COST-BENEFIT ANALYSIS History of Cost-Benefit Analysis CBA has its origins in the water development projects of the U.S.

Army Corps of Engineers. The Corps of Engineers had its orgins in the French engineers hired by George Washington in the American Revolution. For years the only school of engineering in the United States was the Military Academy at West Point, New York. In 1879, Congress created the Mississippi River Commission to "prevent destructive floods." The Commission included civilians but the president had to be an Army engineer and the Corps of Engineers always had veto power over any decision by the Commission. In 1936 Congress passed the Flood Control Act which contained the wording, "the Federal Government should improve or participate in the improvement of navigable waters or their tributaries, including watersheds thereof, for flood-control purposes if the benefits to whomsoever they may accrue are in excess of the estimated costs." The phrase if the benefits to whomsoever they may accrue are in excess of the estimated costs established cost-benefit analysis. Initially the Corps of Engineers developed ad hoc methods for estimating benefits and costs. It wasn't until the 1950s that academic economists discovered that the Corps had developed a system for the economic analysis of public investments. Economists have influenced and improved the Corps' methods since then and cost-benefit analysis has been adapted to most areas of public decision-making Introduction The McGraw-Hill encyclopedia of professional management defines cost-benefit analysis (CBA) as determining "... the ratio of the benefits of a given project to its cost, taking into account the benefits and costs that cannot be directly measured in dollars" (Bittel ed. 1978.) Either to arrive at a benefit to cost ratio of a single project or to assess relatively the effectiveness of different projects, the identification and pertinent measure of all the costs and benefits of projects on as identical scale of measure (e.g., dollars or rupees) is necessary What Does Cost-Benefit Analysis Mean? A process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.

Some consultants or analysts also build the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town. Most analysts will also factor opportunity cost into such equations.

CBA has been considered as a valuable tool for increasing people's awareness of the costs and benefits of information and documentation as a production factor and to provide better basis for budgeting and strategic planning

Modern Benefit-cost Analysis During the 1960s and 1970s the more modern forms of benefit-cost analysis were developed. Most analyses required evaluation of: The present value of the benefits and costs of the proposed project at the time they occurred The present value of the benefits and costs of alternatives occurring at various points in time (opportunity costs) Determination of risky outcomes (sensitivity analysis) The value of benefits and costs to people with different incomes (distribution effects/equity issues) (Layard and Glaister, 1994)

Purpose Developing a system is a form of investment. The purpose of cost/benefit analysis is to give management a reasonable picture of the costs, benefits, and risks associated with a given system development project so they can compare it to other investment opportunities. Cost/benefit analysis is the de facto standard for demonstrating economic feasibility and for comparing and selecting among investment opportunities. It resemble standard accounting and financial measures. If we are like most people these days, we are trying to cut costs and get more for each dollar. However, the best way to do this is not always to simply buy the cheapest option. Instead, it is better to try to maximize the value you get for each purchase by utilizing a cost-benefit analysis.
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Reclaim Your Purchasing Behavior Cost-benefit analysis is a method of outlining the cost and the benefits of a financial decision and weighing them against each other. The important thing about the cost-benefit analysis for our financial life is that it allows us to make more rational decisions about our spending.

