Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis, is a systematic approach to estimating the strengths and weaknesses of alternatives. It is used to determine options which provide the best approach to achieving benefits while preserving savings in, for example, transactions, activities, and functional business requirements. A CBA may be used to compare completed or potential courses of action, and to estimate or evaluate the value against the
cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in whic ...
of a decision, project, or policy. It is commonly used to evaluate business or policy decisions (particularly
public policy
Public policy is an institutionalized proposal or a decided set of elements like laws, regulations, guidelines, and actions to solve or address relevant and real-world problems, guided by a conception and often implemented by programs. Public p ...
), commercial transactions, and project investments. For example, the U.S. Securities and Exchange Commission must conduct cost-benefit analyses before instituting regulations or deregulations.
CBA has two main applications:
# To determine if an investment (or decision) is sound, ascertaining if – and by how much – its benefits outweigh its costs.
# To provide a basis for comparing investments (or decisions), comparing the total expected cost of each option with its total expected benefits.
CBA is related to
cost-effectiveness analysis. Benefits and costs in CBA are expressed in monetary terms and are adjusted for the
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
; all flows of benefits and costs over time are expressed on a common basis in terms of their
net present value
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...
, regardless of whether they are incurred at different times. Other related techniques include
cost–utility analysis Cost–utility analysis (CUA) is a form of economic analysis used to guide procurement decisions.
The most common and well-known application of this analysis is in pharmacoeconomics, especially health technology assessment (HTA).
In health econo ...
,
risk–benefit analysis,
economic impact analysis
An economic impact analysis (EIA) examines the effect of an event on the economy in a specified area, ranging from a single neighborhood to the entire globe. It usually measures changes in business revenue, business profits, personal wages, and/ ...
, fiscal impact analysis, and
social return on investment (SROI) analysis.
Cost–benefit analysis is often used by organizations to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of any alternatives and the ''
status quo''. CBA helps predict whether the benefits of a policy outweigh its costs (and by how much), relative to other alternatives. This allows the ranking of alternative policies in terms of a cost–benefit ratio. Generally, accurate cost–benefit analysis identifies choices which increase
welfare
Welfare, or commonly social welfare, is a type of government support intended to ensure that members of a society can meet basic human needs such as food and shelter. Social security may either be synonymous with welfare, or refer specifical ...
from a
utilitarian
In ethical philosophy, utilitarianism is a family of normative ethical theories that prescribe actions that maximize happiness and well-being for all affected individuals.
Although different varieties of utilitarianism admit different charac ...
perspective. Assuming an accurate CBA, changing the ''status quo'' by implementing the alternative with the lowest cost–benefit ratio can improve
Pareto efficiency
Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
. Although CBA can offer an informed estimate of the best alternative, a perfect appraisal of all present and future costs and benefits is difficult; perfection, in economic efficiency and social welfare, is not guaranteed.
The value of a cost–benefit analysis depends on the accuracy of the individual cost and benefit estimates. Comparative studies indicate that such estimates are often flawed, preventing improvements in
Pareto and
Kaldor–Hicks efficiency
A Kaldor–Hicks improvement, named for Nicholas Kaldor and John Hicks, is an economic re-allocation of resources among people that captures some of the intuitive appeal of a Pareto improvement, but has less stringent criteria and is hence appl ...
. Interest groups may attempt to include (or exclude) significant costs in an analysis to influence its outcome.
