How Do I Do a Cost and Benefit Analysis?

Gregory Hanson

A cost and benefit analysis, sometimes referred to by the acronym CBA, begins with the proper framing of a research question. This involves determining all of the potential positive effects of a particular potential investment decision and then converting them into monetary values. The same process is then followed for all of the costs associated with a project in question. When both sets of values have been computed, they can simply be compared. Projects whose benefits exceed their costs should be undertaken, whereas those whose costs exceed their benefits should be redesigned or canceled.

A cost and benefit analysis involves determining all of the potential positive and negative effects of a decision.
A cost and benefit analysis involves determining all of the potential positive and negative effects of a decision.

This type of analysis is ideally suited for certain types of problems. Any projects that can easily be framed using currency value are good choices for such analysis. Projects whose costs or benefits are difficult to convert to this type of valuation are difficult to analyze satisfactorily with cost and benefit analysis. Cost and benefit analysis requires projects that are limited in both time and space, or the computation of costs and benefits is impossible. Choosing these limits carefully is essential if useful results are to be obtained.

One factor that may affect this decision is environmental impact, which is notoriously hard to assign a reasonable and widely-accepted cost value, as costs are long-term and widely-distributed. Another is the cost of human life, which can be computed, but not always in a manner that is free of controversy. A standard method for determining the value of human life for purposes of cost and benefit analysis relies on the choices that people make themselves when pricing risk of death or injury versus economic reward.

Computing the costs for a cost and benefit analysis involves simply determining the cash value of all the expenditures needed to implement a project. Concrete expenditures for capital and labor are easy to value. Other, less obvious costs must be valued as well and sometimes weighted by the probability that they will occur. Building an airport might impose a small but serious potential cost in the form of a risk of air crashes, and this must be computed.

The valuation of potential benefits proceeds in the same fashion as that of potential costs. Both physical and intangible benefits can be considered. Corporations that make use of cost and benefit analysis typically employ market pricing models to determine the relative value of each unit of benefit, which will tend to decline from unit to unit as consumers become less interested in acquiring more of a particular good.

When computing costs and benefits, time must also be factored into the decision making process. Money that must be spent in the future is less valuable than money that must be spent immediately, as that money can be expected to earn interest in the interim. This makes future expenditures less expensive in terms of current money, and the greater the time before the investment must be made, the greater the effective discount. Careful and conservative computation of the rate at which to discount future costs is crucial to the success of this technique.

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