Sales and marketing efforts are often based on manipulating emotions to drive purchasing behavior. We can reclaim your financial independence against these emotional appeals by using the cost benefit analysis as a framework for making rational decisions with our money. Real World Examples Let us consider a simple case of cost-benefit analysis. In this case, we will assume you want to move to a smaller apartment to save costs, but you have four months left on a lease contract. You must pay a $1500 penalty to terminate the lease early. The current rent you are paying is $1000 per month and the new smaller apartment's rent would be $700 per month. It is easy to see that you will save $300 per month for the next four months by moving, but you will have to pay $1,500. Since you will pay $1,500 and only save $1,200, moving before your lease is up will result in a $300 loss. This is not to mention that you will also be living in a smaller apartment for four months. The example above was very simple, but in real life we would have many other things to consider. For instance, there might be differences in utility bills, differences in commuting costs, additional moving costs, fees for moving our cable, internet, and telephone subscriptions and many other things. The most common problem with cost-benefit analysis is in not recognizing all of these factors in the first place. So it is best to give these things a good amount of thought if there is a large amount of money at stake. Dealing with Uncertainty Many cost-benefit problems are not this easy because they have important elements which are hard to quantify. Whenever this is the case it makes it much more difficult to make an objective financial decision.
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 One place where this problem comes up is when you are shopping for auto insurance. Let's suppose you are trying to decide between auto liability coverage of $50,000 versus $100,000. You can get quotes for each coverage level and find that $100,000 of coverage costs $5 extra per month. In this case, the cost is clear, but it is difficult to quantify the extra benefit you get from the $100,000 coverage. Is it worth the $5? It's hard to tell. In cases like these, the best we can do is to rely on approximations. If the decision involves a lot of money, we can spend a good amount of time developing these approximations to make the best decision we can. In everyday decisions involving smaller amounts, we will often have to just use our best judgment. It is not always possible to make a perfect decision because estimations are often required. The Bottom Line Despite its imperfections, if we consistently employ this cost-benefit thought process we will come closer to maximizing the value we obtain for our money. As we become more experienced at employing cost-benefit analysis, we may find a lot more money left in our wallet without even noticing a decline in our standard of living.
Example Cost Benefit Analysis

As the Production Manager, we are proposing the purchase of a $1 Million stamping machine to increase output. Before we can present the proposal to the Vice President, we know we need some facts to support our suggestion, so we decide to run the numbers and do a cost benefit analysis. We 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. We 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. We 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. We also add the monthly salaries of the three workers. That's a pretty good total benefit.

 Then we 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 us what the power consumption of the machine is and we can get power cost numbers from accounting so us figure the cost of electricity to run the machine and add the purchase cost to get a total cost figure. We subtract our total cost figure from our total benefit value and our analysis shows a healthy profit. All we have to do now is present it to the VP, right? Wrong. We 've got the right idea, but we left out a lot of detail.

Accurate Cost Benefit Analysis

Once we have collected ALL the positive and negative factors and have quantified them we can put them together into an accurate cost benefit analysis. Some people like to total up all the positive factors (benefits), total up all the negative factors (costs), and find the difference between the two. I prefer to group the factors together. It makes it easier for us, and for anyone reviewing our work, to see that we have include all the factors on both sides of the issues that make up the cost benefit analysis. For the example above, our cost benefit analysis might look something like this: Cost Benefit Analysis - Purchase of New Stamping Machine (Costs shown are per month and amortized over four years) Purchase of Machine .................... -$20,000 includes interest and taxes Installation of Machine ..................... -3,125 including screens & removal of existing stampers Increased Revenue .......................... 27,520 net value of additional 100 units per hour, 1 shift/day, 5 days/week Quality Increase Revenue ..................... 358 calculated at 75% of current reject rate Reduced material costs ...................... 1,128 purchase of bulk supply reduces cost by $0.82 per hundred

 Reduced Labor Costs ....................... 18,585 3 operators salary plus labor o/h New Operator ................................. -8,321 salary plus overhead. Includes training Utilities ............................................ -250 power consumption increase for new machine Insurance ......................................... -180 premiums increase Square footage ...................................... 0 no additional floor space is required Net Savings per Month ........................... $15,715 Our cost benefit analysis clearly shows the purchase of the stamping machine is justified. The machine will save your company over $15,000 per month, almost $190,000 a year. This is just one example of how we can use cost benefit analysis determine the advisability of a course of action and then to support it once us propose the action.

