History

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 costbenefit analysis for proposed federal waterway infrastructure.[9] 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.[10]
Public Policy

The application for broader public policy started from the work of Otto Eckstein,[11] who in 1958 laid out a welfare economics foundation for CBA and its application for water resource development. Over the 1960s, CBA was applied in the US for water quality,[12] recreation travel[13] and land conservation.[14] During this period, the concept of option value was developed to represent the non-tangible value of preserving resources such as national parks.[15] CBA was later expanded to address both intangible and tangible benefits of public policies relating to mental illness,[16] substance abuse,[17] college education[18] and chemical waste policies.[19] 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,[20] Australian guide for regulation and finance,[21] US guide for health care programs,[22] and US guide for emergency management programs.[23]

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.[1] 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."

Closely related, but slightly different, formal techniques include cost-effectiveness analysis, costutility analysis, economic impact analysis, fiscal impact analysis and Social return on investment (SROI) analysis.

Theory
Costbenefit 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).[2] 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.[3] 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.[4]

Process
The following is a list of steps that comprise a generic cost-benefit analysis.[5] 1. 2. 3. 4. 5. 6. 7. 8. 9. List alternative projects/programs. List stakeholders. Select measurement(s) and measure all cost/benefit elements. Predict outcome of cost and benefits over relevant time period. Convert all costs and benefits into a common currency. Apply discount rate. Calculate net present value of project options. Perform sensitivity analysis. Adopt recommended choice.

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

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[6] 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).[7] Example Cost Benefit Analysis As the Production Manager, you are proposing the purchase of a $1 Million stamping machine to increase output. Before you can present the proposal to the Vice President, you know you need 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 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? 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 .................... -$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 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 $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 ........................... $15,715 Your cost benefit analysis clearly shows the purchase of the stamping machine is justified. The machine will save your company over $15,000 per month, almost $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.

Accuracy
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[citation needed]. Causes of these inaccuracies include [citation needed]:

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).

References
1. ^ http://www.dot.ca.gov/hq/tpp/offices/ote/benefit_cost/index.html 2. ^ Stephanie Riegg Cellini, James Edwin Kee. COST-EFFECTIVENESS AND COST-BENEFIT ANALYSIS. Chapter 21.http://home.gwu.edu/~scellini/CelliniKee21.pdf 3. ^ http://www.finance.gov.au/obpr/docs/Decision-Rules.pdf 4. ^ Weimer, D., Vining, A. Policy Analysis: Concepts and Practice. Fourth Edition. 2005. 5. ^ Boardman, N. E. (2006). Cost-benefit analysis, concepts and practice. (3 ed.). Upper Saddle River, NJ: Prentice Hall 6. ^ Dunn, William N. "Public Policy Analysis: an Introduction." Longman (2009) 7. ^ R.G. Newell(2003). Journal of Environmental Economics and Management. http://www.nicholas.duke.edu/people/faculty/newell/jeem%20discount.pdf. 8. ^ Campbell and Brown (2003) Ch. 9 provides a useful discussion of sensitivity analysis and risk modelling in CBA. 9. ^ History of Benefit-Cost Analysis, Proceedings of the 2006 Cost Benefit Conference [1] 10. ^ Google book extract from Cases in Public Policy Analysis By George M. Guess, Paul G. Farnham