Cost-benefit analysis
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Cost-benefit analysis is an important technique for project appraisal: the process of 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.
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[edit] 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 risk, loss of reputation, market penetration, long-term strategy alignment, 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.
[edit] Accuracy problems
The accuracy of the outcome of a cost-benefit analysis is dependent on how accurately costs and benefits have been estimated. A peer-reviewed study [1] 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 [2] 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 ([3] Flyvbjerg, Bruzelius, and Rothengatter, 2003).
Another challenge to cost-benefit analysis comes from determining which costs should be included in an analysis. 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 under a rear-impact collision) and the Ford company's decision not to issue a recall, Ford's cost benefit analysis had estimated that: the number of cars in use x the probabile rate deaths due to the design flaw x the amount Ford would pay out of court to settle wrongful death lawsuts, was less than the cost of issuing a recall [citation needed].
[edit] Sources and further reading
- Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press, 2003). [4]
- Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "Underestimating Costs in Public Works Projects: Error or Lie?" Journal of the American Planning Association, vol. 68, no. 3, Summer 2002, pp. 279-295. [5]
- Bent Flyvbjerg, Mette K. Skamris Holm, and Søren L. Buhl, "How (In)accurate Are Demand Forecasts in Public Works Projects? The Case of Transportation." Journal of the American Planning Association, vol. 71, no. 2, Spring 2005, pp. 131-146. [6]
- Tevfik F. Nas, Cost-Benefit Analysis: Theory and Application (Thousand Oaks, Ca.: Sage, 1996). [7]
[edit] See also
- Excess burden of taxation - which should be figured into cost-benefit analyses of publicly funded projects
- Kaldor-Hicks efficiency - economic principle underlying cost-benefit analysis
- Net present value - a similar type of calculation
- Optimism bias
- Pareto efficiency - alternative economic principle
