COST-BENEFIT ANALYSIS

SHAHANA.P.T ROLL NO:52

COST-BENEFIT ANALYSIS

Costbenefit analysis (CBA), sometimes called benefitcost analysis (BCA), is a systematic process for calculating and comparing benefits and costs of a project. CBA is the implicit or explicit assessment of the benefits and costs (i.e., pros and cons, advantages and disadvantages) associated with a particular choice. Benefits and costs may be monetary or nonmonetary.

OBJECTIVES

To determine if it is a sound investment (justification/feasibility) To see how it compares with alternate projects (ranking/priority assignment). 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. The aim is to gauge the economic efficiency of alternate policy options relative to each other including consideration of the costs and benefits of the status quo.

We will choose an action if:

Benefits (B) > Costs (C) or Net Benefits (NB) = B - C > 0.

Investment in international business requires a cost benefit analysis which means analyze benefits gained versus the risks encountered by investing in international business.

In CBA, benefits and costs are expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their "present value. Costbenefit analysis is often used by governments and others, e.g. businesses, to evaluate the desirability of a given policy.

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.

Outlining benefits and costs assists rational decisionmaking. 1. Enumerate benefits and costs. 2. Quantify each benefit and cost as accurately as possible, given the information at hand. The practice of costbenefit analysis differs between countries and between sectors (e.g., transport, health) within countries.

THEORIES

CBA is an analysis of the expected balance of benefits and costs, including an account of foregone alternatives (i.e. opportunity cost) in order to predict whether the benefits of a policy outweigh the costs of that policy, and by how much (i.e. one can rank alternate policies in terms of cost-benefit ratios). Generally, cost-benefit analysis will, when all costs are considered, lead to the selection of projects such that society experiences an increase in social welfare from a utilitarian perspective.

STEPS

Establish alternative projects/programs Compile a list of key players (those with standing or influence) Select measurement and collect all cost and benefits elements Predict outcome of cost and benefits over the duration of the project Put all effects of costs and benefits in dollars Apply discount rate Calculate net present value of project options Sensitivity analysis Recommendation

KEY INDICATORS

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 funds available)

VALUATION

The costs of an intervention are myriad, diverse and generally can only be estimated based on limited and costly information. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to the abundance of market data. The guiding principle of evaluating benefits is to list all parties affected by an intervention and place a value, usually monetary, on the (positive or negative) effect it has on their welfare as it would be valued by them.

TIME AND DISCOUNTING

CBA usually tries to put all relevant costs and benefits on a common temporal footing using time value of money formulas. This is often done by converting the future expected streams of costs and benefits into a present value amount using a suitable discount rate. There is often no consensus on the appropriate discount rate to use. The rate chosen usually makes a large difference in the assessment of interventions with long-term effects.

Expected Value
When values of costs or benefits are not known with certainty, but are known with probability, expected values are used.

Present Value
Future, as well as present, benefits and costs must be included in the analysis.
But costs and benefits that accrue in the future are worth less than costs and benefits today. Economic agents and society as a whole will maximize the present value of expected net benefits.

Discount Rate
The higher the social discount rate, the higher the social value of consumption today relative to consumption tomorrow. Results can be sensitive to the discount rate chosen. Researchers often conduct a sensitivity analysis to see how sensitive the results are to changes in assumptions about the discount rate, costs, and benefits.

RISK AND UNCERTAINTY

Risk associated with the outcome of projects is also usually taken into account using probability theory. Uncertainty in the CBA parameters (as opposed to risk of project failure etc.) is often evaluated using a sensitivity analysis, which shows how the results are affected by changes in the parameters. Alternatively a more formal risk analysis can be undertaken using spreadsheet-based Monte Carlo simulations with add-in software such as @RISK or Crystal Ball.

ACCURACY PROBLEMS

The accuracy of the outcome of a costbenefit analysis depends on how accurately costs and benefits have been estimated. Inaccurate costbenefit analyses likely to lead to inefficient decisions. Another challenge to costbenefit analysis comes from determining which costs should be included in an analysis (the significant cost drivers).