The document provides an overview of cost-benefit analysis (CBA) as a tool for evaluating projects, particularly in the context of government decision-making regarding social and economic policies in Africa. It discusses the distinctions between financial and economic CBA, emphasizing the importance of considering externalities and the broader impacts on society beyond private profitability. Key elements of conducting a CBA include identifying costs and benefits, quantifying impacts, and applying decision criteria such as net present value and internal rate of return.

1. Cost‐Benefit Analysis As Project Evaluation Tool
Workshop on Strengthening Capacity for Strategic Agricultural Policy
and Investment Planning and Implementation in Africa
Safari Park Hotel, Nairobi on 25th‐ 26th April 2012
Paul Guthiga, ReSAKSS‐ECA

2. An Overview of CBA…1
Decision‐making at…
• An individual; intuition, or some analysis
• For a private entity (say company)
– Profit motive hence… full financial appraisal of the
project.
• For the Government; more difficult
– Not just profitability but social cost and benefits of
their choices.
– Other considerations; equity, environmental
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3. An Overview of CBA…4
• CBA is a tool primarily used by governments in
making their social and economic decisions.
• It also considers activities that are not normally
priced by the market (externalities)
• Attempts to quantify and include in estimates of
cost and benefits not just to individual and private
entities but also to rest of community.
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4. An Overview of CBA…2
• Development interventions often involve huge costs
• These costs should be quantified and compared with the
potential or actual benefits
• Can be done through use of a CBA which could be
conducted ex ante and/or ex post
• CBA is not done on a before‐and‐after basis but on a
‘with’ and ‘without’ project basis (to avoid over/under‐
estimation)
• Ultimate measure is the incremental net benefit of the
project

5. An Overview of CBA…3
• Involves comparing costs and benefits from different
time periods
• Money values across time periods are not
immediately comparable; why?
• …because of inflation and returns in the market
• Hence the need to discount future costs and benefits

6. Theoretical foundations of CBA…1
• a) The preferences of individuals are to be taken as
the source of value.
• b) Preferences are measured by a willingness to pay
(WTP) for a benefit and a willingness to accept
compensation (WTA compensation) for a cost.
• c) Individuals’ preferences can be aggregated so that
social benefit = the sum of all individuals’ benefits
and social cost is the sum of all individuals’ costs.

7. Theoretical foundations of CBA…2
• d) If beneficiaries from a change can
‘hypothetically’ compensate the losers from a
change, and have some net gains left over, then
the basic test that benefits exceed costs is met.
• The theoretical concept (d) above is the Kaldor‐
Hicks principle of potential compensation…
• …if the gainers from an action could compensate
the losers, the action is an improvement
regardless of whether compensation is actually
paid.

8. Theoretical foundations of CBA…3
• Provided that compensation could occur then
no one is actually worse off…
• the Pareto‐criterion for improvement in
overall well‐being is met.

9. Limitations of CBA…1
• CBA fails to explicitly account for distribution of
benefits in the society (equity)
• Attempts to integrate distributive issues in CBA by
applying weighting factors to benefits or costs to
reflect the income of individual affected
• The theoretical arguments for these weights are
based on the declining marginal utility of income

10. Limitations of CBA…2
• Some CBA practitioners feel that inclusions of equity
goals fall outside the realm of economics
• But…possibility to track the distribution of costs and
benefits among the various segments of society.

11. Financial versus Economic CBA…1
• Financial CBA is carried out from the perspective of a
private point of view
• Key question; does a project have a sufficiently high
return on investment for a private entity to be worth
implementing.
• A positive outcome of financial CBA means that a
project is profitable to an investor.
• However, projects that may seem appealing to a
private investor…may be unattractive to a country as
a whole.
• Hence the need for an economic CBA.

12. Financial versus Economic CBA…2
• All benefits and costs to society, or all impacts on real
national income, are taken into account in economic
CBA
• An economic CBA will have to be conducted only
when there are reasons to believe that the outcomes
will differ from financial CBA.
• When does this occur;
– This is the case when taxes are levied/subsidies granted,
– External effects exist and/or
– prices are distorted (do not reflect their real scarcity).

