1. COST BENEFIT ANALYSIS
OF A PROJECT
FINANCIAL MANAGEMENT PROJECT
SUBMITTED BY : BIDISHA MAHANTA
A3221510004, IV SEM
BBA LL.B.(H),2010-15
2. Contents
INTRODUCTION ............................................................................................................................3
HISTORY OF COST BENEFIT ANALYSIS.......................................................................................5
Public Policy...............................................................................................................................6
Transportation Investment............................................................................................................6
MAIN STAGES OF CBA ANALYSIS................................................................................................7
COST BENEFIT ANALYSIS EXAMPLE...........................................................................................9
Running The Numbers Means All The Numbers.....................................................................10
More Costs ..............................................................................................................................11
Accurate Cost Benefit Analysis................................................................................................12
PRINCIPLES OF COST BENEFIT ANALYSIS................................................................................13
CONCLUSION................................................................................................................................18
BIBLIOGRAPHY ............................................................................................................................19
3. ACKNOWLEDGEMENT
I would sincerely like to thank my Financial Management teacher, Shweta Arora Ma’am, for
giving me this highly extensive and interesting topic and guiding me through its compilation and
completion.
4. INTRODUCTION
Cost-Benefit Analysis (CBA) estimates and totals up the equivalent money value of the benefits
and costs to the community of projects to establish whether they are worthwhile. These projects
may be dams and highways or can be training programs and health care systems.
The idea of this economic accounting originated with Jules Dupuit, a French engineer whose
1848 article is still worth reading. The British economist, Alfred Marshall, formulated some of
the formal concepts that are at the foundation of CBA. But the practical development of CBA
came as a result of the impetus provided by the Federal Navigation Act of 1936. This act
required that the U.S. Corps of Engineers carry out projects for the improvement of the waterway
system when the total benefits of a project to whomsoever they accrue exceed the costs of that
project. Thus, the Corps of Engineers had create systematic methods for measuring such benefits
and costs. The engineers of the Corps did this without much, if any, assistance from the
economics profession. It wasn't until about twenty years later in the 1950's that economists tried
to provide a rigorous, consistent set of methods for measuring benefits and costs and deciding
whether a project is worthwhile. Some technical issues of CBA have not been wholly resolved
even now but the fundamental presented in the following are well established.
A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn
out. Although a cost benefit analysis can be used for almost anything, it is most commonly done
on financial questions. Since the cost benefit analysis relies on the addition of positive factors
and the subtraction of negative ones to determine a net result, it is also known as running the
numbers.
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 trick to doing a cost benefit
analysis well is making sure you include all the costs and all the benefits and properly quantify
them.
5. Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the
new stamping machine? Will we be better off putting our free cash flow into securities rather
than investing in additional capital equipment? Each of these questions can be answered by
doing a proper cost benefit analysis.
HISTORY OF COST BENEFIT ANALYSIS
CBA has its origins in the water development projects of the U.S. Army Corps of Engineers. The
Corps of Engineers had its orgins in the French engineers hired by George Washington in the
American Revolution. For years the only school of engineering in the United States was the
Military Academy at West Point, New York.
In 1879, Congress created the Mississippi River Commission to "prevent destructive floods."
The Commission included civilians but the president had to be an Army engineer and the Corps
of Engineers always had veto power over any decision by the Commission.
In 1936 Congress passed the Flood Control Act which contained the wording, "the Federal
Government should improve or participate in the improvement of navigable waters or their
tributaries, including watersheds thereof, for flood-control purposes if the benefits to
whomsoever they may accrue are in excess of the estimated costs." The phrase if the benefits to
whomsoever they may accrue are in excess of the estimated costs established cost-benefit
analysis. Initially the Corps of Engineers developed ad hoc methods for estimating benefits and
costs. It wasn't until the 1950s that academic economists discovered that the Corps had
developed a system for the economic analysis of public investments. Economists have influenced
and improved the Corps' methods since then and cost-benefit analysis has been adapted to most
areas of public decision-making.
