COST BENEFIT ANALYSIS

INTRODUCTION:Costbenefit analysis (CBA), sometimes called benefitcost 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: 1. To determine if it is a sound investment/decision (justification/feasibility), 2. To provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much. CBA is related to, but distinct from cost-effectiveness analysis. In CBA, benefits and costs are expressed in monetary 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." This analysis is often used by governments and other organizations, such as private sector 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. CBA helps predict whether the benefits of a policy outweigh its costs, and by how much relative to other alternatives (i.e. one can rank alternate policies in terms of the cost-benefit ratio). Generally, accurate cost-benefit analysis identifies choices that increase welfare from a utilitarian perspective. Assuming an accurate CBA, changing the status quo by implementing the alternative with the lowest cost-benefit ratio can improve Pareto efficiency. An analyst using CBA should recognize that perfect evaluation of all present and future costs and benefits is difficult, and while CBA can offer a well-educated estimate of the best alternative, perfection in terms of economic efficiency and social welfare are not guaranteed.

What is Cost Benefit Analysis?

CBA has been established primarily as a tool for use by governments in making their social and economic decisions. CBA measures costs and benefits to the community of adopting a particular course of action e.g. Constructing a dam, by-pass etc. CBA is a decision making device for evaluating activities that are not priced by the market. CBA attempts to simulate a market result in areas where the market does not operate to establish prices OR attempts to quantify and include in estimates of cost and benefits to client but also to rest of community.

Decision making is about choices

For an individual They might rely on intuition, a gut feel for the right choice. They decide to do an analysis of the choices or it may be a combination of both of these. For a company Being concerned with the profit earning capacity and income flow, they may undertake a cash flow analysis or a full financial appraisal of the project. For the Government Decision making for governments is much harder. Not only are they expected to consider the profitability (or at least neutrality) of the costing but must also include consideration of the social cost and benefits of their choices. They are also expected to act within the political environment to satisfy the political agenda set by the government of the day and finally, must also comply with environmental considerations.

Other issues :
Is the project worthwhile financially? Is it the best option? Should it be undertaken at all?

 Costs of a project can be divided into three areas :

Social cost: being the sum total of costs involved as the result of an economic action Private costs: Those that affect the decisions of the performers ( production costs including, labor, materials, lands and capital) External Costs: Resulting from damage to buildings or decline of property values through smoke emanating from a factory, etc.

Measurement Problems
Difficulties encounter in measuring intangible costs such as foul atmosphere or intangible benefits such as a peaceful neighbourhood.

 Assuming several other costs & benefits associated with the activities; and estimating the costs and benefits involves. Affects by Market condition, state of economy etc. Uneven distribution of benefit to community

Time Problems
Tackling future time problems by discounting future costs and benefits. OR calculating the correct rate for future dollar value as well as accounting for additional benefits and costs associated.

CBA unlikely to be a useful technique unless two main conditions are met: investment must be sufficiently large or important to merit time and cost of CBA.

Social and other intangible costs and/or benefits must be prospectively and sufficiently large for selection by cost-in-use or investment appraisal to be invalid.

The following is a list of steps that comprise a generic cost-benefit analysis. 1. List alternative projects/programs. 2. List stakeholders. 3. Select measurement(s) and measure all cost/benefit elements. 4. Predict outcome of cost and benefits over relevant time period. 5. Convert all costs and benefits into a common currency.
6. 7. 8.

Apply discount rate. Calculate net present value of project options. Perform sensitivity analysis.

9. Adopt recommended choice.

Method
Identify all possible alternatives. Prepare table showing life of the project i.e. year to year basis. Establish Cost of project during the year including capital, operating and maintenance costs, social and other tangible costs Establish total benefits to be obtained from project by way of sales of goods and services including value of social benefits.

Cost calculated at rate of interest such that NPV=Zero Ranking in order of [benefit-cost] or [benefit / cost]

VALUATION:
CBA attempts to measure the positive or negative consequences of a project, which may include: 1. Effects on users or participants 2. Effects on non-users or non-participants
3. 4.

Externality effects Option value or other social benefits.

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.

