to 0.9. Despite various methodological advancements, these requirements are still not met for all CBAs.
Finally, CBA imposes a unitary standard on the valuation and comparison of goods, and it thus subordinates other values to the new standard of monetary exchange value. In environmental CBAs, for example, the existence value of nonhuman species, the survival of which is deemed to be worth protecting, may be overridden by CBA calculations. Their value cannot be priced in real or hypothetical markets because the expected benefit of their survival does not accrue to those who might be asked to reveal or state a WTP for their preference.
As far as human beings are concerned, similar predicaments present themselves: is it permissible to kill one person because his organs could save the lives of four patients whose names are on a donor waiting list? Most of us would consider this option to be objectionable, but given the rationale of CBA it is justifiable, if not mandatory, to proceed that way. The problem encountered here is that with CBA every individual counts as one, and can thus be added up to, or traded against, someone else. In so doing, CBA will override the intrinsic value of human life, a term that denotes our interest in our own continued existence according to which we cannot be used solely as a means for other individuals’ ends. Yet, this is what CBA would recommend us to do. Intrinsic values are nonrelational; that is, they are not defined relative to some other human being, species, or object, nor to the benefit it might provide to them.
The objections presented here are not a reason to reject CBA per se, for it does provide relevant information. Yet they are a reminder that economic evaluations such as CBA should be understood as an input into, rather than a substitute for, political deliberation and judgment.
Adler, M. D., and E. A. Posner, eds. 2001. Cost Benefit Analysis: Legal, Economic, and Philosophical Perspectives. Chicago: Chicago University Press.
Layard, R., and S. Glaister, eds. 1994. Cost-Benefit Analysis. 2nd ed. Cambridge University Press.
Mishan, E. J. 1988. Cost-Benefit Analysis. 4th ed. London: Unwin Hyman.
Since being mandated in the Flood Control Act of 1936 (PL 74–738), cost–benefit analysis has been used routinely in evaluating water projects. Cost–benefit analysis gives decisionmakers a method for evaluating investments in water projects, judging alternative projects, and estimating the impact of various regulatory changes. The basic principle of cost–benefit analysis is that the benefits of a water project must exceed the costs. Therefore, the issue is to measure all the benefits and costs attributable to a project accurately and completely. The application of this principle becomes difficult because of the uncertainty inherent in dealing with projects over time.
The Value of Nonmarket Goods
When conducting project analysis, it should be remembered that all projects will have benefits and costs to the environment not directly accounted for in the planning. These spillovers should be considered so that decision-makers are aware of such costs. Whenever a large public spending program exists, there are both winners and losers.
A major shortcoming of cost–benefit analysis is the difficulty in valuing nonmarket goods . Water projects, by nature, will affect the fish and wildlife habitats in an area as well as recreational and other environmental amenities. Since these benefits and costs are not priced in the market, they are often not included in a project analysis. However, note should be taken of these issues to give decision makers the ability to consider such nonmarket values while evaluating a project.
Valuing the benefit of pollution control is also difficult in cost–benefit analysis and often leads to controversy when studies are publicly released. Economists have no formula for valuing the avoided damage to humans and the environment of pollution control. What is the value of extending life or reducing illness? Still, economics can be useful in determining whether the same water quality improvements might have been achieved at a lower cost or whether the same investment could have purchased greater quality improvements.
Practical Economic Analysis
Despite the difficulty in assigning economic value to certain environmental or human factors, economists and analysts nonetheless can provide decisionmakers with what might be called second-best or practical cost–benefit analysis. Economist John Krutilla summarized the role of economics as follows: "Economic analysis of benefits and costs of long-lived investments involve as much art as science. There is a need to project the relevant course of events within the area of project influence over a very long period of time, and getting to understand human responses to changes in the social and physical environment does not come easily."
Several items must be considered before beginning an analysis of any water project, investment, or spending decision. For example, construction of a public flood-control project or a reservoir often does not consider the effect on fish, wildlife, wetlands, or surrounding watersheds. Or, the evaluation of a water conservation project may not include the effects on the recreational use of a lake or reservoir. Consequently, the fully informed decisionmaker must first determine the scope of the costs and benefits to be taken into account. This way, managers can assure the public that the major relevant factors were considered before making a decision.
