You are on page 1of 26

COST-BENEFIT

ANALYSIS
PRESENTED BY:P.M.NAYAK


―It is best to think of the cost-benefit approach as a way
of organizing thought rather than as a substitute for it.‖

— Michael Drummond
Cost-Benefit Analysis
Cost-benefit analysis (CBA) is the implicit or
explicit assessment of the benefits and costs
(i.e., pros and cons, advantages and
disadvantages) associated with a particular
choice.

Its simple and widely used technique for
deciding whether to make a change
Cost-Benefit Analysis
Cost–benefit analysis (CBA) is a systematic process
for calculating and comparing benefits and costs of a
project for two purposes:

(1) to determine if it is a sound investment
(justification/feasibility)

(2) to see how it compares with alternate projects
(ranking/priority assignment).
History of
Cost-Benefit Analysis
The concept of CBA dates back to an 1848 article by Jules
Dupuit
The British economist, Alfred Marshall, formulated some of
the formal concepts that are at the foundation of CBA
the Federal Navigation Act of 1936 PROVIDED IMPETUS TO
CBA .
CBA has its origins in the water development projects of the
U.S. Army Corps of Engineers
Over the 1960’s, CBA was applied in the US for water quality,
recreation travel and land conservation
In the UK, applications of CBA started with transport
projects in the 1960s
Steps in Cost-Benefit Analysis
A sales director is deciding whether to implement a new computer-based contact
management and sales processing system. His department has only a few computers,
and his salespeople are not computer literate. He is aware that computerized sales
forces are able to contact more customers and give a higher quality of reliability and
service to those customers. They are more able to meet commitments, and can work
more efficiently with fulfillment and delivery staff.
Financial cost/benefit analysis is shown below:
Costs:

New computer equipment:
10 network-ready PCs with supporting software @ $2,450 each
1 server @ $3,500
3 printers @ $1,200 each
Cabling & Installation @ $4,600
Sales Support Software @ $15,000

Training costs:
Computer introduction – 8 people @ $400 each
Keyboard skills – 8 people @ $400 each
Sales Support System – 12 people @ $700 each

An Example
Other costs:
• Lost time: 40 man days @ $200 / day
• Lost sales through disruption: estimate: $20,000
• Lost sales through inefficiency during first months: estimate: $20,000

Total cost: $114,000

Benefits:

• Tripling of mail shot capacity: estimate: $40,000 / year
• Ability to sustain telesales campaigns: estimate: $20,000 / year
• Improved efficiency and reliability of follow-up: estimate: $50,000 / year
• Improved customer service and retention: estimate: $30,000 / year
• Improved accuracy of customer information: estimate: $10,000 / year
• More ability to manage sales effort: $30,000 / year

Total Benefit: $180,000/year

Payback time: $114,000 / $180,000 =0.63 of a year =approx. 8 months
 COMMON UNIT OF MEASUREMENT

 CBA SHOULD REPRESENT CONSUMER OR PRODUCER VALUATIONS

 BENEFITS ARE ACTUALLY MEASURED BY MARKET CHOICES

 INCREASE IN CONSUMPTION –AREA UNDER DEMAND CURVE

 BENEFITS REQUIRE VALUATION OF HUMAN LIFE

 IMPACT OF PROJECT WITH/WITHOUT COMPARISON

 INVOLVES A PARTICULAR STUDY AREA

 DOUBLE COUNTING OF BENFITS/COSTS SHOULD BE AVOIDED

 DECISION CRITERIA FOR PROJECT
PRINCIPLES OF CBA
COMMON UNIT OF MEASUREMENT

• This means that all benefits and costs of a project should be measured
in terms of their equivalent money value.
• 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.

CBA SHOULD REPRESENT CONSUMER OR PRODUCER
VALUATIONS

• The valuation of benefits and costs should reflect preferences revealed
by choices which have been made
• The value of time should be that which the public reveals their time is
worth through choices involving tradeoffs between time and money.

BENEFITS ARE ACTUALLY MEASURED BY 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.

INCREASE IN CONSUMPTION –AREA UNDER 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



BENEFITS REQUIRE VALUATION OF HUMAN LIFE

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.


IMPACT OF PROJECT WITH/WITHOUT COMPARISON

• 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
• 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.

INVOLVES A PARTICULAR STUDY AREA

• The impacts of a project are defined for a particular study area, be it a city,
region, state, nation or the world.
• The nature of the study area is usually specified by the organization
sponsoring the analysis.
• The specification of the study area may be arbitrary but it may significantly
affect the conclusions of the analysis.

DOUBLE COUNTING OF BENFITS/COSTS SHOULD BE AVOIDED

• Sometimes an impact of a project can be measured in two or more ways.
• . For example, when an improved highway reduces travel time and the risk
of injury the value of property in areas served by the highway will be
enhanced.
DECISION CRITERIA FOR PROJECT

• If the discounted present value of the benefits exceeds the discounted
present value of the costs then the project is worthwhile.
• This is equivalent to the condition that the net benefit must be positive.
• . Another equivalent condition is that the ratio of the present value of the
benefits to the present value of the costs must be greater than one.
• If there are more than one mutually exclusive project that have positive net
present value then there has to be further analysis.
• From the set of mutually exclusive projects the one that should be selected
is the one with the highest net present value.

