A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn

out. Although a cost benefit analysis can be used for almost anything, it is most commonly
done on financial questions. Since the cost benefit analysis relies on the addition of positive
factors and the subtraction of negative ones to determine a net result, it is also known as
running the numbers
A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the
benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The
difference between the two indicates whether the planned action is advisable. The real trick to
doing a cost benefit analysis well is making sure you include all the costs and all the benefits
and properly quantify them.

Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the
new stamping machine? Will we be better off putting our free cash flow into securities rather
than investing in additional capital equipment? Each of these questions can be answered by
doing a proper cost benefit analysis.

Example Cost Benefit Analysis

As the Production Manager, you are proposing the purchase of a $1 Million stamping machine
to increase output. Before you can present the proposal to the Vice President, you know you
need some facts to support your suggestion, so you decide to run the numbers and do a cost
benefit analysis.

You itemize the benefits. With the new machine, you can produce 100 more units per hour.
The three workers currently doing the stamping by hand can be replaced. The units will be
higher quality because they will be more uniform. You are convinced these outweigh the costs.

There is a cost to purchase the machine and it will consume some electricity. Any other costs
would be insignificant.

You calculate the selling price of the 100 additional units per hour multiplied by the number of
production hours per month. Add to that two percent for the units that aren't rejected because
of the quality of the machine output. You also add the monthly salaries of the three workers.
That's a pretty good total benefit.

Then you calculate the monthly cost of the machine, by dividing the purchase price by 12
months per year and divide that by the 10 years the machine should last. The manufacturer's
specs tell you what the power consumption of the machine is and you can get power cost
numbers from accounting so you figure the cost of electricity to run the machine and add the
purchase cost to get a total cost figure.

You subtract your total cost figure from your total benefit value and your analysis shows a
healthy profit. All you have to do now is present it to the VP, right? Wrong. You've got the
right idea, but you left out a lot of detail.

Running The Numbers Means All The Numbers

Lets look at the benefits first. Don't use the selling price of the units to calculate the value.
Sales price includes many additional factors that will unnecessarily complicate your analysis if
you include them, not the least of which is profit margin. Instead, get the activity based value
of the units from accounting and use that. You remembered to add the value of the increased
quality by factoring in the average reject rate, but you may want to reduce that a little
because even the machine won't always be perfect. Finally, when calculating the value of
replacing three employees, in addition to their salaries, be sure to add their overhead costs,
the costs of their benefits, etc., which can run 75-100% of their salary. Accounting can give
you the exact number for the workers' "fully burdened" labor rates.

In addition to properly quantifying the benefits, make sure you included all of them. For
instance, you may be able to buy feed stock for the machine in large rolls instead of the
individual sheets needed when the work is done by hand. This should lower the cost of
material, another benefit.

As for the cost of the machine, in addition to it's purchase price and any taxes you will have to
pay on it, you must add the cost of interest on the money spent to purchase it. The company
may purchase it on credit and incur interest charges, or it may buy it outright. However, even
if it buys the machine outright, you will have to include interest charges equivalent to what the
company could have collected in interest if it had not spent the money.

Check with finance on the amortization period. Just because the machine may last 10 years,
doesn't mean the company will keep it on the books that long. It may amortize the purchase
over as little as 4 years if it is considered capital equipment. If the cost of the machine is not
enough to qualify as capital, the full cost will be expensed in one year. Adjust your monthly
purchase cost of the machine to reflect these issues. You have the electricity cost figured out
but there are some cost you missed too.

Cost-benefit analysis is a term that refers both to:

• helping to appraise, or assess, the case for a project or proposal, which itself is a
process known as project appraisal; and
• an informal approach to making decisions of any kind.

Under both definitions the process involves, whether explicitly or implicitly, weighing
the total expected costs against the total expected benefits of one or more actions in order
to choose the best or most profitable option. The formal process is often referred to as
either CBA (Cost-Benefit Analysis) or BCA (Benefit-Cost Analysis).

