Cost Benefit Analysis

Introduction:
Cost Benefit Analysis (CBA) is a technique which seeks to bring greater objectivity into the
decision making. Before erecting a new plant or taking on a new project, planners or managers
conduct a cost-benefit analysis as a means of evaluating all the potential cost revenues that may be
generated if the project is completed. The outcome of the analysis will determine whether the project is
financially feasible or if another should be pursued.
The benefit-cost analysis method is mainly used for economic evaluation of public projects which are
mostly funded by government organizations. In addition, this method can also used for economic
evaluation of alternatives for private projects. The main objective of this method is used to find out
desirability of public projects as far as the expected benefits on the capital investment are concerned,
i.e. the project with higher benefits will be identified. As the name indicates, this method involves the
calculation of benefits to the costs involved in a project and then the determination of benefits to cost
of the project. Therefore, Benefit- Cost analysis has two main purpose:
1. To determine if a decision/investment is sound – Verifying whether its benefits outweigh the

costs.
2. To provide a basis for comparing projects- which involves comparing the total expected cost of
each option against its total benefits.
History of Benefit-Cost Analysis:

Jules Dupuit, a French engineer and economist, introduced the concepts behind Benefit-Cost Analysis
(also called ‘Cost-Benefit Analysis’ or ‘CBA’ in short). At present, CBA is being used in both
government and international organization. While certain concepts of the technique oriented
from Europe in 1840s, the use of CBA in environmental economics is relatively a new incidence
which is becoming recognized after regulations were set by the US government. And this made
the use of CBA compulsory in the 1930s (E.J. Mishan and Euston, 2007). It was used to generate
a solution toward the problems of water provision. After World War II, there was pressure
towards the "efficiency in government" and the search was on for ways to make sure that the
public funds were efficiently utilized in major public investments. This resulted in the beginnings
of the fusion of the new welfare economics, which was essentially a Cost-Benefit Analysis and
practical decision-making. This particular process arrived in the United Kingdom in 1960s in
support of the transportation sector. It was applied to the construction of M1 motorway and the
Victoria line on the underground (Economic & Labor Market Review, December 2008). In recent
years, it is recognized as the major appraisal technique for public investments and public policy.
Emergence of CBA:
CBA allows different projects to be rank according to highest expected net gains in
social welfare. This is giving important limitations of government spending. The main
stages in CBA approaches are,
1. Calculation of social costs and benefits. This is including direct and indirect costs
and benefits.
2. Sensitive analysis of events occurring.
3. Discounting the future value of benefits.
4. Comparing the costs and benefits.
5. Comparing the net rate of benefits.
Principles of CBA:
There are eight basic principles under this CBA. These are;
1. There must be a common unit of measurement.

2. CBA valuations should represent consumers or producer’s valuations as revealed by their actual
behavior.
3. Benefits are usually measured by market choices.
4. Some measurements of benefits require the valuation of human life.
5. The analysis of project should involve a with or without comparison.
6. CBA involves particular study area.
7. Double counting of benefits or costs must be avoided.
8. Decision criteria projects
CBA and Time Value of Money:

The time value of money is the concept that money available at the present time is worth more than the
identical sum in the future due to its potential earning capacity. The money in hand today has the
capacity to earn more money, hence its value increases with time.
In benefit-cost analysis method, the time value of money is taken in to account for calculating the
equivalent worth of the costs and benefits associated with a project. The benefit-cost ratio of a
project is calculated by taking the ratio of the equivalent worth of benefits to that of the costs
associated with that project. CBA usually tries to put all relevant costs and benefits on a common
temporal floor using either of present worth, annual worth or future worth methods to find out the
equivalent worth of costs and benefits associated with the project. The choice of discount rate is
however a subjective matter.
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒
Present Value= (1+𝑖)𝑛
Future Value= Present Value x (1+i)n , Where i= Interest Rate , n= Time Period

Cost Benefit Analysis

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Introduction:

1. To determine if a decision/investment is sound – Verifying whether its benefits outweigh the

History of Benefit-Cost Analysis:

1. There must be a common unit of measurement.

CBA and Time Value of Money:

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