Another question concerns the entity to be maximized: Returns to the system? Rate payer benefits? Water use? Environmental concerns? Whether a project is a net benefit to the system, the community, or the environment will depend on the objective that is being sought.
Third, analysts must know the investment criteria. Whether one project is chosen over another or no investment is made depends on the criteria for ranking projects.
Fourth is the relevant timeframe for the project. A period of analysis must be chosen. For example, how long is a reservoir to last? The analyst must also remember that different projects have different cash flows over time; some have early returns, others more distant returns.
Evaluating Dollars Over Time
In project evaluation, benefits and costs clearly accrue over many years. Thus, it is necessary to discount the present value of a project over time: $1,000 is worth more today than it will be 5 years from now. A method is needed to take future costs and benefits and put them into today's dollars.
Planners "discount" future dollars to take into account the time value of money. By using a discount rate , planners can compare today's costs and benefits to those in the future. The discounted net present value is the discounted sum of benefits minus costs. Only projects where net present value is positive would be economically feasible.
see also Economic Development; Ethics and Professionalism; Planning and Management, Water Resources.
Jeffrey L. Jordan
Frederick, K. D. "The Economics of Risk in Water Resource Planning." In Water Resources Administration in the United States: Policy, Practice, and Emerging Issues. Martin Reuss, editor. East Lansing: Michigan State University Press, 1993.
Krutilla, John V. "The Use of Economics in Project Evaluation." In Transitions of the 40th North American Wildlife and Natural Resources Conference. Washington, D.C., 1975.
Schmid, A. Allan. Benefit-Cost Analysis: A Political Economy Approach. Boulder, CO: Westview, 1989.
PORK BARREL PROJECTS
The term "pork barrel" dates from just after the American Civil War (1861–1865) and comes from the plantation owners' practice of distributing rations of salt pork to slaves from wooden barrels. The term "pork barrel spending" can be traced to about 1905, defining such spending as "a government appropriation . . . that provides funds for local improvements designed to ingratiate legislators with their constituents." Such spending implies federal legislation filled with special projects for members of Congress to give to the voters back home paid for by federal taxpayers.
Most pork barrel projects, also referred to as line-item, or "earmark," projects, are infrastructure spending on items such as roads, airports, government buildings, and often water projects. However, "ear marks" are not evaluated competitively. Pork barrel projects are often seen as a growing trend for Congress to become heavily involved in local and states affairs through the "power of the purse."
Environmentalists might believe that total elimination of risk that comes with pollution and other forms of environmental degradation is possible and even desirable, but economists argue that the benefits of risk elimination have to be balanced against the costs. Measuring risk is itself very complicated. Risk analysis in the case of pollution, for instance, involves determining the conditions of exposure, the adverse effects, the levels of exposure, the level of the effects, and the overall contamination. Long latency periods, the need to draw implications from laboratory studies of animal species , and the impact of background contamination complicate these efforts. Under these conditions, simple cause and effect statements are out of the question.
The most that can be said in health risk assessment is that exposure to a particular pollutant is likely to cause a particular disease. Risk has to be stated in terms of probabilities, not certainties, and has to be distinguished from safety, which is a societal judgment about how much risk society is willing to bear. When assessing the feasibility of technological systems, different types of risks—from mining, radiation, industrial accidents, or climate impacts, for example—have to be compared. This type of comparison further complicates the judgments that have to be made.
Reducing risk involves asking to what extent the proposed methods of reduction are likely to be effective, and how much these proposed methods will cost. In theory, decision making could be left to the individual. Society could provide people with information and each person could then decide whether to purchase a product or service, depending upon the environmental and resource consequences. However, relying upon individual judgments in the market may not adequately reflect society's preference for an amenity such as air quality , if that amenity is a public good with no owner and no price attached to it. Thus, social and political judgments are needed.
However much science reduces uncertainty, gaps in knowledge remain. Scientific limitations open the door for political and bureaucratic biases that may not be rational. In some instances, politicians have framed legislation in ways that seriously hinder if not entirely prohibit the consideration of costs (as in the Delaney Clause and the Clean Air Act ). In other instances, of which the President's Regulatory Review Council is a good example, they have explicitly required a consideration of cost factors.
There are different ways that cost factors can be considered. Analysts can carry out cost effectiveness analyses, in which they attempt to figure out how to achieve a given goal with limited resources, or they can carry out more formal risk-benefit and cost-benefit analyses in which they have to quantify both the benefits of risk reduction and the costs.
