Cost Benefit Analysis
What is a cost benefit analysis?
• It is an assessment of the benefits and costs (i.e., pros and cons,
advantages and disadvantages) associated with a particular choice.
• Benefits and costs may be monetary (money) or non-monetary
(benefits that can’t be defined by dollars, like environmental impacts)
Think about this example
• Should we raise the speed limit on a highway?
• Raising the maximum speed limit from 55 to 65 increased travel speed
plus about 2 mph (people often exceed posted speed) saving 45
million hours travel time per year, and inducing about 360 deaths per
year (125,000 hours of life).
Our collective decision to drive faster infers that 45 million hours of
travel time is worth more than 360 deaths.
Expected Value
• When values of costs or benefits are not known with certainty, but
are known with probability, expected values are used.
• In our solar power example the calculator used expected value of
electricity and solar production to tell us when they would pay for
themselves
Step of a CBA
• Step 1
• Brainstorm all costs and benefits.
• Even if they are not monetary
• Direct costs are often associated with production of a cost object (product, service,
customer, project, or activity)
• Indirect costs are usually fixed in nature, and may come from overhead of a department
or cost center
• Tangible costs are easy to measure and quantify, and are usually related to an
identifiable source or asset, like payroll, rent, and purchasing tools
• Intangible costs are difficult to identify and measure, like shifts in customer satisfaction,
and productivity levels
• Real costs are expenses associated with producing an offering, such as labor costs and
raw materials
• Step 2
• Calculate value of all costs and benefits
• For items that aren’t directly monetary, you still have to assign a value for
these
• Step 3
• Calculate costs and benefits across the assumed life of a project or
initiative
• Step 4
• Compare cost and benefits using all information
• Step 5
• Discount future costs and benefits to obtain present values.
• Step 6
• Calculate Benefit/Cost using present values