Uses of Cost Benefit Analysis
• The Framework

• Costs and Benefits

• Results & Biases
1. Net Present Value (NPV)
2. Benefit-Cost Ratio
3. Internal Rate of Return

Applications of CBA
• Evaluate or rank the feasibility of projects

• Analyze the effect of regulation

• Justify equipment and technology investment

• Determine the most effect way to cut costs

• Determine the relative benefits of outsourcing versus leasing

• Quantify hidden costs and intangible benefits

• Ensure accountability of decision makers
Accuracy problems:

• The accuracy of the outcome of a cost–benefit analysis depends on how
accurately costs and benefits have been estimated.
• 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.These
outcomes are to be expected because such estimates
• Rely heavily on past like projects
• Rely heavily on the project's members to identify the significant cost drivers
• Rely on very crude heuristics to estimate the money cost of the intangible
elements
• Are unable to completely dispel the usually unconscious biases of the team
members and the natural psychological tendency to "think positive“
Problems in Cost Benefit Analysis
• Reference class forecasting was developed to increase accuracy in
estimates of costs and benefits.
• 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.

Failure to address and incorporate other issues

Execution of Government policies and regulations on:
oEnvironmental issues
oHealth hazards
oPollution

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.
Social- Cost Benefit Analysis: Delhi
Metro
• Delhi Metro is a rapid transit system
serving Delhi, Gurgaon,Noida and Ghaziabad in the National Capital
Region of India. It is one of the largest metro networks in the world.

• The network consists of six lines with a total length of 189.63 kilometres
(117.83 mi) with 142 stations of which 35 are underground.

• Delhi’s metro rail system, to be constructed in four phases covering 245
kilometers, is scheduled to be finished in 2021. Today three functioning lines
connect central Delhi to east, north, and southwest Delhi
Phase I (1995 - 2005) Phase II (2005 -2011)
Distance 65.10 km 53.02 km
Corridors
1) Shahdara - Barwala (22) 1) Vishwa Vidhyalaya- Jahangirpuri (6.36)
2) Vishwa Vidhyalaya- Central Secretariat (11) 2) Central Secretariat- Qutab Minar (10.87)
3) Barakhamba Road - Dwarka (22.8) 3) Shahdra- Dilshad Garden (3.09)
4) Barakhamba Road - Indraprastha (2.8) 4) Indraprastha- New Ashok Nagar (8.07)
5) Extension into Dwarka Sub city (6.5) 5) Yamuna Bank- Anand Vihar ISBT (6.16)
6) Kirti Nagar- Mundka (18.47)
Investment Rs 6406 crores (2004 prices) Rs 8026 crores (2004 prices)
Phase III Phase IV
Distance 62.2 km
Corridors
1) Rangpuri to Shahabad Mohammadpur 1) Jahangirpuri to Sagarpur West
2) Barwala to Bawana 2) Narela to Najafgarh
3) Jahangirpuri to Okhla Industrial Area Phase I 3) Andheria Mod to Gurgaon
4) Shahbad Mohammadpur to Najafgarh
Benefits
• DM contributes to the diversion of a very high proportion of current passenger traffic
from road to Metro.
• Reduction in traffic
• Saving travel time of passengers on Delhi roads
• Reduction in air pollution in Delhi because of the substitution of electricity for petrol
and diesel and reduced congestion on the roads
• Reductions in motor vehicles’ operation and maintenance charges to both the
government and the private sector
• Employment benefits to the unskilled labour
• Savings in Foreign Exchange due to reduced Fuel Consumption
Cost-Benefit Comparison:
Delhi Metro
Cost-Benefit Comparison: Delhi Metro
Items Foreign Exchange
(Rs. Million)
Local Cost Total
Civil works - 31,327 31,327
Electrical works - 6,970 6,970
Signaling and
telecommunication
2,574 1,930 4,504
Rolling stock 4,596 6,403 10,999
Land - 3,339 3,339
General establishment and
consultancy charges
322 4,779 5,101
Contingencies 230 1,593 1,823
The total project cost of Rs. 64,060 million at 2004 prices for Phase I
consists of the foreign exchange cost of Rs. 7720 million and the domestic
material and labour cost of Rs. 56,340 million.
Cost Estimate of DM (Phase I)
• Savings in fuel consumption
- Due to diversion of a part of the Delhi road traffic to Metro and reduced congestion to vehicles
- inter-fuel substitution of petrol and CNG to electricity and saving of forex
- Fuel saved due to traffic diverted to the Metro (assuming the annual run and fuel consumption)



Identification of Financial Benefits
Annual Run and Fuel Consumption Norms
Traffic Mode
Diverted
Traffic
Fuel
Consumption
Norm
Daily Run Fuel Savings
Value of
Fuel savings
(million)
Cars 164,252 13 30 138,350,586 5,257
Two-wheelers 985,789 35 25 257,009,274 9,766
Buses 9,450 18 209 39,651,154 714
For cars and two-wheelers using petrol, price is Rs. 38/ltr
For buses using CNG, price is Rs. 18/kg

Current Statistics:
• The residual traffic on Delhi roads for the year 2011-12 are 200,752 and 28,351 respectively.
• The fuel savings during the year 2011-12 due to the decongestion effect for cars and buses are
20,714,391 ltr and 38,510,952 ltr, respectively.
Cost Benefit Analysis is a useful technique
Do you Agree?
Yes No
1. It helps to measure the benefits It may ignore the distributional impact For
example non-motorists are overlooked.
2. It offers an aid to decision making A CBA may be ignored for political
reasons
3. A decision has to be made. The cost
benefits of any decision have to be
weighed up. This technique helps to
confront the need to make such a
decision
It is difficult to put a value on safety
(Facts are based on estimation)
By reducing the positive and negative impacts of a project to their
equivalent money value Cost-Benefit Analysis determines whether on
balance the project is worthwhile.
References
 www. wikipedia.org
 www.sjsu.edu/faculty/watkins/cba.htm
 www.mindtools.com › Decision Making
 www.management.about.com/cs/money/a/CostBenefit.htm