Cost-benefit analysis (CBA) is a process by which business decisions are analyzed to determine the acceptability of certain options. Perhaps predictably, when employing CBA the benefits and costs of a given option are quantified and summed. Often in this valuation intangible benefits and costs factored into the analysis model to present the most complete assessment.
Cost-Benefit Analysis History:
Originally, CBA was conceptualized in an 1848 article by Jules Dupuit. Subsequently, British economist Alfred Marshall formalized the concept several years later. However, formal application of CBA did not arrive in the US until the Federal Navigation Act of 1936 which required CBA for a proposed federal waterway infrastructure improvement plan. Three years later the Flood Control Act established CBA as federal policy when assessing the viability of government spending options.
Depending on the requirements of the organization, there may be additional steps to implementing a proper CBA, but the following steps provide an ideal basis for a proper cost-benefit analysis for a given proposed action.
- List all alternative actions.
- Create a list of stakeholders.
- Determine a basis for measurement and quantify all cost and benefits elements using a unified standard.
- Forecast both the costs and benefits over a relevant time period.
- Apply the appropriate discount rate
- Determine the net present value (NPV) of proposed options.
- Perform a sensitivity analysis to determine sensitivity of the proposed option in relation to external factors.
- Arrive at the optimal option and communicate to stakeholders.
Challenges in Valuation:
Cost Benefit Analysis attempts to correctly quantify both the positive and negative outcomes of a given option. Accordingly, many intangible aspects must be quantified. Examples of these are:
• Effects on both users and non-users
• The effect on external factors (and vice-versa)
• Opportunity cost – specifically with regard to intangible outcomes
The final value of any cost benefit analysis depends on the accuracy of the each estimate. Studies indicate that these estimates are often skewed in favor of one option or another. Causes of inaccuracies include:
• Bias among project supporters (often one decision rewards supporters over another)
• Overreliance on historic data from previous decisions
• Inappropriate subjectivity among those responsible for the CBA
• Cost benefit analysis is simple and easy to comprehend for decision makers.
• CBA allows for a standardized decision making process factoring in relevant considerations for an organization.
• It standardizes the unit of measurement forcing the quantification of intangible outcomes as well as tangible outcomes such as resource inflows and outflows.