13. Financial versus Economic CBA…3
• To transform a financial CBA into an
economic CBA three groups of adjustments
have to be made:
– Step 1: transfers (taxes, subsidies) are to be
removed;
– Step 2: all positive and negative external effects
have to be included;
– Step 3: market prices of goods and services have
to be replaced by economic prices;

14. Financial versus Economic CBA…4
• Financial CBA may give artificially positive outcomes;
when subsidies are more important than taxation.
• Subsidization; e.g. cheap fertilizer to farmers.
• Makes farmers production costs to be lower than
those of imported commodities, hence artificially high
financial NPV/IRRs.
• Subsidies should be ignored in an economic analysis.
• The economic IRR will, all other things assumed equal,
be lower than the financial IRR.

15. Financial versus Economic CBA…5
• Low profitability resulting in financial CBA may be
caused by excessive taxation
• Tax payments are part of a project's costs, and
therefore negatively affect the financial
profitability.
• For instance, if in the financial CBA of a firm the
import costs of US$ 0.5m for raw materials include
a 25% import tariff..
• The corresponding cost to the nation in economic
terms is just US$ 0.375m.

16. Financial versus Economic CBA…6
• Prices play an essential role in CBA, because the
method requires that all effects are recorded in
monetary terms
• Financial CBA applies actual, domestic market prices;
• Whether these are free‐market prices, or the result
of government intervention is of no importance to
private decision‐makers.
• In economic CBA, that question is elementary.
• Prices in economic CBA should give a comprehensive
picture of the value to society (a measure of their
scarcity).

17. Financial versus Economic CBA…7
• If market prices fail to do so, if they are distorted,
and economic CBA prescribes that prices are
replaced by economic (or accounting or shadow)
prices.
• These prices are not observed in reality, but
calculated on the basis of the concept of opportunity
costs.

18. STEPS OF CARRYING OUT CBA

19. Steps…1
1. Identifying the resources being reallocated in a
given project or activity as well as the gainers and
the losers in that process (set the boundary of the
analysis);
2. Identifying the economically relevant impacts of the
project/activity implementation.
3. Group them into positive impacts (benefits) and
negative impacts (costs).

20. Typical costs and benefits….
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21. Steps…2
4. The identified impacts are physically
quantified and assigned a monetary value.
5. The decision criteria are applied once the net
benefits are discounted.
The decision criteria include NPV; Internal Rate of Return
(IRR) or Benefit‐Cost ratio (B‐C ratio)
Any course of action is judged acceptable if it confers a
net benefit (present value of benefits outweighs the
present value of costs)

22. Steps…3
6. Finally, sensitivity analysis is carried out to capture
the different possible scenarios.
How? By varying the discount rate, time frame or policy
scenarios.

23. Decision‐Criteria…1
• Net present value/worth
If NPV(W) >0; B/C>1 the project is worthwhile

24. Decision‐Criteria…2
Decision rule; largest IRR above cut‐off rate (many
projects can give multiple IRRs from the same data set
and cannot decide among many projects)

25. Critical issues in CBA

26. Discount rate…1
• The concepts of discounting and choice of a
discount rate are controversial in CBA
• Discounting & discount rate has implications
for future benefits and costs
• Decisions on implementation of long term
projects depend on the choice of discount
rate.
• Implication of discounting;
– Benefits and costs long in future are weighed less;
higher the time bias.

27. Discount rate…2
• From an economic perspective, discount rate is the
rate at which society weighs future consumption
against present consumption, or..
• Rate by which it attaches a social time preference to
consumption by its members.
• From a financial perspective the discount rate
is the prevailing interest rate..
• Which one would be higher and why?

28. Discount rate…3
• The process of discounting is defended by
economists as reflecting the way people value
things….
– Positive rate of time preference (for both consumers
and producers) and…
– Opportunity cost of capital (for producers) the future
is treated as less important than the present.
• In practice the choice of the discount rate is the
onus of the researcher guided by various
considerations such as;
– The discount rates applied for government agencies
– The length of the project time considered
– Opportunity cost of capital in the country/area

29. Time horizon
• An important consideration in CBA
• From private individual perspective…it is the most
relevant time horizon is the part of their lifetime that
they are likely to benefit from the project.