Cost/Benefit Analysis

Evaluating Quantitatively Whether to Follow a Course of Action

You may have been intensely creative in generating solutions to a problem, and rigorous in your selection of the best one available. This solution may still not be
worth implementing, as you may invest a lot of time and money in solving a problem that is not worthy of this effort.
Cost Benefit Analysis or cba is a relatively* simple and widely used technique for deciding whether to make a change. As its name suggests, to use the technique
simply add up the value of the benefits of a course of action, and subtract the costs associated with it.
Costs are either one-off, or may be ongoing. Benefits are most often received over time. We build this effect of time into our analysis by calculating a payback period.
This is the time it takes for the benefits of a change to repay its costs. Many companies look for payback over a specified period of time – e.g. three years.
In its simple form, cost-benefit analysis is carried out using only financial costs and financial benefits. For example, a simple cost/benefit analysis of a road scheme
would measure the cost of building the road, and subtract this from the economic benefit of improving transport links. It would not measure either the cost of
environmental damage or the benefit of quicker and easier travel to work.
A more sophisticated approach to cost/benefit measurement models is to try to put a financial value on intangible costs and benefits. This can be highly subjective – is,
for example, a historic water meadow worth $25,000, or is it worth $500,000 because if its environmental importance? What is the value of stress-free travel to work
in the morning?
These are all questions that people have to answer, and answers that people have to defend.
The version of cost/benefit analysis we explain here is necessarily simple. Where large sums of money are involved (for example, in financial market transactions),
project evaluation can become an extremely complex and sophisticated art. The fundamentals of this are explained in Principles of Corporate Finance by Richard
Brealey and Stewart Myers – this is something of an authority on the subject.
Example:
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.
His 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
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

A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn out. Although a cost benefit analysis can be used for almost anything,
it is most commonly done on financial questions. Since the cost benefit analysis relies on the addition of positive factors and the subtraction of negative ones to
determine a net result, it is also known as running the numbers.
 Cost Benefit Analysis

A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs.
The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the
costs and all the benefits and properly quantify them.

Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the new stamping machine? Will we be better off putting our free cash flow
into securities rather than investing in additional capital equipment? Each of these questions can be answered by doing a proper cost benefit analysis.

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.

Cost-benefit analysis

Cost-benefit analysis is a term that refers both to:

 helping to appraise, or assess, the case for a project, programme or policy proposal;

 an approach to making economic decisions of any kind.

Under both definitions the process involves, whether explicitly or implicitly, weighing the total expected costs against the total expected

benefits of one or more actions in order to choose the best or most profitable option. The formal process is often referred to as either CBA

(Cost-Benefit Analysis) or BCA (Benefit-Cost Analysis).

Benefits and costs are often expressed in money 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 “present value.”

Closely related, but slightly different, formal techniques include cost-effectiveness analysis, economic impact analysis, fiscal impact analysis

and Social Return on Investment (SROI) analysis. The latter builds upon the logic of cost-benefit analysis, but differs in that it is explicitly

designed to inform the practical decision-making of enterprise managers and investors focused on optimizing their social and environmental

impacts.

Theory

Cost–benefit analysis is often used by governments to evaluate the desirability of a given intervention. It is heavily used in today's

government. It is an analysis of the cost effectiveness of different alternatives in order to see whether the benefits outweigh the costs. The

aim is to gauge the efficiency of the intervention relative to the status quo. The costs and benefits of the impacts of an intervention are

evaluated in terms of the public's willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs are typically

measured in terms ofopportunity costs - the value in their best alternative use. The guiding principle is to list all parties affected by an

intervention and place a monetary value of the effect it has on their welfare as it would be valued by them.

The process involves monetary value of initial and ongoing expenses vs. expected return. Constructing plausible measures of the costs and

benefits of specific actions is often very difficult. In practice, analysts try to estimate costs and benefits either by using survey methods or by

drawing inferences from market behavior. For example, a product manager may compare manufacturing and marketing expenses with

projected sales for a proposed product and decide to produce it only if he expects the revenues to eventually recoup the costs. Cost–benefit

analysis attempts to put all relevant costs and benefits on a common temporal footing. A discount rate is chosen, which is then used to

compute all relevant future costs and benefits in present-value terms. Most commonly, the discount rate used for present-value calculations

is an interest rate taken from financial markets (R.H. Frank 2000). This can be very controversial; for example, a high discount rate implies a

very low value on the welfare of future generations, which may have a huge impact on the desirability of interventions to help the

environment. Empirical studies suggest that in reality, people's discount rates do decline over time. Because cost–benefit analysis aims to

measure the public's true willingness to pay, this feature is typically built into studies.

