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Introduction

Cost - Benefit Analysis

Cost-Benefit analysis (CBA), also occasionally referred to as Analysis of Benefits and Costs (ABC), is one of the most widely used methodologies when carrying out ALARP analysis, and is a phrase with which most of us will be familiar even if we have never carried out a Cost-Benefit analysis ourselves.

As was described in the video, CBA is a systematic approach to analysing and evaluating the strengths and weaknesses of a series of alternatives, which is used to decide the best options when considering some activity, product etcetera. To be fair a CBA should always include an analysis of the status quo – that is the effect of doing nothing.

CBA generally has two main applications:

1. Determine if a decision is sound, that is does the benefit outweigh the cost, and if so by how much?
2. Provide a basis for comparing decisions or investments when not every option can be taken.

Benefits in CBA are usually expressed in financial terms and adjusted for current values – that is the cost is given at an estimate of today’s rate, even if the work is intended to take place some distance into the future. This is to allow for useful comparison and analysis.

CBA is generally used to decide the desirability of a policy, or to demonstrate the desirability of some course of action to others.  When used correctly, CBA will allow for ranking of various options, either as a cost benefit ratio or in absolute terms, whichever is the most appropriate.

If the CBA is performed accurately then Pareto efficiency (Pareto efficiency is a state where you cannot move resources to one area without making another area worse off) can be improved by implementing the alternative with the lowest cost-benefit ratio, but, as explained in the video, accurately assigning the value to benefits and costs is extremely difficult; if a group or individual with a vested interest is involved, an unrealistic value may be assigned to a cost or benefit in an attempt to influence the outcome of the CBA. Even ignoring this potential for a deliberate attempt to influence, carrying out a perfect appraisal of future costs and benefits is difficult to the point of near impossibility, meaning that although a CBA can offer an informed estimate of the best alternative, it cannot be guaranteed to be the best – and even after the fact this is difficult to prove.

As with most processes that we have discussed, companies tend to have their own methodology for carrying out CBA, and will often have a template available to improve efficiency, however a generic CBA would be expected to contain the following steps:

1. Define the goals and objectives of the project
2. List possible alternative routes to these goals
3. List stakeholders – note, these may vary between the various alternative routes
4. Select the way in which cost and benefit will be measured
5. Predict outcome of costs and benefits over the lifetime of the project
6. Convert all costs and benefits to common currency (note, this currency does not have to be financial, although it is very rare that it is not)
7. Apply any applicable discount rate
8. Calculate net present value of the actions
9. Perform sensitivity analysis
10. Adopt the best course of action as identified by the CBA – which may mean doing nothing.

CBA, despite its ubiquity, is not without its flaws. As already stated, estimating, and assigning value to cost and benefit is extremely difficult, though costs tend to be easier to value. However, estimating the compensation that a person would require is an inexact science, to say the least. Surveys and past market behaviour are often used to provide these estimates, but they provide extremely different values in many cases suggesting that, when asked, individuals tend to misrepresent their true preference. Unfortunately, however, market data does not provide information relating to non-market impact.

Perhaps the most controversial element of cost benefit analysis – especially when referring to safety in a high hazard industry – is the fact that it tends to assign a monetary value to human life. This can be avoided by using cost-utility analysis (discussed later) but using non-monetary methods has limited use when comparing methods with significantly different outcomes. This also holds true – though less controversially as a rule – when referring to other areas such as the effect on the environment, both natural and man-made.

Cost Effectiveness Analysis

Cost Effectiveness Analysis (CEA) is another form of economic analysis that compares the costs of certain courses of action with their outcomes (effects). It differs from cost-benefit analysis in that it does not (necessarily) assign a monetary value to an effect (Bleichrodt & Quiggin 1999). It is commonly used in healthcare where it is not appropriate to monetize a health effect but is also becoming more commonplace in other fields. For example, the financial benefit of some ecological effect may be marginal, or even negative, but could still be considered to be of value in other ways.

A special case when CEA can be applied is when carrying out energy efficiency calculations to calculate energy saved in terms of value/unit. This is a virtual calculation, as the energy is not consumed, but rather assumed to be saved due to the energy efficiency investment that is being considered. The major benefit here is that it removes the need to predict future energy prices – a notoriously difficult task given the volatility of the energy market (Tuominen et al, 2015).

Cost-Utility Analysis

Cost-utility analysis (CUA) is basically a special form of CEA, primarily used in the healthcare industry, particularly in the health technology assessment and pharmacoeconomic sectors.

For this reason the language and methodology developed so far largely only makes sense in this field, but with development this methodology can be applied to other fields and this is beginning to be the case, for example, prior to their buy-out, Gael technology were beginning to look into applying the cost-utility method to the dairy industry. Cost-utility analysis in the healthcare industry works in the following way:

Cost is measured – as expected – in monetary units, usually the local currency. The benefit however needs to be expressed in a way that allows less than perfect health states to be considered as less desirable than perfect health. These benefits do not need to be expressed in monetary terms however, with the usual unit being Quality – Adjust Life Years (QALYs).

Social Return on Investment

Social Return on Investment (SROI) is another method of analysis that seeks to assess and measure extra – financial value which is not currently reflected in conventional accounts.

Social Value UK have created a standardised methodology that takes into account stakeholder’s views of impact and puts a financial proxy value onto those projects that do not have a traditional market value. As stakeholder’s views of impact will vary, the system has in-built flexibility to account for this. The aim is to consider the values of those that are usually excluded from traditional markets on the same footing (money) as traditional market analysis.

Summary

Further Study

References

Bleichrodt, H., and Quiggin, J. (1999) 'Life-cycle Preferences Over Consumption and Health: When is cost-effectiveness Analysis Equivalent to Cost-benefit Analysis?' Journal of Health Economics. Vol 18 (6): pp 681-708.

Tuominen, P., Reda, F., Dawoud, W., Elboshy, B., Elshafei, G. & Negm, A. (2015) 'Economic Appraisal of Energy Efficiency in Buildings Using Cost – Effectiveness Assessment)' Procedia Economics and Finance. Vol 21: pp 422-430.