Economists admit that formal, quantitative approaches to balancing costs and benefits do not eliminate the need for qualitative judgments. Cost-benefit analysis initially was developed for water projects where the issues, while complicated, were not of the same kind as society now faces. For example, how does one assess the value of a magnificent vista obscured by air pollution ? What is the loss to society if a given genetic strain of grass or animal species becomes extinct? How does one assess the lost opportunity costs of spending vast amounts of money on air pollution that could have been spent on productivity enhancement and global competitiveness?
The most recalcitrant question concerns the value of human life. Cost-benefit analysis requires quantifying the value of a human life in dollars, so that specific health risks can be entered into the calculations against the cost of reducing such risks. Many different methods of arriving at an appropriate figure have been undertaken, all with predictably absurd results. Estimates range from $70,000 to several million dollars a head. Although the question does not admit of a sensible answer, society must nevertheless decide how much it is willing to pay to save a given number of lives (or how much specific polluters should pay for endangering them).
Equity issues (both interpersonal and intergenerational) cannot be ignored when carrying out cost-benefit analysis. The costs of air pollution reduction may have to be borne disproportionately by the poor in the form of higher gasoline and automobile prices. The costs of water pollution reduction, on the other hand, may be borne to a greater extent by the rich because these costs are financed through public spending. Regions dependent on dirty coal may find it in their interests to unite with environmentalists in seeking pollution control technology. The pollution control technology saves coal mining jobs in West Virginia and the Midwest, where the coal is dirty, but draws away resources from the coal mining industry in the West where large quantities of clean-burning coal are located.
Intergenerational equity also plays a role. Future generations have no current representatives in the market system or political process. How their interests are to be taken into account ultimately amounts to a philosophical discussion about altruism: to what extent should current generations hold back on their own consumption for the sake of posterity? Should Jeremy Bentham's utilitarian ideal of "achieving the greatest good for the greatest number" be modified to read "achieving sufficient per capita product for the greatest number over time?"
[Alfred A. Marcus ]
Buchholz, R., A. Marcus, and J. Post. Managing Environmental Issues. Englewood Cliffs, NJ: Prentice-Hall, 1992.
Mann, D., and H. Ingram. "Policy Issues in the Natural Environment." In Public Policy and the Natural Environment, edited by H. Ingram and R. K. Goodwin. Greenwich, CT: JAI Press, 1985.
Cost-benefit analysis is used for determining which alternative is likely to provide the greatest return for a proposed investment. Sometimes referred to as cost-effectiveness analysis, it is relevant to businesses as well as to not-for-profit entities and governmental units.
A business might find it helpful to use cost-benefit analysis to determine if additional funds should be invested in a facility in the home country or in another country. A community not-for-profit organization that provides a variety of programs for children might use cost-benefit analysis to assist management in determining which activities will provide the most services for the costs specified. A federal governmental agency might use cost-benefit analysis to determine which of several projects planned for the national parks is likely to be most used by interested citizens, given the costs.
Because resources such as money and time are limited, an organization usually cannot undertake every project proposed. To decide whether to undertake a project, decision makers weigh the benefits from the project against the cost of the resources it requires, normally approving a project when its benefits exceed its costs. Cost-benefit analysis provides the structure and support for making such decisions.
Benefits increase the welfare of the organization. Some benefits are monetary benefits, such as the dollar amount of cash inflows from additional sales of a product or the saving in cash outflows that a project enables. Other benefits are important but harder to quantify. For example, a project may increase customer satisfaction; increased customer satisfaction may increase future sales, but the exact relationship between sales and satisfaction is often hard to specify.
Costs are the outlays or expenditures made in order to obtain a benefit. Many costs are measured monetarily, such as the cost of buying a new machine or of hiring an additional employee.
COST-BENEFIT ANALYSIS IN BUSINESS
A cost-benefit analysis is straightforward when all costs and benefits are measurable in monetary terms. Assume that Company A must decide whether to rent an ice cream machine for the summer for $900. The ice cream machine will produce additional cash inflows of $1,000 during the summer. The benefit of additional cash inflows ($1,000) exceeds the additional cost ($900), so the project should be undertaken. Not all cost-benefit analyses are this simple, however. If the benefits and costs occur in different time periods, it may be necessary to discount the future cash flows to their current equivalent worth.