During cost–benefit analysis, monetary values may also be assigned to less tangible effects such as the various risks that could contribute to

partial or total project failure, such as loss of reputation, market penetration, or long-term enterprise strategy alignments. This is especially

true when governments use the technique, for instance to decide whether to introduce business regulation, build a new road, or offer a new

drug through the state healthcare system. In this case, a value must be put on human life or the environment, often causing great
controversy. For example, the cost–benefit principle says that we should install a guardrail on a dangerous stretch of mountain road if the

dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and property damage thus prevented (R.H. Frank 2000).

Cost–benefit calculations typically involve using time value of money formulas. This is usually done by converting the future expected

streams of costs and benefits into a present value amount.

[edit]Application and history

The practice of cost–benefit analysis differs between countries and between sectors (e.g., transport, health) within countries. Some of the

main differences include the types of impacts that are included as costs and benefits within appraisals, the extent to which impacts are

expressed in monetary terms, and differences in the discount rate between countries. Agencies across the world rely on a basic set of key

cost–benefit indicators, including the following:

 NPV (net present value)

 PVB (present value of benefits)

 PVC (present value of costs)

 BCR (benefit cost ratio = PVB / PVC)

 Net benefit (= PVB - PVC)

 NPV/k (where k is the level of funds available)

The concept of CBA dates back to an 1848 article by Dupuit and was formalized in subsequent works by Alfred Marshall. The practical

application of CBA was initiated in the US by the Corps of Engineers, after the Federal Navigation Act of 1936 effectively required cost–

benefit analysis for proposed federal waterway infrastructure. [1] The Flood Control Act of 1939 was instrumental in establishing CBA as

federal policy. It specified the standard that "the benefits to whomever they accrue [be] in excess of the estimated costs. [2]

Subsequently, cost–benefit techniques were applied to the development of highway and motorway investments in the US and UK in the

1950s and 1960s. An early and often-quoted, more developed application of the technique was made to London Underground's Victoria Line.

Over the last 40 years, cost–benefit techniques have gradually developed to the extent that substantial guidance now exists on how transport

projects should be appraised in many countries around the world.

In the UK, the New Approach to Appraisal (NATA) was introduced by the then Department for Transport, Environment and the Regions. This

brought together cost–benefit results with those from detailed environmental impact assessments and presented them in a balanced way.

NATA was first applied to national road schemes in the 1998 Roads Review but subsequently rolled out to all modes of transport. It is now a

cornerstone of transport appraisal in the UK and is maintained and developed by the Department for Transport.[11]

The EU's 'Developing Harmonised European Approaches for Transport Costing and Project Assessment' (HEATCO) project, part of its Sixth

Framework Programme, has reviewed transport appraisal guidance across EU member states and found that significant differences exist

between countries. HEATCO's aim is to develop guidelines to harmonise transport appraisal practice across the EU.[12][13] [3]

Transport Canada has also promoted the use of CBA for major transport investments since the issuance of its Guidebook in 1994. [4]
More recent guidance has been provided by the United States Department of Transportation and several state transportation departments,

with discussion of available software tools for application of CBA in transportation, including HERS, BCA.Net, StatBenCost, CalBC,

andTREDIS. Available guides are provided by the Federal Highway Administration[5][6], Federal Aviation Administration[7], Minnesota

Department of Transportation[8], California Department of Transportation (Caltrans)[9], and the Transportation Research Board Transportation

Economics Committee [10].

In the early 1960s, CBA was also extended to assessment of the relative benefits and costs of healthcare and education in works by Burton

Weisbrod.[11][12] Later, the United States Department of Health and Human Services issued its CBA Guidebook.[13]

[edit]Accuracy problems

The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs and benefits have been estimated.

A peer-reviewed study [14] of the accuracy of cost estimates in transportation infrastructure planning found that for rail projects actual costs

turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4 percent higher (Flyvbjerg, Holm, and Buhl, 2002).

For benefits, another peer-reviewed study [15] found that actual rail ridership was on average 51.4 percent lower than estimated ridership;

for roads it was found that for half of all projects estimated traffic was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005).