Problem: A new transportation project is proposed to the city. This project is a form of "guide wire", where cars can hook to these moving, below-ground wires and be transported for free around town. This project is proven to reduce gas consumption by $5 million in its completion year. The city's preferred contractor says that it will take 10 years to build the thing and cost $470,000 a year, which is "perfect" because benefit would exceed costs by more than $300,000. Knowing that inflation is 3 percent, as an expert evaluator, is this a wise decision? Solution: Convert everything to Present Value and see just how great a deal this is. For the present value of the $5,000,000 benefit (gas reduction):

 The benefit in present-day value is $3,720,469.57. For the money (cost) being sent to the contractor, a payment of $470,000 per year, the present value would be:

The cost in present-day value is $4,009,195.33. Therefore, this detail, while shiny in appearance at first, is NOT a wise decision, since costs exceed benefits Problem: A new Southstar rail line is proposed. This project is expected to reduce travel time for 2,000 commuters by 30 minutes per day, in its completion year. The line only operates on weekdays (Monday-Friday). It will take 2 years to build and cost $320,000,000 total (Net Present Value). If the interest rate is 3 percent, above what value of time must average value of time for SouthStar Passengers be in order for the benefit/cost ratio to exceed 1. Assume a 30 year lifespan. The interest rate is annual Solution: Benefits considered are only Travel Time Savings. Travel Time Savings = 2,000 Commuters x 0.5 Hours/day (30 minutes/day) Travel Time Savings = 1000 Commuters-Hours/day x 5 days/week 52 weeks/year Travel Time Savings = 260,000 Commuters-Hours/year Travel Time Savings start after two years (given in the problem statement). Other assumptions are: Present Year is 0, no growth (constant commuters ev- ery year, and thus constant savings), and constant Value of Travel Time (VOT). Therefore, Benefits must be discounted to Present value for each year and added for a total during the lifespan of the project considered (30 years). Adding up all Present Value of Travel Time Present Value of Travel Time = (VOT )(260,000)(1/[1+0.03]^2 + 1/[1+0.03]^3 + ... + 1/[1+0.03]^29 + 1/[1+0.03]^30) You can sum it up in an excel spreadsheet or recognize that this is a geometric series.
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The sum is 18.63 inside the parentheses. Total Present Value of Travel Time = (4,843,687.57)(VOT) Costs are given by Total Present Value of $320,000,000. Benefits/Costs = 1 Thus (4,843,687.57)(VOT)/320,000,000 = 1 VOT = USD$66/Hr. The VOT must be at least 66 US dollars. Now consider two cases In case 1, we have a road project that costs $10.00 today, and at the end of 10 years has some economic value remaining, let's say a salvage value of $5.00, which when discounted back to the present is $1.93 (at 10% interest). This value is the residual value of the road. Thus, the total present cost of the project $10.00 - $1.93 = $8.07. Clearly the road cannot be moved. However, its presence makes it easier to build future roads ... the land has been acquired and graded, some useful material for aggregate is on-site perhaps, and can be thought of as the amount that it reduces the cost of future generations to build the road. Alternatively, the land could be sold for development if the road is no longer needed, or turned into a park. Assume the present value of the benefit of the road is $10.00. The benefit/cost ratio is $10.00 over $8.07 or 1.23. If we treat the salvage value as a benefit rather than cost, the benefit is $10.00 + $1.93 = $11.93 and the cost is $10, and the B/C is 1.193. In 10 years time, the community decides to replace the old worn out road with a new road. This is a new project. The salvage value from the previous project is now the sunk cost of the current project (after all the road is there and could not be moved, and so does not cost the current project anything to exploit). So the cost of the project in 10 years time would be $10.00 - $5.00 = $5.00. Discounting that to the present is $1.93. The benefit in 10 years time is also $10.00, but the cost in 10 years time was $5.00, and the benefit/cost ratio they perceive is $10.00/$5.00 = 2.00 Aggregating the two projects the benefits are $10 + $3.86 = $13.86 the costs are $8.07 + $1.93 = $10.00 the collective benefit/cost ratio is 1.386 the NPV is benefits - costs = $3.86
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 One might argue the salvage value is a benefit, rather than a cost reduction. In that case the benefits are $10.00 + $1.93 + $3.86 = $15.79 the costs are $10.00 + $1.93 = $11.93 the collective benefit/cost ratio is 1.32 the NPV remains $3.86