In another example, cost savings is a benefit. Assume that Company B makes about 100,000 photocopies a year. Company B does not have its own copy machine and currently pays 4 cents per copy, or $4,000 a year, to Copy-cat Copiers. Company B can lease a copy machine for $2,500 a year. It must also pay 2 cents per page for paper for the leased machine, or $2,000. In this example, the cost of leasing the machine and buying paper ($2,500+$2,000=$4,500) exceeds the benefit of saving the $4,000 normally paid to Copycat Copiers. Company B should continue to use Copycat Copiers for its photo-copies. However, Company B must have a pretty good estimate of the number of copies it needs to be comfortable with its decision. If Company B needs 150,000 copies this year instead of 100,000, the cost of the leasing the machine and buying paper ($2,500+$3,000=$5,500) is cheaper than the $6,000 (150,000×$0.04) savings in fees to Copycat Copiers.
A third example involves a project with benefits that are difficult to quantify. Assume that Company C is deciding whether to give a picnic costing $50,000 for its employees. Company C would receive the benefit of increased employee morale from the picnic. Better employee morale might cause employees to work harder, increasing profits. However, the link between increased morale and increased monetary profits is tenuous. The decision maker must use his or her judgment to compare the nonmonetary benefit to the monetary cost, possibly deciding that increased employee morale is worth the $50,000 cost but would not be worth a $100,000 cost.
In the preceding examples, cost-benefit analysis provided a framework for decision making. The range of objectivity related to measurement of the factors is typical. Techniques used in business as a basis for determining costs and benefits, such as return on investment, are generally quantifiable and thus appear to be objective. However, it is not uncommon for qualitative factors to enter into the decision-making process. For example, providing a product that individuals with limited incomes will be able to purchase may not provide the highest monetary return on investment in the short run, but might prove to be a successful long-term investment. Careful decision makers attempt to deal with a difficult-to-quantify factor in as objective a manner as possible. However, cost-benefit analysis in most situations continues to introduce measurement problems.
COST-BENEFIT ANALYSIS IN NONBUSINESS ENTITIES
Cost-benefit analyses are also common in nonbusiness entities. Boards of not-for-profit organizations establish priorities for their programs, and such priorities often specify desired program outputs. For example, assume a not-for-profit organization is interested in reducing the level of illiteracy among the citizens of a rural community in a state that has one of the lowest per-capita incomes in the United States. As alternative programs for those who need to learn to read are considered, there will be cost-benefit analyses that focus on a number of factors, including the extent to which a particular program can attract those who are illiterate. A program in the downtown area of a small town might be considered because a facility is available there at low cost, and that low cost is appealing. Focus on cost is not sufficient, however. When benefits are considered, it might become clear that those who are eager for such a program do not have cars and that there is no public transportation from where they reside to the center of the small town. Further consideration of relevant factors and of alternatives, undertaken in good faith, should result in cost-benefit analyses that provide valuable information as the agency makes decisions.
At all levels of government in the United States, cost-benefit analyses are used as a basis for allocating resources for the public good to those programs, projects, and services that will meet the expectations of citizens. For example, decision makers at the federal level who have policy responsibility for environmental standards, air-quality rules, or services to the elderly often find information from cost-benefit analyses to be critical to the decisionmaking task.
CONTINUING EFFORTS TO QUANTIFY COST-BENEFIT FACTORS
As possibilities for the use of funds increase, there is motivation for better measurement of both costs and benefits as well as for speedier ways of accomplishing analyses for alternatives that are appealing. All types of entities, including businesses, not-for-profit organizations, and governmental units, strive to improve the measurements used in cost-benefit analyses. The capabilities of electronic equipment provide promising assistance in accumulating data relevant for analyses. Wise use of resources is an important goal in every organization; cost-benefit analyses make a key contribution to this goal. Therefore, attention is given to improving both the effectiveness and efficiency of such analyses.
Boardman, Anthony, E. (2006). Cost-Benefit Analysis: Concepts and Practice. Upper Saddle River, NJ: Pearson/Prentice-Hall.
Nas, Tevik F. (1996). Cost-Benefit Analysis: Theory and Application. Thousand Oaks, CA: Sage Publications.