Comparative studies indicate that similar inaccuracies apply to fields other than transportation. These 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, as defined by Pareto and Kaldor-Hicks efficiency ([16] Flyvbjerg, Bruzelius, and Rothengatter, 2003).These outcomes

(almost always tending to underestimation unless significant new approaches are overlooked) are to be expected because such estimates:

1. Rely heavily on past like projects (often differing markedly in function or size and certainly in the skill levels of the team members)

2. Rely heavily on the project's members to identify (remember from their collective past experiences) the significant cost drivers

3. Rely on very crude heuristics to estimate the money cost of the intangible elements

4. Are unable to completely dispel the usually unconscious biases of the team members (who often have a vested interest in a

decision to go ahead) and the natural psychological tendency to "think positive" (whatever that involves)

Reference class forecasting was developed to increase accuracy in estimates of costs and benefits. [14]

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.

In the case of the Ford Pinto (where, because of design flaws, the Pinto was liable to burst into flames in a rear-impact collision), the Ford

company's decision was not to issue a recall. Ford's cost–benefit analysis had estimated that based on the number of cars in use and the

probable accident rate, deaths due to the design flaw would run about $49.5 million (the amount Ford would pay out of court to

settle wrongful death lawsuits). This was estimated to be less than the cost of issuing a recall ($137.5 million) [17]. In the event, Ford

overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (because it

led to the recall anyway and to measurable losses in sales).

In the field of health economics, some analysts think cost–benefit analysis can be an inadequate measure because willingness-to-pay

methods of determining the value of human life can be subject to bias according to income inequity. They support use of variants such

ascost-utility analysis and quality-adjusted life year to analyze the effects of health policies.

[edit]Use in regulation

Cost-benefit analysis was widely in the United States under the Bush administration to prevent regulatory initiatives, and there is some

debate about whether it is neutral to regulatory initiatives or whether it anti-regulatory and undervalues human life, health, and the

environment.[15] In the case of environmental and occupational health regulation, it has been argued that if modern cost-benefit analyses had

been applied prospectively to proposed regulations such as removing lead from gasoline, not turning the Grand Canyon into a hydroelectric

dam, and regulating workers' exposure to vinyl chloride, these regulations would not have been implemented even though they are

considered to be highly successful in retrospect. [15] The Clean Air Act has been cited in retrospective studies as a case where benefits

exceeded costs, but the knowledge of the benefits (attributable largely to the benefits of reducing particulate pollution) was not available until

many years later.[15]

Cost-Benefit Analysis (CBA) estimates and totals up the

equivalent money value of the benefits and costs to the
community of projects to establish whether they are
worthwhile. These projects may be dams and highways or
can be training programs and health care systems.
The idea of this economic accounting originated with Jules
Dupuit, a French engineer whose 1848 article is still worth
reading. The British economist, Alfred Marshall, formulated
some of the formal concepts that are at the foundation of
CBA. But the practical development of CBA came as a result
of the impetus provided by the Federal Navigation Act of
1936. This act required that the U.S. Corps of Engineers
carry out projects for the improvement of the waterway
system when the total benefits of a project to whomsoever
they accrue exceed the costs of that project. Thus, the Corps
of Engineers had create systematic methods for measuring
such benefits and costs. The engineers of the Corps did this
without much, if any, assistance from the economics
profession. It wasn't until about twenty years later in the
1950's that economists tried to provide a rigorous, consistent
set of methods for measuring benefits and costs and deciding
whether a project is worthwhile. Some technical issues of
CBA have not been wholly resolved even now but the
fundamental presented in the following are well established.

Principles of Cost Benefit Analysis

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.

There Must Be a Common Unit of

Measurement
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." The most convenient common unit is money.
This means that all benefits and costs of a project should be
measured in terms of their equivalent money value. A
program may provide benefits which are not directly
expressed in terms of dollars but there is some amount of
money the recipients of the benefits would consider just as
good as the project's benefits. For example, a project may
provide for the elderly in an area a free monthly visit to a
doctor. The value of that benefit to an elderly recipient is the
minimum amount of money that that recipient would take
instead of the medical care. This could be less than the
market value of the medical care provided. It is assumed
that more esoteric benefits such as from preserving open
space or historic sites have a finite equivalent money value to
the public.
Not only do the benefits and costs of a project have to be
expressed in terms of equivalent money value, but they have
to be expressed in terms of dollars of a particular time. This
is not just due to the differences in the value of dollars at
different times because of inflation. A dollar available five
years from now is not as good as a dollar available now. This
is because a dollar available now can be invested and earn
interest for five years and would be worth more than a
dollar in five years. If the interest rate is r then a dollar
invested for t years will grow to be (1+r)t. Therefore the
amount of money that would have to be deposited now so
that it would grow to be one dollar t years in the future is
(1+r)-t. This called the discounted value or present value of a
dollar available t years in the future.
When the dollar value of benefits at some time in the future
is multiplied by the discounted value of one dollar at that
time in the future the result is discounted present value of
that benefit of the project. The same thing applies to costs.
The net benefit of the projects is just the sum of the present
value of the benefits less the present value of the costs.
The choice of the appropriate interest rate to use for the
discounting is a separate issue that will be treated later in
this paper.