History
The concept of CBA dates back to an 1848 article by
Jules Dupuit, and was formalized in subsequent works by
Alfred Marshall. Jules Dupuit pioneered this approach by first calculating "the social profitability of a project like the construction of a road or bridge" In an attempt to answer this, Dupuit began to look at the utility users would gain from the project. He determined that the best method of measuring utility is by learning one's willingness to pay for something. By taking the sum of each user's willingness to pay, Dupuit illustrated that the social benefit of the thing (bridge or road or canal) could be measured. Some users may be willing to pay nearly nothing, others much more, but the sum of these would shed light on the benefit of it. It should be reiterated that Dupuit was not suggesting that the government perfectly price-discriminate and charge each user exactly what they would pay. Rather, their willingness to pay provided a theoretical foundation on the societal worth or benefit of a project. The cost of the project proved much simpler to calculate. Simply taking the sum of the materials and labor, in addition to the maintenance afterward, would give one the cost. Now, the costs and benefits of the project could be accurately analyzed, and an informed decision could be made.
The
Corps of Engineers initiated the use of CBA in the US, after the Federal Navigation Act of 1936 mandated cost–benefit analysis for proposed federal-waterway infrastructure. The
Flood Control Act of 1939 was instrumental in establishing CBA as federal policy, requiring that "the benefits to whomever they accrue
ein excess of the estimated costs."
Public policy
CBA's application to broader public policy began with the work of
Otto Eckstein, who laid out a welfare economics foundation for CBA and its application to
water-resource development in 1958. It was applied in the US to water quality, recreational travel, and land conservation during the 1960s, and the concept of
option value was developed to represent the non-tangible value of resources such as national parks.
CBA was expanded to address the intangible and tangible benefits of public policies relating to mental illness, substance abuse, college education, and chemical waste. In the US, the
National Environmental Policy Act of 1969 required CBA for regulatory programs; since then, other governments have enacted similar rules. Government guidebooks for the application of CBA to public policies include the Canadian guide for regulatory analysis, the Australian guide for regulation and finance, and the US guides for health-care and emergency-management programs.
Transportation investment
CBA for transport investment began in the UK with the
M1 motorway
The M1 motorway connects London to Leeds, where it joins the A1(M) near Aberford, to connect to Newcastle. It was the first inter-urban motorway to be completed in the UK; the first motorway in the country was the Preston By-pass, which ...
project and was later used for many projects, including the
London Underground
The London Underground (also known simply as the Underground or by its nickname the Tube) is a rapid transit system serving Greater London and some parts of the adjacent counties of Buckinghamshire, Essex and Hertfordshire in England.
The ...
's
Victoria line
The Victoria line is a London Underground line that runs between in south London and in the north-east, via the West End. It is printed in light blue on the Tube map and is one of the only two lines on the network to run completely underg ...
.
The
New Approach to Appraisal (NATA) was later introduced by the
Department for Transport, Environment and the Regions. This presented balanced cost–benefit results and detailed
environmental impact assessments. NATA was first applied to national road schemes in the 1998 Roads Review, and was subsequently rolled out to all transport modes. Maintained and developed by the
Department for Transport, it was a cornerstone of UK transport appraisal in 2011.
The
European Union
The European Union (EU) is a supranational political and economic union of member states that are located primarily in Europe. The union has a total area of and an estimated total population of about 447million. The EU has often been de ...
's Developing Harmonised European Approaches for Transport Costing and Project Assessment (HEATCO) project, part of the EU's
Sixth Framework Programme
The Framework Programmes for Research and Technological Development, also called Framework Programmes or abbreviated FP1 to FP9, are funding programmes created by the European Union/European Commission to support and foster research in the Europe ...
, reviewed transport appraisal guidance of EU member states and found significant national differences. HEATCO aimed to develop guidelines to harmonise transport appraisal practice across the EU.
Transport Canada
Transport Canada (french: Transports Canada) is the department within the Government of Canada responsible for developing regulations, policies and services of road, rail, marine and air transportation in Canada. It is part of the Transporta ...
promoted CBA for major transport investments with the 1994 publication of its guidebook. US federal and state transport departments commonly apply CBA with a variety of software tools, including HERS, BCA.Net, StatBenCost, Cal-BC, and
TREDIS. Guides are available from the
Federal Highway Administration
The Federal Highway Administration (FHWA) is a division of the United States Department of Transportation that specializes in highway transportation. The agency's major activities are grouped into two programs, the Federal-aid Highway Program ...