Establishing a steel production plant in a port community: Costs (-)

Construction. Pollution. Devaluing house prices etc. Benefits (+) employment

 increase port trade steel for local industry

Establishing a brick production plant in a community

Identify the problem Identify the sectors affected:

local authorities developer existing occupiers proposed occupiers local community Identify the costs and benefits Quantify the costs and benefits Summarise conclusion

Example of Costs and Benefits of the dam

Costs

The dam is completed in five years at a cost of $200,000,000. Inflation in the interim period is estimated to be 5%. Discounted to Present value = 0.7352 x $0.2 billion = $156,704,000 Benefit The dam will not start to provide benefits until the water is used for irrigation and crop yields improve. Let us assume this will be in seven years time and the value of this benefit is $100,000,000

per year in future values. We will keep the same inflation rate for ease of comparison

Let us first assume a calculation period for the CBA only covers seven years: Discounted to present value = 0.71068 x $0.1 billion = $71,068,000 Conclusion: Based on a seven year time span Costs = $157 million Benefits = $71 million Conclude that Project is not acceptable

Let us consider a ten year time span: Benefit: Discount $100,000,000 In year 7 = $100,000,000 x 0.71068 In year 8 = $100,000,000 x 0.67683 In year 9 = $100,000,000 x 0.64460 In year 10 = $100,000,000 x 0.61391 Total present value = 265,000,000 Conclusion: Based on a seven year time span Costs = $157 million

Benefits = $265 million

Conclude that Project is acceptable

Time and Discounting

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 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 inconsistencyvaluing 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).

LITERATIVE SURVEY :

The concept of CBA dates back to an 1848 article by Jules Dupuit and was formalized in subsequent works by Alfred Marshall. The Corps of Engineers initiated the use of CBA in the US, after the Federal Navigation Act of 1936 effectively required cost benefit analysis for proposed federal waterway infrastructure. The Flood Control Act of 1939 was instrumental in establishing CBA as federal policy. It demanded that "the benefits to whomever they accrue [be] in excess of the estimated costs. The value of a costbenefit 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).

Cost-benefit evaluation techniques help analysts, managers and other decision-makers assess the economic efficiency of an activity or program. Analysts in business, government and other settings use cost-benefit techniques to gauge efficiency and guide investment and policy decisions. Despite its popularity, cost-benefit analysis remains controversial, especially in public programs, because of the difficulty in measuring the intangible benefits of many programs.

(i) Features:
Cost-benefit analysis techniques require analysts to estimate the tangible and intangible benefits of a program, initiative or investment, and compare them with the costs of undertaking the action. Evaluation techniques require expressing the costs and benefits in a common measure for comparison purposes, usually in monetary figures. Because this analysis requires expressing costs and benefits in financial terms, cost-benefit techniques are the least controversial when evaluating industrial and technical projects.

Considerations:
The challenges of cost-benefit evaluation are not limited to assigning monetary values to benefits and results that are difficult to measure by price. When assessing the costs of an activity or program, it is important to consider not only the direct and indirect costs, such as salaries and materials, but also the opportunity costs or the foregone opportunities resulting from allocating resources to the activity in question rather than an alternative project.

ADVANTAGES OF COSTS AND BENEFIT ANALYSIS:l

A cost-benefit analysis is a business activity that examines the positive and negative effects of a particular project or activity. The costs of the project include all the money the business must spend on the project, including both fixed and continual costs (as well as the opportunity cost of not spending the funds in other areas). The benefits of the project include all the profit the business will make by the end of the project. There are several advantages to this simple form of business analysis.

Examining Futures
A cost-benefit analysis makes it easy to examine the worth of a project. Project planners may have high hopes for their ideas, but the cost-benefit analysis takes each factor of the project and examines its factual costs and benefits. Forecasts are still used, but analysts do not guess at figures. The result is an accurate look at the final effects the project will have, making it easier for the business to decide whether it is worth spending funds on. Costbenefit analysis can show that a project will actually cost more than the revenue it will produce, showing a clear problem.

Exploring Unknown Factors

A cost-benefit analysis requires that all aspects of the project are thoroughly examined and have values tied to them. For some aspects, costs are already known and easy to figure out. But the analysis also gives planners the chance to examine factors of the project they have not fully thought out or researched enough. Sometimes this extra research can yield surprising results, showing a way the project could be even more efficient or changing the direction of the project because of unforeseen costs.

Flexibility
Because the cost-benefit analysis is so simple, it is easy for businesses to mold it to their own purposes. Some organizations may prefer to assign monetary values to all aspects of the project. Other projects are designed to bring the business benefits other than money, such as added skills for employees or a better reputation among customers--intangible factors that analysts can use formulas to explore and assign values to.