CBA Valuations Should Represent Consumers

or Producers
Valuations As Revealed by Their Actual
Behavior
The valuation of benefits and costs should reflect preferences
revealed by choices which have been made. For example,
improvements in transportation frequently involve saving
time. The question is how to measure the money value of
that time saved. The value should not be merely what
transportation planners think time should be worth or even
what people say their time is worth. The value of time should
be that which the public reveals their time is worth through
choices involving tradeoffs between time and money. If
people have a choice of parking close to their destination for
a fee of 50 cents or parking farther away and spending 5
minutes more walking and they always choose to spend the
money and save the time and effort then they have revealed
that their time is more valuable to them than 10 cents per
minute. If they were indifferent between the two choices they
would have revealed that the value of their time to them was
exactly 10 cents per minute.
The most challenging part of CBA is finding past choices
which reveal the tradeoffs and equivalencies in preferences.
For example, the valuation of the benefit of cleaner air could
be established by finding how much less people paid for
housing in more polluted areas which otherwise was
identical in characteristics and location to housing in less
polluted areas. Generally the value of cleaner air to people
as revealed by the hard market choices seems to be less than
their rhetorical valuation of clean air.

Benefits Are Usually 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.
Therefore for any consumer buying some of a commodity,
the marginal benefit is equal to the market price. The
marginal benefit will decline with the amount consumed just
as the market price has to decline to get consumers to
consume a greater quantity of the commodity. The
relationship between the market price and the quantity
consumed is called the demand schedule. Thus the demand
schedule provides the information about marginal benefit
that is needed to place a money value on an increase in
consumption.

Gross Benefits of an Increase in Consumption

is an Area Under the 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. But
the marginal benefit curve is the same as the demand curve
so the increase in benefits is the area under the demand
curve. As shown in Figure 1 the area is over the range from
the lower limit of consumption before the increase to
consumption after the increase.

Figure 1
When the increase in consumption is small compared to the
total consumption the gross benefit is adequately
approximated, as is shown in a welfare analysis, by the
market value of the increased consumption; i.e., market
price times the increase in consumption.

Some Measurements of Benefits Require the

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. There are many
cases in which people voluntarily accept increased risks in
return for higher pay, such as in the oil fields or mining, or
for time savings in higher speed in automobile travel. These
choices can be used to estimate the personal cost people
place on increased risk and thus the value to them of
reduced risk. This computation is equivalent to placing an
economic value on the expected number of lives saved.
 The Analysis of a Project Should Involve
a With Versus Without Comparison
The impact of a project is the difference between what the
situation in the study area would be with and without the
project. 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. For example, in determining the impact of a fixed
guideway rapid transit system such as the Bay Area Rapid
Transit (BART) in the San Francisco Bay Area the number
of rides that would have been taken on an expansion of the
bus system should be deducted from the rides provided by
BART and likewise the additional costs of such an expanded
bus system would be deducted from the costs of BART. 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.
Another example shows the importance of considering the
impacts of a project and a with-and-without comparison.
Suppose an irrigation project proposes to increase cotton
production in Arizona. If the United States Department of
Agriculture limits the cotton production in the U.S. by a
system of quotas then expanded cotton production in
Arizona might be offset by a reduction in the cotton
production quota for Mississippi. Thus the impact of the
project on cotton production in the U.S. might be zero rather
than being the amount of cotton produced by the project.
 Cost Benefit Analysis 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. In the
above example concerning cotton the impact of the project
might be zero for the nation but still be a positive amount for
Arizona.
The nature of the study area is usually specified by the
organization sponsoring the analysis. Many effects of a
project may "net out" over one study area but not over a
smaller one. The specification of the study area may be
arbitrary but it may significantly affect the conclusions of
the analysis.

Double Counting of Benefits or Costs Must 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.
The increase in property values due to the project is a very
good way, at least in principle, to measure the benefits of a
project. But if the increased property values are included
then it is unnecessary to include the value of the time and
lives saved by the improvement in the highway. The
property value went up because of the benefits of the time
saving and the reduced risks. To include both the increase in
property values and the time saving and risk reduction
would involve double counting.