,
Federal Aviation Administration
The Federal Aviation Administration (FAA) is the largest transportation agency of the U.S. government and regulates all aspects of civil aviation in the country as well as over surrounding international waters. Its powers include air traffic ...
,
Minnesota Department of Transportation,
California Department of Transportation
The California Department of Transportation (Caltrans) is an executive department of the U.S. state of California. The department is part of the cabinet-level California State Transportation Agency (CalSTA). Caltrans is headquartered in Sacr ...
(Caltrans), and the
Transportation Research Board
The Transportation Research Board (TRB) is a division of the National Academy of Sciences, Engineering, and Medicine, formerly the National Research Council of the United States, which serves as an independent adviser to the President of the Uni ...
's Transportation Economics Committee.
Accuracy
In
health economics
Health economics is a branch of economics concerned with issues related to efficiency, effectiveness, value and behavior in the production and consumption of health and healthcare. Health economics is important in determining how to improv ...
, CBA may be an inadequate measure because willingness-to-pay methods of determining the value of human life can be influenced by income level. Variants, such as
cost–utility analysis Cost–utility analysis (CUA) is a form of economic analysis used to guide procurement decisions.
The most common and well-known application of this analysis is in pharmacoeconomics, especially health technology assessment (HTA).
In health econo ...
,
QALY
The quality-adjusted life year (QALY) is a generic measure of disease burden, including both the quality and the quantity of life lived. It is used in economic evaluation to assess the value of medical interventions. One QALY equates to one year ...
and
DALY to analyze the effects of health policies, may be more suitable.
For some environmental effects, cost–benefit analysis can be replaced by
cost-effectiveness analysis. This is especially true when one type of physical outcome is sought, such as a reduction in energy use by an increase in energy efficiency. Using cost-effectiveness analysis is less laborious and time-consuming, since it does not involve the monetization of outcomes (which can be difficult in some cases).
It has been argued that if modern cost–benefit analyses had been applied to decisions such as whether to mandate the removal of
lead
Lead is a chemical element with the symbol Pb (from the Latin ) and atomic number 82. It is a heavy metal that is denser than most common materials. Lead is soft and malleable, and also has a relatively low melting point. When freshly cu ...
from gasoline, block the construction of two proposed dams just above and below the
Grand Canyon on the
Colorado River
The Colorado River ( es, Río Colorado) is one of the principal rivers (along with the Rio Grande) in the Southwestern United States and northern Mexico. The river drains an expansive, arid watershed that encompasses parts of seven U.S. s ...
, and regulate workers' exposure to
vinyl chloride
Vinyl chloride is an organochloride with the formula H2C=CHCl. It is also called vinyl chloride monomer (VCM) or chloroethene. This colorless compound is an important industrial chemical chiefly used to produce the polymer polyvinyl chloride (PVC ...
, the measures would not have been implemented (although all are considered highly successful).
The US
Clean Air Act has been cited in retrospective studies as a case in which benefits exceeded costs, but knowledge of the benefits (attributable largely to the benefits of reducing
particulate pollution) was not available until many years later.
Process
A generic cost–benefit analysis has the following steps:
# Define the goals and objectives of the action.
# List alternative actions.
# List
stakeholders.
# Select measurement(s) and measure all cost and benefit elements.
# Predict outcome of costs and benefits over the relevant time period.
# Convert all costs and benefits into a common currency.
# Apply
discount rate.
# Calculate the
net present value
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...
of actions under consideration.
# Perform
sensitivity analysis
Sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be divided and allocated to different sources of uncertainty in its inputs. A related practice is uncertainty anal ...
.
