Cost benefit analysis

Cost benefit analysis

Cost-Benefit Analysis: Meaning and Uses

Private companies are focused on the profit opportunities when making business decisions and take into account the direct internal effects (which are the cash flow as well as expenditures) and do not take into consideration the external factors that might cost or benefit society through a business project. 

Public institutions, however, as well as non-governmental organizations (NGOs) would usually consider the social repercussions of their resource allocation and investment decisions. This only means that they feel both internal and external factors and conflicts that investment would impact a specific community. 

In this regard, an analytical model called Cost-Benefit Analysis was formed. 

Cost-Benefit Analysis Defined

This analytical model is used to analyze the broader impact of resource allocation and investment decisions. Commonly known as social cost-benefit analysis (with the word ‘social’ usually omitted), it is an analysis of investment projects.  

Hence, cost-benefit analysis is the act of estimating both the direct and indirect costs of a project to the society as well as the direct and indirect benefits to it. The indirect costs and benefits are referred to as externalities. 

The public sector uses the cost-benefit analysis model to analyze the desirability of its projects and programs. It is also the counterpart of capital budgeting technique which is used when evaluating an investment project by a private firm. 

Prest and Turvey, who pioneered the model, describes cost-benefit analysis as a “practical way of assessing the desirability of projects where it is important to take a long view (in the sense of looking at repercussions in the distant future as well as the nearer future) and a wider view (in the sense of allowing for side-effects of many kinds and many persons, industries, regions, etc.), i.e., it implies the enumeration and evaluation of all relevant costs and benefits.” 

The Use of Cost-Benefit Analysis

Cost-benefit analysis is used when considering a project’s more comprehensive view of effects in society. It covers all direct economic effects as well as indirect spillover effects of a program. Moreover, the model is used to assess whether a project or specific public expenditure program should be accepted or rejected. In this sense, direct and indirect benefits or expenditure and other costs incurred on the project over the years are estimated using an appropriate discount rate from social points of view.

 In particular, cost-benefit analysis is used when evaluating big public investment schemes such as building airports, controlling diseases, planning for defense and safety, and spending on health, education, and research programs.

Cost-benefit analysis is also used to determine whether the size of the project in progress will be increased and up to what extent. The traditional margin analysis is used along with cost-benefit to estimate additional benefits from the proposed increase in size and additional cost to be incurred.

Another notable use of cost-benefit analysis is encapsulated by Thirlwall as he noted that, “The technique of cost-benefit analysis is recommended for the appraisal of publicly financed projects in order to allocate resources in a way that is most profitable to the society, recognizing that the market prices of goods and factors of production do not necessarily reflect their social values and costs respectively and given that the society is concerned with the future level of consumption as well as the present, the level of current saving may be suboptimal.”

The general steps in performing a cost-benefit analysis include: (1) specifying objective social functions, (2) identifying various benefits and costs, (3) evaluating social benefits and costs, (4) finding a social discount rate, and (5) using a decision criterion to choose a project.

Importance of Cost-Benefit Analysis for planning

The emphasis of cost-benefit analysis in economic planning should no longer be put in question as it helps investors decide whether a project or investment is worth investing in or not. In developing countries, the cost-benefit analysis is used in economic planning for growth and employment generation. 

A five-year plan, for example, can be best determined to materialize using the cost-benefit analysis model and achieve the goal and objectives of the program. Moreover, cost-benefit analysis helps in promoting social interest rather than any sectional or group interest. If the projects are chosen in light of the cost-benefit analysis, it becomes difficult for any vested interests or groups of people to oppose them if these projects go against their priorities and personal interests.

Cost-benefit analysis justifies and validates a specific project or investment as it yields an all-encompassing study that covers both the direct and indirect effects of that project in society.