Decision Criteria for Projects

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 projects 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.
If the funds required to carry out all of the projects with
positive net present value are less than the funds available
this means the discount rate used in computing the present
values is too low and does not reflect the true cost of capital.
The present values must be recomputed using a higher
discount rate. It may take some trial and error to find a
discount rate such that the funds required for the projects
with a positive net present value is no more than the funds
available. Sometimes as an alternative to this procedure
people try to select the best projects on the basis of some
measure of goodness such as the internal rate of return or
the benefit/cost ratio. This is not valid for several reasons.
The magnitude of the ratio of benefits to costs is to a degree
arbritrary because some costs such as operating costs may
be deducted from benefits and thus not be included in the
cost figure. This is called netting out of operating costs. This
netting out may be done for some projects and not for
others. This manipulation of the benefits and costs will not
affect the net benefits but it may change the benefit/cost
ratio. However it will not raise the benefit cost ratio which is
less than one to above one. For more on this topic
see Benefit/ cost Ratio Magnitude.

An Example
To illustrate how CBA might be applied to a project, let us
consider a highway improvement such as the extension of
Highway 101 into San Jose. The local four-lane highway
which carried the freeway and commuter traffic into San
Jose did not have a median divider and its inordinate
number of fatal head-on collisions led to the name "Blood
Alley." The improvement of the highway would lead to more
capacity which produces time saving and lowers the risk.
But inevitably there will be more traffic than was carried by
the old highway.
The following is a highly abbreviated analysis using
hypothetical data.
 History of Cost-Benefit Analysis
CBA has its origins in the water development projects of the
U.S. Army Corps of Engineers. The Corps of Engineers had
its orgins in the French engineers hired by George
Washington in the American Revolution. For years the only
school of engineering in the United States was the Military
Academy at West Point, New York.
In 1879, Congress created the Mississippi River Commission
to "prevent destructive floods." The Commission included
civilians but the president had to be an Army engineer and
the Corps of Engineers always had veto power over any
decision by the Commission.
In 1936 Congress passed the Flood Control Act which
contained the wording, "the Federal Government should
improve or participate in the improvement of navigable
waters or their tributaries, including watersheds thereof, for
flood-control purposes if the benefits to whomsoever they
may accrue are in excess of the estimated costs." The phrase
if the benefits to whomsoever they may accrue are in excess
of the estimated costs established cost-benefit analysis.
Initially the Corps of Engineers developed ad hoc methods
for estimating benefits and costs. It wasn't until the 1950s
that academic economists discovered that the Corps had
developed a system for the economic analysis of public
investments. Economists have influenced and improved the
Corps' methods since then and cost-benefit analysis has been
adapted to most areas of public decision-making.
Cost-benefit analysis (CBA) and related economic appraisal methodologies allow investors to determine the economic return to potential
disaster risk reduction interventions, to support a rational comparison of available options and to help ensure that investment decisions are
accountable. Such tools can be used to determine the net economic benefits both of dedicated disaster risk reduction projects and of the
inclusion of disaster risk reduction features in other development projects.

Economic criteria are not the only ones by which projects are judged and only multilateral lending agencies routinely undertake formal
economic analysis as part of their project appraisal process. However, in the face of tight budgetary constraints and many competing
demands for public resources, there is widespread pressure to demonstrate that government funding and international aid resources are
well spent. As such, international development organisations and governments at least require robust secondary evidence that their
investment decisions are economically sound. Evidence on the potential net economic benefits of disaster risk reduction activities also plays
a more fundamental role in securing initial attention in and commitment to disaster risk reduction.

Cost-benefit analysis of disaster risk reduction investments

The cost-benefit analysis of disaster risk reduction investments involves a number of particular challenges, including that

 The flow of benefits is probabilistic, with the actual level realised dependent on the degree of severity of hazard events – if any –
occurring over the life of a project.
 Little related information may be available on the frequency and intensity of the hazard event, particularly in a developing country
context, implying uncertainty about the level of risk.
 Many of the benefits of any disaster risk reduction measures, whether undertaken in the context of a disaster risk reduction project
or as part of another type of development project, are related to the direct and indirect losses that will not ensue should the
related hazard event occur over the life of the project, rather than streams of positive benefits that will take place, as would be the
case for other investments. This can present certain measurement difficulties.
 Levels and forms of vulnerability may change considerably over the life of a project, particularly in developing countries undergoing
rapid socioeconomic change and/or high demographic growth. These changes need to be considered in exploring potential flows of
net benefits resulting from related disaster risk reduction measures.
 Predicted impacts of global warming on the frequency and intensity of climatological hazards over the life of the project need to be
taken into account.

In recognition of these and other challenges, a number of resources have been developed providing specific guidance on the economic
appraisal of disaster risk reduction investments and discussing related methodological issues.