# Adopt the recommended course of action.
Evaluation
CBA attempts to measure the positive or negative consequences of a project. A similar approach is used in the environmental analysis of
total economic value. Both costs and benefits can be diverse. Costs tend to be most thoroughly represented in cost–benefit analyses due to relatively-abundant market data. The net benefits of a project may incorporate cost savings, public
willingness to pay (implying that the public has no legal right to the benefits of the policy), or
willingness to accept compensation (implying that the public has a right to the benefits of the policy) for the policy's welfare change. The guiding principle of evaluating benefits is to list all parties affected by an intervention and add the positive or negative value (usually monetary) that they ascribe to its effect on their welfare.
The actual compensation an individual would require to have their welfare unchanged by a policy is inexact at best. Surveys (stated preferences) or market behavior (
revealed preferences) are often used to estimate compensation associated with a policy. Stated preferences are a direct way of assessing willingness to pay for an environmental feature, for example. Survey respondents often misreport their true preferences, however, and market behavior does not provide information about important non-market welfare impacts. Revealed preference is an indirect approach to individual willingness to pay. People make market choices of items with different environmental characteristics, for example, revealing the value placed on environmental factors.
The value of human life is controversial when assessing road-safety measures or life-saving medicines. Controversy can sometimes be avoided by using the related technique of cost–utility analysis, in which benefits are expressed in non-monetary units such as
quality-adjusted life year
The quality-adjusted life year (QALY) is a generic measure of disease burden, including both the quality and the quantity of life lived. It is used in economic evaluation to assess the value of medical interventions. One QALY equates to one year ...
s. Road safety can be measured in cost per life saved, without assigning a financial value to the life. However, non-monetary metrics have limited usefulness for evaluating policies with substantially different outcomes. Other benefits may also accrue from a policy, and metrics such as cost per life saved may lead to a substantially different ranking of alternatives than CBA.
Another metric is valuing the environment, which in the 21st century is typically assessed by valuing
ecosystem services
Ecosystem services are the many and varied benefits to humans provided by the natural environment and healthy ecosystems. Such ecosystems include, for example, agroecosystems, forest ecosystem, grassland ecosystems, and aquatic ecosystems. ...
to humans (such as air and
water quality
Water quality refers to the chemical, physical, and biological characteristics of water based on the standards of its usage. It is most frequently used by reference to a set of standards against which compliance, generally achieved through tr ...
and
pollution
Pollution is the introduction of contaminants into the natural environment that cause adverse change. Pollution can take the form of any substance (solid, liquid, or gas) or energy (such as radioactivity, heat, sound, or light). Pollutants, the ...
). Monetary values may also be assigned to other intangible effects such as business reputation, market penetration, or long-term enterprise strategy alignment.
Time and discounting
CBA generally attempts to put all relevant costs and benefits on a common temporal footing, using
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
calculations. This is often done by converting the future expected streams of costs (
) and benefits (
) into a
present value
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
amount with a
discount rate (
) and the net present value defined as:
The selection of a discount rate for this calculation is subjective. A smaller rate values the current generation and future generations equally. Larger rates (a market rate of return, for example) reflects human present bias or
hyperbolic discounting
In economics, hyperbolic discounting is a time-''inconsistent'' model of delay discounting. It is one of the cornerstones of behavioral economics and its brain-basis is actively being studied by neuroeconomics researchers.
According to the disc ...
: valuing money which they will receive in the near future more than money they will receive in the distant future. Empirical studies suggest that people discount future benefits in a way similar to these calculations. The choice makes a large difference in assessing interventions with long-term effects. An example is the
equity premium puzzle, which suggests that long-term returns on equities may be higher than they should be after controlling for risk and uncertainty. If so, market rates of return should not be used to determine the discount rate because they would undervalue the distant future.
Methods for choosing a discount rate
For publicly traded companies, it is possible to find a project's discount rate by using an equilibrium
asset pricing model to find the required
return on equity
The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on ''a ...
for the company and then assuming that the risk profile of a given project is similar to that the company faces. Commonly used models include the
capital asset pricing model (CAPM):