Benefits and costs are often expressed in money terms, and are adjusted for the time
value of money, so that all flows of benefits and flows of project costs over time (which
tend to occur at different points in time) are expressed on a common basis in terms of
their “present value.” Closely related, but slightly different, formal techniques include
cost-effectiveness analysis, economic impact analysis, fiscal impact analysis and Social
Return on Investment (SROI) analysis. The latter builds upon the logic of cost-benefit
analysis, but differs in that it is explicitly designed to inform the practical decision-
making of enterprise managers and investors focused on optimising their social and
environmental impacts.
Cost–benefit analysis is typically used by governments to evaluate the desirability of a
given intervention. It is heavily used in today's government. It is an analysis of the cost
effectiveness of different alternatives in order to see whether the benefits outweigh the
costs. The aim is to gauge the efficiency of the intervention relative to the status quo. The
costs and benefits of the impacts of an intervention are evaluated in terms of the public's
willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs
are typically measured in terms of opportunity costs - the value in their best alternative
use. The guiding principle is to list all parties affected by an intervention and place a
monetary value of the effect it has on their welfare as it would be valued by them.

The process involves monetary value of initial and ongoing expenses vs. expected return.
Constructing plausible measures of the costs and benefits of specific actions is often very
difficult. In practice, analysts try to estimate costs and benefits either by using survey
methods or by drawing inferences from market behavior. For example, a product
manager may compare manufacturing and marketing expenses with projected sales for a
proposed product and decide to produce it only if he expects the revenues to eventually
recoup the costs. Cost–benefit analysis attempts to put all relevant costs and benefits on a
common temporal footing. A discount rate is chosen, which is then used to compute all
relevant future costs and benefits in present-value terms. Most commonly, the discount
rate used for present-value calculations is an interest rate taken from financial markets
(R.H. Frank 2000). This can be very controversial; for example, a high discount rate
implies a very low value on the welfare of future generations, which may have a huge
impact on the desirability of interventions to help the environment. Empirical studies
suggest that in reality, people's discount rates do decline over time. Because cost–benefit
analysis aims to measure the public's true willingness to pay, this feature is typically built
into studies.

During cost–benefit analysis, monetary values may also be assigned to less tangible
effects such as the various risks that could contribute to partial or total project failure,
such as loss of reputation, market penetration, or long-term enterprise strategy
alignments. This is especially true when governments use the technique, for instance to
decide whether to introduce business regulation, build a new road, or offer a new drug
through the state healthcare system. In this case, a value must be put on human life or the
environment, often causing great controversy. For example, the cost–benefit principle
says that we should install a guardrail on a dangerous stretch of mountain road if the
dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and
property damage thus prevented (R.H. Frank 2000).

Cost–benefit calculations typically involve using time value of money formulas. This is
usually done by converting the future expected streams of costs and benefits with a
present value amount.

[edit] Application and history

Cost–benefit analysis is used mainly to assess the monetary value of very large private
and public sector projects. This is because such projects tend to include costs and benefits
that are less amenable to being expressed in financial or monetary terms (e.g.,
environmental damage), as well as those that can be expressed in monetary terms. Private
sector organizations tend to make much more use of other project appraisal techniques,
such as rate of return, where feasible.

The practice of cost–benefit analysis differs between countries and between sectors (e.g.,
transport, health) within countries. Some of the main differences include the types of
impacts that are included as costs and benefits within appraisals, the extent to which
impacts are expressed in monetary terms, and differences in the discount rate between
countries. Agencies across the world rely on a basic set of key cost–benefit indicators,
including the following:

• 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 of funds available)

The concept of CBA dates back to an 1848 article by Dupuit and was formalized in
subsequent works by Alfred Marshall. The practical application of CBA was initiated in
the US by the Corps of Engineers, after the Federal Navigation Act of 1936 effectively
required cost–benefit analysis for proposed federal waterway infrastructure. [1] The Flood
Control Act of 1939 was instrumental in establishing CBA as federal policy. It specified
the standard that "the benefits to whomever they accrue [be] in excess of the estimated
costs.[2]

Subsequently, cost–benefit techniques were applied to the development of highway and

motorway investments in the US and UK in the 1950s and 1960s. An early and often-
quoted, more developed application of the technique was made to London Underground's
Victoria Line. Over the last 40 years, cost–benefit techniques have gradually developed
to the extent that substantial guidance now exists on how transport projects should be
appraised in many countries around the world.