Mary Ellen Oliverio
Cost-benefit analysis (C-BA) is a form of economic analysis in which costs and benefits are quantified and compared. C-BA is used primarily to evaluate public expenditure decisions with regard to such factors as esthetics, ethics, and long-term environmental costs (e.g., pollution costs).
Origins in the 1930s
C-BA had its origins in 1936 with the dam projects of the Works Progress Administration (WPA) in the western United States. At the time the federal government's policy was that projects would only be started if accrued benefits exceeded accrued costs. Although such a statement would be judged quite simplistic by today's standards, this philosophy is still the basis for C-BA.
Costs vs. benefits. The power of C-BA lies in its ability to organize and evaluate an action's likely effects and overall impact on economic welfare. CB-A states that if a project is to proceed on a successful basis, then total benefits should outweigh total costs. Consider, for instance, the following hypothetical scenario. The construction of an industrial complex next to an existing residential community will provide a needed boost to the community, which has a high unemployment rate. However, the new businesses will also cause substantial localized air and water pollution. CB-A will sum up all the benefits and costs in order to determine whether the new arrangement will be positive or negative for local residents and businesses.
Evolution into a Sophisticated Technique
C-BA has evolved into a highly technical subject, which normally requires that all costs and benefits (whether tangible or intangible) be expressed in monetary units. Tangible means that costs and benefits are capable of being understood and evaluated. An example of a tangible cost is the price of land for locating a new company. Intangible means just the opposite, that the economic costs and benefits are difficult to define clearly. The measurement of intangibles causes the most difficulty for C-BA. Pollution is one such intangible that is exceptionally difficult to measure because of its unique problems. For example, it is not easy to determine the value of clean air vs. degraded air quality due to pollution from a proposed manufacturing complex.
A number of sophisticated techniques have been developed to successfully measure such intangibles as pollution. In the earlier hypothetical case, one such technique estimates how much an individual is willing to pay to use or retain clean air. Another technique is a subsidy offered to individuals to live with polluted instead of clean air. A third technique involves the measure of today's intrinsic value of clean air vs. the future costs of remedying the consequences of polluted air (such as respiratory problems and environmental cleanup).
Oklawaha River Canal
A good example of C-BA with respect to pollution was a 1962 U.S. Army Corps of Engineers proposal for a 177-kilometer (110-mile) canal to be dug across central Florida. The canal would have provided a shortcut for barge traffic from Texas and Louisiana to the Atlantic Coast by, in part, expanding 80 kilometers (50 miles) of the pristine Oklawaha River. Numerous citizen and environmental groups opposed the canal, citing the pollution and general environmental degradation it could potentially cause.
To the Rescue. A C-BA was undertaken with respect to various interest groups that would be affected, such as shippers using the canal and fishers using the river. The analysis determined that few benefits would be realized, and that the proposed project would be detrimental to most interest groups. Because of the evidence provided by the C-BA, the project was halted in 1971 by a citizen's group lawsuit and a presidential executive order.
Although C-BA has many strengths as a tool, it also has numerous weaknesses such as the inability to conclude anything without the use of financial costs and benefits and the inherent problem of introducing uncertainty of data when using intangible items unable to be analyzed even with sophisticated techniques. Even so, it is still a valuable tool for governments to consider in making decisions about the most effective use of their resources. C-BA can gather all the essential data related to an issue and establish reasonable economic, demographic, and technical assumptions that will serve as the ground-rules for the ensuing debate. C-BA is thus an important ingredient in the decision-making process concerning proposed projects that impact the environment and, especially, pollution.
Dorfman, Robert, and Dorfman, Nancy S., eds. (1993). Economics of the Environment: Selected Readings, 3rd edition. New York: W.W. Norton.
Florida Defenders of the Environment. (1970). Environmental Impact of the Cross-Florida Barge Canal with Special Emphasis on the Oklawaha Regional Ecosystem. Gainesville, FL.
College of Agriculture and Life Sciences, University of Arizona. "A Student's Guide to Cost Benefit Analysis for Natural Resources: Lesson 3—Cost-Benefit Analysis in Theory and Application." Available from http://ag.arizona.edu/classes.
Florida Defenders of the Environment. "Oklawaha River Restoration: History of Restoration Efforts." Available from http://www.fladefenders.org/publications.
