Cost–benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic process for calculating and comparing benefits and costs of a project, decision or government policy (hereafter, "project"). CBA has two purposes:
CBA is related to, but distinct from cost-effectiveness analysis. In CBA, benefits and costs are expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their "net present value."
Closely related, but slightly different, formal techniques include cost-effectiveness analysis, cost–utility analysis, economic impact analysis, fiscal impact analysis and Social return on investment (SROI) analysis.
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Cost–benefit analysis is often used by governments and others, e.g. businesses, to evaluate the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of foregone alternatives and the status quo, helping predict whether the benefits of a policy outweigh its costs, and by how much (i.e. one can rank alternate policies in terms of the ratio of costs and benefit). Altering the status quo by choosing the lowest cost-benefit ratio can improve pareto efficiency, in which no alternative policy can improve one group's situation without damaging another. Generally, accurate cost-benefit analysis identifies choices that increase welfare from a utilitarian perspective. Otherwise, cost-benefit analysis offers no guarantees of increased economic efficiency or increases of social welfare; generally positive microeconomic theory is moot when it comes to evaluating the impact on social welfare of a policy.
The following is a list of steps that comprise a generic cost-benefit analysis.[2]
CBA attempts to measure the positive or negative consequences of a project, which may include:
A similar breakdown is employed in environmental analysis of total economic value. Both costs and benefits can be diverse. Financial 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 or public willingness to pay compensation (implying the public has no legal right to the benefits of the policy) or willingness to accept compensation (implying the public has a right to the benefits of the policy) for the welfare change resulting from the policy. The guiding principle of evaluating benefits is to list all (categories of) 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 preference techniques) or market behavior (revealed preference techniques) are often used to estimate the compensation associated with a policy, however survey respondents often have strong incentives to misreport their true preferences and market behavior does not provide any information about important non-market welfare impacts.
One controversy is valuing a human life, e.g. when assessing road safety measures or life-saving medicines. However, this 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 years. For example, road safety can be measured in terms of cost per life saved, without formally placing a financial value on the life. However, such non-monetary metrics have limited usefulness for evaluating policies with substantially different outcomes. Additionally, many other benefits may accrue from the policy, and metrics such as 'cost per life saved' may lead to a substantially different ranking of alternatives than traditional cost-benefit analysis.
Another controversy is valuing the environment, which in the 21st century is typically assessed by valuing ecosystem services to humans, such as air and water quality and pollution. Monetary values may also be assigned to other intangible effects such as business reputation, market penetration, or long-term enterprise strategy alignment.
CBA usually tries to put all relevant costs and benefits on a common temporal footing using time value of money calculations. This is often done by converting the future expected streams of costs and benefits into a present value amount using a discount rate. Empirical studies and a technical framework[3] suggest that in reality, people do discount the future like this.
The choice of discount rate is subjective. A smaller rate values future generations equally with the current generation. Larger rates (e.g. a market rate of return) reflects humans' attraction to time inconsistency—valuing money that they receive today more than money they get in the future. The choice makes a large difference in assessing interventions with long-term effects, such as those affecting climate change. One issue is the equity premium puzzle, in which long-term returns on equities may be rather higher than they should be. If so then arguably market rates of return should not be used to determine a discount rate, as doing so would have the effect of undervaluing the distant future (e.g. climate change).
Risk associated with project outcomes is usually handled using probability theory. This can be factored into the discount rate (to have uncertainty increasing over time), but is usually considered separately. Particular consideration is often given to risk aversion—people usually consider a loss to have a larger impact than an equal gain, so a simple expected return may not take into account the detrimental effect of uncertainty.
Uncertainty in CBA parameters (as opposed to risk of project failure etc.) is often evaluated using a sensitivity analysis, which shows how results respond to parameter changes. Alternatively a more formal risk analysis can be undertaken using Monte Carlo simulations.[4]
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 the discount rate between countries. Agencies across the world rely on a basic set of key cost–benefit indicators, including the following:
The concept of CBA dates back to an 1848 article by Jules Dupuit and was formalized in subsequent works by Alfred Marshall. The practical application of CBA was initiated in the US by the Corps of Engineers, after the Federal Navigation Act of 1936 effectively required cost–benefit analysis for proposed federal waterway infrastructure.[5] The Flood Control Act of 1939 was instrumental in establishing CBA as federal policy. It specified the standard that "the benefits to whomever they accrue [be] in excess of the estimated costs.[6]
Use for Public Policy. The application of cost-benefit techniques for broader public policy started from the work of Otto Eckstein[7], who in 1958 laid out a welfare economics foundation for CBA and its application for water resource development. Over the 1960’s, CBA was applied in the US for water quality [8], recreation travel [9] and land conservation [10]. During this period, the concept of option value was developed to represent the non-tangible value of preserving resources such as national parks [11] . CBA was later expanded to address both intangible and tangible benefits of public policies relating to mental illness [12], substance abuse [13], college education [14] and chemical waste policies [15]. In the US, the National Environmental Policy Act of 1969 first required the application of CBA for regulatory programs, and since then, a variety of other governments have enacted similar rules. Government guidebooks for the application of CBA to public policies include the Canadian guide for regulatory analysis [16], Australian guide for regulation and finance,[17] US guide for health care programs,[18] and US guide for emergency management programs.[19]
Use for Transport Investment. CBA application for transport investment started in the UK, with the M1 motorway project in 1960. It was later applied for many projects including London Underground's Victoria Line. Later, 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.[12]
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.[13][14] [20]
CBA is also broadly used in North America. Transport Canada has promoted the use of CBA for major transport investments since the issuance of its Guidebook in 1994.[21] In the US, both federal and state transport departments commonly apply CBA, using a variety of available software tools including HERS, BCA.Net, StatBenCost, Cal-BC, and TREDIS. Available guides are provided by the Federal Highway Administration,[22][23] Federal Aviation Administration,[24] Minnesota Department of Transportation,[25] California Department of Transportation (Caltrans),[26] and the Transportation Research Board Transportation Economics Committee.[27]
The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs and benefits have been estimated. The public interest is an ever moving target containing a highly varied and complex set of interest based on the individual standing and/or stake holder role.
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. Inaccurate cost–benefit analyses likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks efficiency. These outcomes (almost always tending to underestimation unless significant new approaches are overlooked) are to be expected because such estimates:
Reference class forecasting was developed to increase accuracy in estimates of costs and benefits.[28]
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 because organizations or interest groups may think that some costs should be included or excluded from a study.
In the case of the Ford Pinto (where, because of 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) [15]. In the event, Ford overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (because it led to the recall anyway and to measurable losses in sales).
In the field of health economics, some analysts think cost–benefit analysis can be an inadequate measure because willingness-to-pay methods of determining the value of human life can be subject to bias according to income inequity. They support use of variants such as cost–utility analysis and quality-adjusted life year to analyze the effects of health policies.
In the case of environmental and occupational health regulation, it has been argued that if modern cost-benefit analyses had been applied prospectively to proposed regulations such as removing lead from gasoline, not turning the Grand Canyon into a hydroelectric dam, and regulating workers' exposure to vinyl chloride, these regulations would not have been implemented even though they are considered to be highly successful in retrospect.[30] The Clean Air Act has been cited in retrospective studies as a case where benefits exceeded costs, but the knowledge of the benefits (attributable largely to the benefits of reducing particulate pollution) was not available until many years later.[30]