Cost-benefit analysis requires that estimates of the direct and indirect costs and the tangible and intangible benefits be translated into a common measure, usually a monetary unit.
Basic Components of Cost-Benefit Analysis
Cost-benefit analysis involves an identification of: (1) an objective function, (2) constraints, (3) externalities, (4) time dimensions, and (5) risk and uncertainty.
Selecting an objective function involves the identification and quantification of the benefits and costs associated with each alternative.
Constraints are the "rules of the game"--the limits within which a solution must be sought. Solutions that are otherwise optimal frequently must be discarded because they do not conform to these imposed rules.
Projects may have externalities or spill-over effects--i.e., unintended consequences that may be beneficial or detrimental--which may be difficult to identify and measure and may be excluded from the analysis initially in order to make the problem statement more manageable.
Two common bases for discounting to accommodate the time dimensions of the analysis reflect both local conditions and the marketplace for investments:
(1) Cost of borrowing the capital necessary to finance a project or program, and
(2) Rate of return based that could be realized if an equivalent amount were invested for the same period of time.
Criteria for Analysis
Three choices for a composite criterion for analysis are:
o Maximize benefits for given costs.
o Minimize costs while achieving a fixed level of benefits.
o Maximize net benefits (benefits minus costs).
A benefit/cost ratio is defined as the present value of benefits divided by the present value of costs (or average annual benefits over average annual costs).
The net benefit/cost ratio is a variation on the basic benefit/cost ratio which emphasizes the return on invested capital by segregating operational costs and subtracting them from both sides of the ratio.
Net benefits measure difference, whereas benefit/cost calculations produce a ratio.
Limitations of Cost-Benefit Analysis
Cost-benefit analyses provide only limited assistance in evaluating programs of relatively broad scope or in comparing programs with widely differing objectives.
Other factors must be considered in selecting an appropriate or "best" decision, including:
(1) the time stream of costs and benefits and the time preference for present as opposed to future consumption of goods or services;
(2) limitations imposed by revenue (budgetary) constraints; and
(3) whether goals and objectives can be specified in sufficient detail to permit a fuller identification of direct and indirect costs and benefits.
The effectiveness of a program is measured by the extent to which, if implemented, some desired objective will be achieved --either (1) a desired level of performance at the minimum cost or (2) the maximum level of performance possible for a given level of cost.
Output Orientation
Costs can ordinarily be expressed in monetary terms; levels of achievement are usually represented by nonmonetary indexes, or measures of effectiveness, i.e., direct and indirect effects of resource allocations.
Cost-effectiveness analysis must move from some base that represents existing capabilities and existing resource commitments.
The objective is to determine what additional resources are required to achieve some specified additional performance capability.
Effectiveness measures involve a basic scoring technique for determining increments in output achieved relative to the investment of additional increments of cost, often expressed in relative terms--e.g., percentage increase in some measure of educational attainment or percentage reduction in incidence of a disease.
Supporting analyses required under the cost-effectiveness approach include:
(1) Cost-goal studies identify feasible levels of achievement by approximating the sensitivity of costs (inputs) to changes in the level of goal achievement (outputs).
(2) Cost-effectiveness comparisons relate incremental costs to increments in achievement in an effort to identify the most effective program alternative.
(3) Cost-constraint assessments determine the cost of employing less than the most optimal program by comparing the program costs that might be adopted if no constraints were present with the cost of the constrained program.
Certainty can be defined as a state of knowledge in which the specific and invariable outcomes of each alternative course of action are known in advance.
Uncertainty can be defined as a state of knowledge in which one or more courses of action may result in a set of possible specific outcomes, the probabilities of which, however, are neither known or meaningful.
Risk is a state of knowledge in which each alternative leads to one of a set of specific outcomes, each outcome occurring with a probability that is known to the decision maker.
Risk and uncertainty must be confronted from two primary sources:
(1) Statistical uncertainty, and
(2) Uncertainty about the state of the real world in the future.
Establishing a probability function can bring problems within more manageable bounds by reducing uncertainty to some level of risk that may be tolerable, depending on the risk threshold.
Uncertainty and Cost Sensitivity
An expected value approach often must be applied when the environment is uncertain.
In mathematical terms, expected value (EV) can be expressed as:
EV = P1$1 + P2$2 + . . . Pn$n.
where P stands for probability, $ stands for the value of an outcome, and P1 + P2 + . . . Pn = 1.
Techniques utilizing the concept of expected value have been developed to analyze uncertainty about the future state of events include:
o Sensitivity analysis--measures (often quite crudely) the effects that variations in uncertain decision elements (i.e., costs) may have on the alternatives under analysis.
o Contingency analysis--examines the effects on alternative choices when a relevant change is postulated in the evaluation criteria; also can be used to determine the effects of a major change in the "ground rules" within which the problem situation exists.
o A fortiori analysis (from the Latin, meaning "with stronger reason")--a method of deliberately "stacking the deck" in favor of one alternative to determine how it might stand up in comparison to other approaches.
Uncertainty, Risk, and Expected Utility
The values for the probabilities will be unique for each individual and not unlike the values of utility that might be assigned to an individual through a study of his or her social preferences.
Determining strategic choice under uncertainty is a threefold process. [1]
(1) Alternatives must be assessed to determine what probabilities and payoffs are implied for individual members of the organization and its clientele.
(2) Attitudes toward risk of these individuals must be evaluated to determine the certainty equivalents of these probabilities and payoffs.
(3) Having estimated the equivalent benefits that each alternative offers to different members of the organization, the decision maker must select the preferred outcome.
Reduction of uncertainty may cause the risk associated with a particular choice to:
(1) Remain unchanged;
(2) Decrease (where a reduction in uncertainty permits the assessment of more definitive probabilities); or even
(3) Increase (when the additional information reveals risk factors previously unknown).