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William Arthur Atkins
What It Means
Cost-benefit analysis is a method of comparing the positive and negative effects of a project, a decision, or another business venture that an organization is considering. A cost-benefit analysis is a forecast; that is, it is done in advance of starting a project to show whether the project’s negative effects (the costs) will outweigh its positive effects (the benefits). In general, the only business projects that are justified are those in which the benefits exceed the costs. Cost-benefit analysis evaluates such factors as how much the project will cost, how long it will take to create, and how it will affect current and future employees.
Businesses, nonprofit organizations, and governmental agencies use cost-benefit analysis to identify how best to expend their money, effort, and materials. Money and time are finite resources for every organization. Cost-benefit analysis can help organizations avoid taking on projects that could ultimately waste money, time, and human energy. For example, a business might use cost-benefit analysis to determine whether it should include gym membership in its employee benefit plan. A nonprofit educational organization that is considering starting a new tutoring program might use cost-benefit analysis to determine if the program is financially feasible.
When Did It Begin?
Cost-benefit analysis was first used by government agencies to understand if the benefits of certain programs, laws, and projects would outweigh their costs. Cost-benefit analysis was applied in the U.S. Flood Control Act of 1936. This legislation required that the U.S. Army Corps of Engineers evaluate the costs and benefits of flood-control and water-resource projects. The objective of the law was to show that flood control, in such forms as levees and canals, impacted human lives. After this law was passed, other government agencies in the United States began using cost-benefit analysis to study how public-works projects affected social welfare.
In England in the 1950s and 1960s, the government used cost-benefit analysis in its improvements of the nation’s transportation system. A cost-benefit analysis showed that a new subway line, called the Victoria Line, would improve the quality of life and mobility for those passengers who lived and worked along its proposed route, running from the southwest to the northeast of London. When it was ultimately built, the Victoria Line was the world’s first automatic railway line.
More Detailed Information
There are many different scenarios in which cost-benefit analysis is a useful tool. A business might use cost-benefit analysis to determine whether to open an office in another country or invest in new computer equipment. A nonprofit organization that provides programs for young parents might use cost-benefit analysis to determine which programs would provide the most services to its customers for the specified amount of money the organization has to spend. Cost-benefit analysis is also used to evaluate major investments of public funds in the building of bridges, roads, transit systems, convention centers, and dams. Before approving projects, experts study the project’s impacts and rewards. The costs and benefits of a project may be tangible, such as money spent and earned, or intangible, such as improvements in quality of life.
In general, benefits are those things that increase the prosperity of the organization. The sale of a certain product will bring cash into a company; this is an example of a monetary benefit. Another project might save the company money. Other benefits may be indirect and harder to measure. The benefits to the public of a new city park are clear, but they can be difficult to measure.
In general, a cost is any spending or payment that an organization makes in order to reap some form of benefit, even if the benefit may not be measurable until a future date. The costs of a project or decision can be direct or indirect. The costs of buying new manufacturing equipment and hiring more employees, for example, are measurable in terms of dollars. It is harder to estimate indirect costs in such areas as quality of life, job satisfaction, reputation, or company morale, though, in some cases, these factors are assigned monetary values.
A cost-benefit analysis is a fairly straightforward process when all costs and benefits can be measured in monetary terms. Assume, for example, that a snow-clearing business must decide whether to purchase a new snowplow that costs $15,000. The business owner estimates that the new plow will bring in additional revenue of $20,000. The benefit of this additional revenue exceeds the cost of the plow, so the owner decides to purchase the new plow.
Businesses and organizations have become more complex over the last few decades, and the methods of cost-benefit analysis also have become more complex. At the government level, experts have developed cost-benefit analysis methods to distribute funds to projects that will have the most positive impact on the public. For example, program directors use cost-benefit analysis to set environmental standards and establish air-quality rules. In these cases, experts must often put a monetary value on human life or the environment, which often makes their decisions controversial.
Most areas of government have used cost-benefit analysis since the 1960s to plan and develop budgets. Some governmental projects, such as building roads and constructing water systems, can be analyzed with a high degree of accuracy. Other types of projects can be harder to estimate accurately, such as the costs and benefits of engaging in military conflict.
The main difficulty with cost-benefit analysis is how to assign monetary values to social costs and benefits, especially when these affect different social groups, users and non-users of the proposed facility. The objection most often raised is that it gives a spurious air of economic rationality and objectivity to decisions that are necessarily social and political in nature.