In the UK, the New Approach to Appraisal (NATA) was introduced by the then
Department for Transport, Environment and the Regions. This brought together cost–
benefit results with those from detailed environmental impact assessments and presented
them in a balanced way. NATA was first applied to national road schemes in the 1998
Roads Review but subsequently rolled out to all modes of transport. It is now a
cornerstone of transport appraisal in the UK and is maintained and developed by the
Department for Transport.[10]

The EU's 'Developing Harmonised European Approaches for Transport Costing and
Project Assessment' (HEATCO) project, part of its Sixth Framework Programme, has
reviewed transport appraisal guidance across EU member states and found that
significant differences exist between countries. HEATCO's aim is to develop guidelines
to harmonise transport appraisal practice across the EU.[11][12] [3]

Transport Canada has also promoted the use of CBA for major transport investments
since the issuance of its Guidebook in 1994.[4]

More recent guidance has been provided by the United States Department of
Transportation and several state transportation departments, with discussion of available
software tools for application of CBA in transportation, including HERS, BCA.Net,
StatBenCost, CalBC, and TREDIS. Available guides are provided by the Federal
Highway Administration[5][6], Federal Aviation Administration[7], Minnesota Department
of Transportation,[8] and California Department of Transportation (Caltrans)[9].

In the early 1960s, CBA was also extended to assessment of the relative benefits and
costs of healthcare and education in works by Burton Weisbrod.[10][11] Later, the United
States Department of Health and Human Services issued its CBA Guidebook.[12]

[edit] Accuracy problems

The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs
and benefits have been estimated. A peer-reviewed study [13] of the accuracy of cost
estimates in transportation infrastructure planning found that for rail projects actual costs
turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4
percent higher (Flyvbjerg, Holm, and Buhl, 2002). For benefits, another peer-reviewed
study [14] found that actual rail ridership was on average 51.4 percent lower than
estimated ridership; for roads it was found that for half of all projects estimated traffic
was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005). Comparative
studies indicate that similar inaccuracies apply to fields other than transportation. These
studies indicate that the outcomes of cost–benefit analyses should be treated with caution
because they may be highly inaccurate. In fact, inaccurate cost–benefit analyses may be
argued to be a substantial risk in planning, because inaccuracies of the size documented
are likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks
efficiency ([15] Flyvbjerg, Bruzelius, and Rothengatter, 2003).

These outcomes (almost always tending to underestimation unless significant new

approaches are overlooked) are to be expected because such estimates:

1. Rely heavily on past like projects (often differing markedly in function or size and
certainly in the skill levels of the team members)
2. Rely heavily on the project's members to identify (remember from their collective
past experiences) the significant cost drivers
3. Rely on very crude heuristics to estimate the money cost of the intangible
elements
4. Are unable to completely dispel the usually unconscious biases of the team
members (who often have a vested interest in a decision to go ahead) and the
natural psychological tendency to "think positive" (whatever that involves)
Another challenge to cost–benefit analysis comes from determining which costs should
be included in an analysis (the significant cost drivers). This is often controversial
because organizations or interest groups may think that some costs should be included or
excluded from a study.

In the case of the Ford Pinto (where, because of design flaws, the Pinto was liable to
burst into flames in a rear-impact collision), the Ford company's decision was not to issue
a recall. Ford's cost–benefit analysis had estimated that based on the number of cars in
use and the probable accident rate, deaths due to the design flaw would run about $49.5
million (the amount Ford would pay out of court to settle wrongful death lawsuits). This
was estimated to be less than the cost of issuing a recall ($137.5 million) [16]. In the
event, Ford overlooked (or considered insignificant) the costs of the negative publicity so
engendered, which turned out to be quite significant (because it led to the recall anyway
and to measurable losses in sales).

In the field of health economics, some analysts think cost–benefit analysis can be an
inadequate measure because willingness-to-pay methods of determining the value of
human life can be subject to bias according to income inequity. They support use of
variants such as cost-utility analysis and quality-adjusted life year to analyze the effects
of health policies