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COST-BENEFIT ANALYSIS

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


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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 alsoss4 rest of to community.

For private decisions, such as taking martial arts classes or going to a movie on Saturday night, we are often not aware of any internal process of consideration of costs and benefits, but behave as though we do. An individual will choose an action if:
Benefits (B) > Costs (C) or Net Benefits (NB) = B - C > 0.

CBA is most commonly used for public decisions policy proposals, programs, and projects, e.g., dams, bridges, traffic circles, riverfront parks, libraries, drunk driving laws, and anything else the government might fund. CBA can be used to rank alternative projects as well as evaluating the social value of one particular project.

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
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Process of CBA

IDENTIFICATION OF COSTS AND BENEFITS

EVALUATION OF COSTS AND BENEFITS

CHOICE OF SYSTEM

At the initial stage of CBA , various related costs and benefits are identified with a view to measure comparative costs/benefits of all the systems so that the system which gives maximum benefits in relation to its costs is finally selected.

After identifying costs and benefits , they should be categorized so that their exact nature can be determined.
They are categorized as -: tangible and intangible costs and benefits Fixed and variable costs and benefits Direct and indirect costs and benefits

An example of Tangible and Intangible costs and benefits

Fixed and variable costs and benefits


Do not change with level of output. Example: cost-depreciation Benefit- income from non business activities.

Fixed cost and benefits Variable costs and benefits

Change proportionally with the level of output Example: Cost- cost of raw material Benefit: sales revenue

Direct and indirect costs and benefits

Direct costs and benefits: Associated directly to An operation Example: cost of raw material

Indirect costs and benefits: Associated indirectly to an operation Example: insurance cost

Costs

Benefits

After identifying costs and benefits of various systems under consideration, these benefits should be evaluated to have a comparative view. For this purpose capital budgeting models are used, which are as follows :
Discounted cash flow criteria
Net present value Internal rate of return Profitability index Discounted payback period

Non -Discounted cash flow criteria


Simple payback period Accounting rate of return

Net present value method evaluates the investment proposals by using Discounted Cash flow (DCF) criteria, recognizing the time value of money.

In IRR method, the rate of return has to be determined at which the net present value Is zero, i:e present value of investment and present value of future cash inflows are equal.

PROFITABILITY INDEX

It is calculated by dividing the present value of the total cash inflows from an investm By the initial cost of investment

Discounted payback period

Pay back period is defined as number of years required to recover the original c outlay Invested in a project.

Simple payback period

In simple payback period method, the cash inflows are not discounted to find the present value but cash inflows are taken on their original value.

Accounting rate of return

Accounting rate of return, also known as return on investment , uses accoun information as revealed by financial statements , to measure the profitability investment .

ARR does not take into account time value of money .

After evaluation of costs and benefits of various competing systems is completed , The Results obtained have to be interpreted to arrive at final choice of a system .

Overall Appraisal of CBA


Cons: - intangibles - BC analysts and information sources are often biased - distributional Issues occasionally objectionable * weighs same period impacts equally * weighs future impacts less Pros: - help prevent bad decisions which would otherwise be undiscovered - counters rent-seeking (which might normally be successful in the political process).