Case 2 is an identical road, but now the community has a 20 year time horizon to start. The initial cost is $10, and the cost in 10 years time is $5.00 (discounted to $1.93). The benefits are $10 now and $10 in 10 years time (discounted to $3.86). There is no salvage value at the end of the first period, or sunk costs at the beginning of the second period. What is the benefit cost ratio? the costs are $11.93 the benefits are still $13.86 the benefit/cost ratio is 1.16 The NPV is $1.93. If we are the community, which will we invest in? Case 1 has an initial B/C of 1.23 (or 1.193), Case 2 has a B/C of 1.16. But the real benefits and real costs of the roads are identical. The salvage value in this example is, like so much in economics (think Pareto optimality), an accounting fiction. In this case no transaction takes place to realize that salvage value. On the other hand, excluding the salvage value over-estimates the net cost of the project, as it ignores potential future uses of the project. Time horizons on projects must be comparable to correctly assess relative B/C ratio, yet not all projects do have the same benefit/cost ratio.

Problem: Cash flow depicted in fig., 10 percent per year minimum rate of returns. Estimate the actual rate of return generated by the project depicted. $60000 $60000 $60,000 $60,000 $60,000 1 2 3 4 5 time in years

-$2,000,000 Solution: a) P = A[ (1+ i)^n 1/ i(1+ i)^n] P = 60,000[ (1+0.10)^5 - 1/0.10(1+0.10)^5] P = 60,000(3.790790) P = $ 2,274,474 NPV = 2,274,474 - 2,000,000 = $ 274,474. Since, the NPV is positive, the minimum desired rate of return is exceeded. b) We know that actual rate of return is more than 10 percent so, i n Net return Present Value 0.11 5 600,000 600,000(3.69590) 0.12 5 600,000 600,000(3.60478) 0.13 5 600,000 600,000(3.51723) 0.14 5 600,000 600,000(3.43308) 0.15 5 600,000 600,000(3.35216) 0.16 5 600,000 600,000(3.27429) The actual rate of return is between 15% to 16%.

$ 2,217,540. $ 2,162,868. $ 2,110.338. $ 2,059,848. $ 2,011,296 $ 1,964,574.

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References
1. Benefit-cost analysis is sometimes referred to as cost-benefit analysis (CBA) 2. Weighting Waiting: Evaluating Perception of In-Vehicle Travel Time Under Moving and Stopped Conditions 3. Frank S. Budnick.( Applied Mathematics For Business Economics) 4. McGraw-Hill encyclopedia of professional management. 5. http://www.investorwords.com/4372/salvage_value.html 6. http://www.investorwords.com/4813/sunk_cost.html

Aruna, D. Social Cost-Benefit Analysis Madras Institute for Financial Management and Research, pp. 124, 1980. Boardman, A. et al., Cost-Benefit Analysis: Concepts and Practice, Prentice Hall, 2nd Ed, Dorfman, R, Forty years of Cost-Benefit Analysis: Economic Theory Public Decisions Selected Essays of Robert Dorfman, pp. 323, 1997. Dupuit, Jules. On the Measurement of the Utility of Public Works R.H. Babcock (trans.). International Economic Papers 2. London: Macmillan, 1952. Ekelund, R., Hebert, R. Secret Origins of Modern Microeconomics: Dupuit and the Engineers, University of Chicago Press, pp. 468, 1999. Flyvbjerg, B. et al. Megaprojects and Risk: An Anatomy of Ambition, Cambridge University Press, pp. 207, 2003. Gramlich, E., A Guide to Benefit-cost Analysis, Prentice Hall, pp. 273, 1981. Hicks, John (1941) The Rehabilitation of Consumers Surplus, Review of Economic Studies, pp. 108-116. Kaldor, Nicholas (1939) Welfare Propositions of Economics and Interpersonal Comparisons of Utility, Economic Journal, 49:195, pp. 549-552. Layard, R., Glaister, S., Cost-Benefit Analysis, Cambridge University Press; 2nd Ed, pp. 507, 1994. Pareto, Vilfredo., (1906) Manual of Political Economy. 1971 translation of 1927 edition, New York: Augustus M. Kelley. Perksy, J., Retrospectives: Cost-Benefit Analysis and the Classical Creed Journal of Economic Perspectives, 2001 pp. 526, 2000. Treasury Board of Canada Benefit-cost Analysis Guide, 1998 http://classwebs.spea.indiana.edu/krutilla/v541/Benfit-Cost%20Guide.pdf

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