Cost-Benefit Analysis (CBA) is a technique that compares the monetary value of benefits with the monetary value of costs in order to evaluate and prioritize issues. The effect of time (i.e. the time it takes for the benefits of a change to repay its costs) is taken into consideration by calculating a payback period. In its simple form, CBA uses only financial costs and financial benefits (e.g. a simple CBA of a road scheme would measure the cost of building the road, and subtract this from the economic benefit of improving transport links). A more sophisticated CBA approach attempts to put a financial value on intangible costs and benefits (e.g. the cost of environmental damage or the benefit of quicker and easier travel to work) through measuring WTP (‘willingness to pay’ for an environmental gain) and WTA (‘willingness to accept’ compensation for an environmental loss).
CBA is the social appraisal of marginal investment projects, and policies, which have consequences over time.It uses criteria derived from welfare economics, rather than commercial criteria. CBA seeks to correct project appraisal for market failure. Environmental impacts of projects/policies are frequently externalities, both negative and positive CBA seeks to attach monetary values to external effects so that they can be taken account of along with the effects on ordinary inputs and outputs to the project/policy.
Process of tool application
- Identify all costs and benefits - Measure them - Discount them back to common time period - Assess whether benefits>costs - Assess who bears the benefits and costs - Perform sensitivity analysis - Assess whether proposal is worth it.
You can carry out a Cost-Benefit Analysis using only financial costs and benefits. However, you may decide to include intangible items within the analysis. As you must estimate a value for these items, this inevitably brings more subjectivity into the process.
Some examples of the types of business decisions that may be facilitated by cost-benefit analysis include whether or not to add employees, introduce a new technology, purchase equipment, change vendors, implement new procedures, and remodel or relocate facilities. In evaluating such opportunities, managers can justify their decisions by applying cost-benefit analysis. This type of analysis can identify the hard dollar savings (actual, quantitative savings), soft dollar savings (less tangible, qualitative savings, as in management time or facility space), and cost avoidance (the elimination of a future cost, like overtime or equipment leasing) associated with the opportunity.