6. Public Policy
The application for broader public policy started from the work of Otto Eckstein, 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, recreation
travel and land conservation. During this period, the concept of option value was developed to
represent the non-tangible value of preserving resources such as national parks.
CBA was later expanded to address both intangible and tangible benefits of public policies
relating to mental illness, substance abuse, college education and chemical waste policies. In the
US, the National Environmental Policy Act of 1969 first required the application of CBA for
regulatory programs, and 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, Australian guide for regulation and finance, US guide for health care
programs, and US guide for emergency management programs.
Transportation Investment
CBA application for transport investment started in the UK, with the M1 motorway project in
1960. It was later applied on 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 presented cost–benefit results and detailed
environmental impact assessments in a balanced way. NATA was first applied to national road
schemes in the 1998 Roads Review but subsequently rolled out to all transport modes. As of
2011 it was a cornerstone of transport appraisal in the UK and is maintained and developed by
the Department for Transport.
The EU's 'Developing Harmonised European Approaches for Transport Costing and Project
Assessment' (HEATCO) project, part of its Sixth Framework Programme, 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.
Transport Canada promoted the use of CBA for major transport investments with the 1994
issuance of its Guidebook.
7. 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. Guides
are available from the Federal Highway Administration, Federal Aviation
Administration, Minnesota Department of Transportation, California Department of
Transportation (Caltrans), and the Transportation Research Board Transportation Economics
Committee.
MAIN STAGES OF CBA ANALYSIS
At the heart of any investment appraisal decision is this basic question – does a planned project
lead to a net increase in social welfare?
o Stage 1(a) Calculation of social costs & social benefits. This would include calculation
of:
o Tangible Benefits and Costs (i.e. direct costs and benefits)
o Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)
o This process is very important – it involves trying to identify all of the significant costs &
benefits
o Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important question
- If you estimate that a possible benefit (or cost) is £x million, how likely is that
outcome? If you are reasonably sure that a benefit or cost will ‘occur’ – what is the scale
of uncertainty about the actual values of the costs and benefits?
8. o Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time.
Individuals normally prefer to enjoy the benefits now rather than later – so the value of
future benefits has to be discounted
o Stage 3: - Comparing the costs and benefits to determine the net social rate of return
o Stage 4: - Comparing net rate of return from different projects – the government may
have limited funds at its disposal and therefore faces a choice about which projects
should be given the go-ahead.
Evaluation: Criticisms of COBA
There are several objections to the use of CBA for environmental impact assessment:
1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such
as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are
more difficult – not least when a project has a significant impact on the environment. The
value attached to the destruction of a habitat is to some “priceless” and to others
“worthless”. Costs are also subject to change over time – I.e. the construction costs of a
new bridge over a river or the introduction of electronic road pricing
2. The CBA may not cover everyone affected (i.e. all third parties) – inevitably with major
construction projects such as a new airport or a new road, there are a huge number of
potential “stakeholders” who stand to be affected (positively or negatively) by the
decision. COBA cannot hope to include all stakeholders – there is a risk that some groups
might be left out of the decision process
a. Future generations – are they included in the analysis?
b. What of “non-human” stakeholders?
1. Distributional consequences: Costs and benefits mean different things to different income
groups - benefits to the poor are usually worth more (or are they?). Those receiving
benefits and those burdened with the costs of a project may not be the same. Are the
losers to be compensated? To many economists, the equity issue is as important as the
efficiency argument.
9. 2. Social welfare is not the same as individual welfare - What we want individually may not
be what we want collectively. Do we attach a different value to those who feel
“passionately” about something (for example the building of new housing on greenfield
sites) contrasted with those who are more ambivalent?
3. Valuing the environment: How are we to place a value on public goods such as the
environment where there is no market established for the valuation of “property rights”
over environmental resources? How does one value “nuisance” and “aesthetic values”?
4. Valuing human life: Some measurements of benefits require the valuation of human life –
many people are intrinsically opposed to any attempt to do this. This objection can be
partly overcome if we focus instead on the probability of a project “reducing the risk of
death” – and there are insurance markets in existence which tell us something about how
much people value their health and life when they take out insurance policies.
5. Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically modified foods
a. Precautionary Principle: Assume toxicity until proven safe
1. If in doubt, then regulate
b. Free Market Principle: Assume it is safe until a hazard is identified
1. If in doubt, do not regulate.
Despite these problems, most economists argue that CBA is better than other ways of including
the environment in project appraisal.
COST BENEFIT ANALYSIS EXAMPLE
As the Production Manager, you are proposing the purchase of a Rs.1 Million stamping machine
to increase output. Before you can present the proposal to the Vice President, you know you need
10. 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.
Running The Numbers Means All The Numbers
Lets look at the benefits first. Don't use the selling price of the units to calculate the value. Sales
price includes many additional factors that will unnecessarily complicate your analysis if you
include them, not the least of which is profit margin. Instead, get the activity based value of the
11. units from accounting and use that. You remembered to add the value of the increased quality by
factoring in the average reject rate, but you may want to reduce that a little because even the
machine won't always be perfect. Finally, when calculating the value of replacing three
employees, in addition to their salaries, be sure to add their overhead costs, the costs of their
benefits, etc., which can run 75-100% of their salary. Accounting can give you the exact number
for the workers' "fully burdened" labor rates.
In addition to properly quantifying the benefits, make sure you included all of them. For
instance, you may be able to buy feed stock for the machine in large rolls instead of the
individual sheets needed when the work is done by hand. This should lower the cost of material,
another benefit.
As for the cost of the machine, in addition to it's purchase price and any taxes you will have to
pay on it, you must add the cost of interest on the money spent to purchase it. The company may
purchase it on credit and incur interest charges, or it may buy it outright. However, even if it
buys the machine outright, you will have to include interest charges equivalent to what the
company could have collected in interest if it had not spent the money.
Check with finance on the amortization period. Just because the machine may last 10 years,
doesn't mean the company will keep it on the books that long. It may amortize the purchase over
as little as 4 years if it is considered capital equipment. If the cost of the machine is not enough
to qualify as capital, the full cost will be expensed in one year. Adjust your monthly purchase
cost of the machine to reflect these issues. You have the electricity cost figured out but there are
some cost you missed too.
More Costs
The typical failure of a cost benefit analysis is not including all the costs. In the case of the
stamping machine, here are some of the overlooked costs:
Floor Space
Will the machine fit in the same space currently occupied by the three workers?
12. Installation
What will it cost to remove the manual stampers and install the new machine? Will you have
to cut a hole in a wall to get it in or will it fit through the door? Will you need special rollers
or machinists with special skills to install it?
Operator?
Somebody has to operate the machine. Does this person need special training? What will the
operator's salary, including overhead, cost?
* Environment
Will the new machine be so noisy that you have to build soundproofing around it? Will the
new machine increase the insurance premiums for the company?
Accurate Cost Benefit Analysis
Once you have collected ALL the positive and negative factors and have quantified them you
can put them together into an accurate cost benefit analysis.
Some people like to total up all the positive factors (benefits), total up all the negative factors
(costs), and find the difference between the two. I prefer to group the factors together. It makes it
easier for you, and for anyone reviewing your work, to see that you have include all the factors
on both sides of the issues that make up the cost benefit analysis. For the example above, our
cost benefit analysis might look something like this:
Cost Benefit Analysis - Purchase of New Stamping Machine
(Costs shown are per month and amortized over four years)
1. Purchase of Machine .................... -Rs.20,000
includes interest and taxes
2. Installation of Machine ..................... -3,125
including screens & removal of existing stampers
3. Increased Revenue .......................... 27,520
net value of additional 100 units per hour, 1 shift/day, 5 days/week
13. 4. Quality Increase Revenue ..................... 358
calculated at 75% of current reject rate
5. Reduced material costs ...................... 1,128
purchase of bulk supply reduces cost by Rs.0.82 per hundred
6. Reduced Labor Costs ....................... 18,585
3 operators salary plus labor o/h
7. New Operator ................................. -8,321
salary plus overhead. Includes training
8. Utilities ............................................ -250
power consumption increase for new machine
9. Insurance ......................................... -180
premiums increase
10. Square footage ...................................... 0
no additional floor space is required
Net Savings per Month ........................... Rs.15,715
Your cost benefit analysis clearly shows the purchase of the stamping machine is justified. The
machine will save your company over Rs.15,000 per month, almost Rs.190,000 a year.