 Winning Commitment
One of the greatest benefits of the cost-benefit analysis is the effect it has on the management levels that make decisions regarding the projects. Often these business leaders are interested in seeing the bottom line and making decisions based on the end result of the project. The analysis allows them to examine this bottom line free of extemporaneous details, making it easier to win their commitment to the project.

There are four steps for cost/benefit analysis.

1.costs and benefits identification 2.classification of costs and benefits 3.Select evaluation method 4.Interpret results of the analysis and final action

Costs and benefits identification

There are two types of identification-easily identifiable and non-identifiable. In easily identifiable the costs and benefits can easily identify from company invoice payments or canceled checks. Example for this is direct costs and direct benefits. In the second type, the costs and benefits are not easily identifiable. Example for this is opportunity costs and benefits. These are the costs or benefits forgone by selecting one alternative over another. They do not show in the organization accounts and therefore are not easy to identify.

Classifications of costs and benefits.

There are three classifications 1. Tangible or intangible costs and benefits 2. Direct or indirect costs and benefits 3. Fixed and variable costs and benefits. 1. Tangible or intangible: Tangible costs and benefits are those that can be easily identified and measured. Ex for tangible costs are Purchase of hardware and software, personnel training, employee salaries.ex for tangible benefits are completing jobs in fewer hours, producing report with no errors. Intangible costs and benefits are those that cannot be easily identifiable and measured accurately. Ex for in table costs are employee morale problem caused by new system, lowered company image. Ex for intangible benefits are more satisfied customers.

2.Direct or indirect Direct costs and benefits are those functions that are directly applied to the operation Ex for direct costs is purchase of a box of diskettes. A new system that can handle 25 percent more transactions per day is a direct benefit. Indirect costs and benefits are those whose results of the operations that are not directly associated with given system or activity. Indirect costs are referred to as overhead. Ex-indirect costs are insurance, maintenance, and protection of computer center, air conditioning. Indirect benefits are defined as a by-product of another activity or system. 3.Fixed or variable Fixed costs and benefits are constant, they do not change. Fixed costs are insurance.ex for fixed benefits is decrease in a number of personnel by 20 percent resulting from the use of a new computer. Variable costs and benefits are changeable. They are not constant

Select evaluation method

When all the financial data have been identified and broken down into cost categories, the analyst must select a method of evaluation. Several evaluation methods are available. The common methods are 1.Net benefit analysis 2.present value analysis 3.net present value 4.payback analysis 5.break-even analysis 6.cash flow analysis 1. Net benefit analysis: Net benefit analysis simply involves subtracting total costs from total benefits. It is easy to calculate, easy to interpret, easy to present. The main disadvantage is it does not account for the time value of the money and does not discount future cash flow. 2.Present value analysis: The formula for finding present value analysis is P=f/(1+I)n

Where p=present value of investment F=future value of an investment , I=interest rate , n=number of years 3.Net present value: The net present value is equal to discounted benefits minus discounted costs. This value is relatively easy to calculate and accounts for the time value of money. 4. Payback analysis The payback method is a common measure of the relative time value of a project. It determines the time it takes for the accumulated benefits equal to the initial investment. Obviously, the shorter the payback period, the sooner a profit is realized .This is calculated by Overall cost outlay/annual cash return. 5.Break-even analysis This method compares costs of the current system and costs of the candidate system. When these both costs are equal then it is called break even .if the cost of candidate system exceeds the costs of existing system then it is called investment period. If the cost of candidate system is less than the existing system then it is called return period. 6.Cash flow analysis Cash flow analysis keeps track of accumulated costs and revenues on a regular basis.i.e it will collect detailed information about the flow of cash in the system. Interpret results of the analysis and final action When the evaluation of the project is complete, the results have to be interpreted. This entails comparing actual results against a standard or the result of an alternative investment. After comparing the final action is to select the best candidate system. In summary cost/benefit, analysis is a tool for evaluating projects rather than a replacement of the decision maker. Like any other tool, however, it has problems 1.valuation problems. Intangible costs and benefits are difficult to quantify and tangible costs are generally more pronounced than tangible benefits. 2.Distortion problems. There are two waysides distorting the results of cost/benefit analysis. One is the intentional favoritism of an alternative for political reasons. The second is when data are incomplete or missing from the analysis.

3. Completeness problems. Occasionally an alternative is overlooked that compromises the quality of the final choice. Furthermore, the costs related to cost/benefit analysis may be on the high side or not enough costs may be considered to do a complete analysis

REFERENCE:
This term paper is made by a synchronous Gatsby of various reference books, course books, and internet websites.

The sources of information includes: .) Wikipedia