Cost-Benefit Analysis

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What is Cost-Benefit Analysis? Definition

Cost-benefit analysis (CBA) is the weighing-scale approach for decision-making. All the positive elements (cash-flows and other intangible benefits) are put on one side of the balance and all the negative elements (the costs and disadvantages) are put on the other.  Whichever weighs the heavier wins.

Example of a Cost-Benefit Analysis

A company that would like to buy Business Intelligence software to improve its business might use a CBA to make up its mind.

On the minus (cost) side would be:

- the price of the software,

- the cost of consultants to install and implement the software, and

- the cost of training for the users of the software.

However on the plus (benefits) side would be:

- improved business processes (leading to an annual cost decrease),

- due to better available information, the company will be able to take better decisions (leading to additional cash-flows), and

- increased staff moral, due to using these modern tools to support the business.

Mistakes and Problems with Cost-Benefit Analysis

• A frequently made mistake in the CBA method is to use non-discounted amounts for calculating the costs and benefits. A method like NPV or Economic Value Added or CFROI is strongly recommended, because all of these account for the time value of money.
• A frequent problem with CBA is that typically the costs are tangible, hard and financial, while the benefits are hard and tangible, but also soft and intangible. Caution should be taken here against people who claim that "if you can't measure it does not exist / it has no value".
• Especially in more strategic investments, frequently the intangible benefits clearly outweigh the financial benefits.
• Risk must often be considered as a factor in making the decision.

History of Cost Benefit Analysis

The idea of this methodology originated with Jules Dupuit, a French engineer whose 1848 article is still worth reading. The British economist, Alfred Marshall, conceived 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 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 assistance from the economics profession. It wasn't until about twenty years later in the 1950s that economists tried to provide a rigorous, consistent set of methods for measuring benefits and costs and deciding whether a project is worthwhile.

Book: Anthony E. Boardman - Cost-Benefit Analysis: Concepts and Practice (2nd Edition)

Book: Henry M. Levin, Patrick J. McEwan - Cost-Effectiveness Analysis : Methods and Applications

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