This is just one example of how you can use cost benefit analysis determine the advisability of a
course of action and then to support it once you propose the action.
PRINCIPLES OF COST BENEFIT ANALYSIS
One of the problems of CBA is that the computation of many components of benefits and costs is
intuitively obvious but that there are others for which intuition fails to suggest methods of
measurement. Therefore some basic principles are needed as a guide.
14. There Must Be a Common Unit of Measurement
In order to reach a conclusion as to the desirability of a project all aspects of the project, positive
and negative, must be expressed in terms of a common unit; i.e., there must be a "bottom line."
The most convenient common unit is money. This means that all benefits and costs of a project
should be measured in terms of their equivalent money value. A program may provide benefits
which are not directly expressed in terms of dollars but there is some amount of money the
recipients of the benefits would consider just as good as the project's benefits. For example, a
project may provide for the elderly in an area a free monthly visit to a doctor. The value of that
benefit to an elderly recipient is the minimum amount of money that that recipient would take
instead of the medical care. This could be less than the market value of the medical care
provided. It is assumed that more esoteric benefits such as from preserving open space or historic
sites have a finite equivalent money value to the public.
Not only do the benefits and costs of a project have to be expressed in terms of equivalent money
value, but they have to be expressed in terms of dollars of a particular time. This is not just due
to the differences in the value of dollars at different times because of inflation. A dollar available
five years from now is not as good as a dollar available now. This is because a dollar available
now can be invested and earn interest for five years and would be worth more than a dollar in
five years. If the interest rate is r then a dollar invested for t years will grow to be (1+r)t.
Therefore the amount of money that would have to be deposited now so that it would grow to be
one dollar t years in the future is (1+r)-t. This called the discounted value or present value of a
dollar available t years in the future.
When the dollar value of benefits at some time in the future is multiplied by the discounted value
of one dollar at that time in the future the result is discounted present value of that benefit of the
project. The same thing applies to costs. The net benefit of the projects is just the sum of the
present value of the benefits less the present value of the costs.
The choice of the appropriate interest rate to use for the discounting is a separate issue that will
be treated later in this paper.
15. CBA Valuations Should Represent Consumers or Producers
Valuations As Revealedby Their Actual Behavior
The valuation of benefits and costs should reflect preferences revealed by choices which have
been made. For example, improvements in transportation frequently involve saving time. The
question is how to measure the money value of that time saved. The value should not be merely
what transportation planners think time should be worth or even what people say their time is
worth. The value of time should be that which the public reveals their time is worth through
choices involving tradeoffs between time and money. If people have a choice of parking close to
their destination for a fee of 50 cents or parking farther away and spending 5 minutes more
walking and they always choose to spend the money and save the time and effort then they have
revealed that their time is more valuable to them than 10 cents per minute. If they were
indifferent between the two choices they would have revealed that the value of their time to them
was exactly 10 cents per minute.
The most challenging part of CBA is finding past choices which reveal the tradeoffs and
equivalencies in preferences. For example, the valuation of the benefit of cleaner air could be
established by finding how much less people paid for housing in more polluted areas which
otherwise was identical in characteristics and location to housing in less polluted areas.
Generally the value of cleaner air to people as revealed by the hard market choices seems to be
less than their rhetorical valuation of clean air.
Benefits Are Usually Measuredby Market Choices
When consumers make purchases at market prices they reveal that the things they buy are at least
as beneficial to them as the money they relinquish. Consumers will increase their consumption of
any commodity up to the point where the benefit of an additional unit (marginal benefit) is equal
to the marginal cost to them of that unit, the market price. Therefore for any consumer buying
some of a commodity, the marginal benefit is equal to the market price. The marginal benefit
will decline with the amount consumed just as the market price has to decline to get consumers
to consume a greater quantity of the commodity. The relationship between the market price and
the quantity consumed is called the demand schedule. Thus the demand schedule provides the
16. information about marginal benefit that is needed to place a money value on an increase in
consumption.
Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve
The increase in benefits reulting from an increase in consumption is the sum of the marginal
benefit times each incremental increase in consumption. As the incremental increases considered
are taken as smaller and smaller the sum goes to the area under the marginal benefit curve. But
the marginal benefit curve is the same as the demand curve so the increase in benefits is the area
under the demand curve. As shown in Figure 1 the area is over the range from the lower limit of
consumption before the increase to consumption after the increase.
Figure 1
When the increase in consumption is small compared to the total consumption the gross benefit
is adequately approximated, as is shown in a welfare analysis, bythe market value of the increased
consumption; i.e., market price times the increase in consumption.
Some Measurements of Benefits Require the Valuation of Human Life
17. It is sometimes necessary in CBA to evaluate the benefit of saving human lives. There is
considerable antipathy in the general public to the idea of placing a dollar value on human life.
Economists recognize that it is impossible to fund every project which promises to save a human
life and that some rational basis is needed to select which projects are approved and which are
turned down. The controversy is defused when it is recognized that the benefit of such projects is
in reducing the risk of death. There are many cases in which people voluntarily accept increased
risks in return for higher pay, such as in the oil fields or mining, or for time savings in higher
speed in automobile travel. These choices can be used to estimate the personal cost people place
on increased risk and thus the value to them of reduced risk. This computation is equivalent to
placing an economic value on the expected number of lives saved.
The Analysis of a Project Should Involve a With Versus Without Comparison
The impact of a project is the difference between what the situation in the study area would be
with and without the project. This that when a project is being evaluated the analysis must
estimate not only what the situation would be with the project but also what it would be without
the project. For example, in determining the impact of a fixed guideway rapid transit system such
as the Bay Area Rapid Transit (BART) in the San Francisco Bay Area the number of rides that
would have been taken on an expansion of the bus system should be deducted from the rides
provided by BART and likewise the additional costs of such an expanded bus system would be
deducted from the costs of BART. In other words, the alternative to the project must be explicitly
specified and considered in the evaluation of the project. Note that the with-and-without
comparison is not the same as a before-and-after comparison.
Another example shows the importance of considering the impacts of a project and a with-and-
without comparison. Suppose an irrigation project proposes to increase cotton production in
Arizona. If the United States Department of Agriculture limits the cotton production in the U.S.
by a system of quotas then expanded cotton production in Arizona might be offset by a reduction
in the cotton production quota for Mississippi. Thus the impact of the project on cotton
production in the U.S. might be zero rather than being the amount of cotton produced by the
project.
18. CONCLUSION
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. Causes of these inaccuracies include:
1. Overreliance on data from past projects (often differing markedly in function or size and
the skill levels of the team members)
2. Use of subjective impressions by assessment team members
3. Inappropriate use of heuristics to derive money cost of the intangible elements
4. Confirmation bias among project supporters (looking for reasons to proceed)
Reference class forecasting was developed to increase accuracy in estimates of costs and
benefits.
Interest groups may attempt to include or exclude significant costs from an analysis to influence
the outcome.
In 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 influenced by
income level. They support use of variants such as cost–utility analysis and quality-adjusted life
year to analyze the effects of health policies.
In environmental and occupational health regulation, it has been argued that if modern cost-
benefit analyses had been applied prospectively to decisions such as removing lead from
gasoline, building Hoover Dam in the Grand Canyon and regulating workers' exposure to vinyl
chloride, they would not have been implemented even though they are considered to be highly
successful in retrospect. 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.
