A Guide to Understanding Cost-Benefit Analysis

Governments, corporations, and nonprofit agencies regularly embark on large projects and programs that require significant sums of money and have major impacts, both positive and negative. Since the funds used to execute these projects are limited, the stakeholders of the organizations that pursue such projects need justification that the funds are being used effectively and deserve funding more than competing projects. Cost-benefit analysis is a set of techniques for assessing the...
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Governments, corporations, and nonprofit agencies regularly embark on large projects and programs that require significant sums of money and have major impacts, both positive and negative. Since the funds used to execute these projects are limited, the stakeholders of the organizations that pursue such projects need justification that the funds are being used effectively and deserve funding more than competing projects. Cost-benefit analysis is a set of techniques for assessing the benefits and costs of a project and measuring its worthiness. The text presents the fundamentals of cost-benefit analysis, with particular emphasis on aiding readers of cost-benefit analysis reports to better understand the rationale behind the tables, graphs, and conclusions that appear in those reports, as well as to be able to critically assess the impact of the assumptions being made. The main challenge of any cost-benefit study is how to measure the costs and benefits in monetary units. We address methods typically used for assessment of both direct and indirect effects of projects, as well as both economic and non-economic impacts. Two other key challenges in a cost-benefit study are timing and uncertainty. A dollar of benefits in several years is generally not viewed as sufficient return for incurring a dollar of cost today. To measure the net impact of a project, future costs and benefits need to be adjusted in order to be compared to current costs. Discount rates are a common tool for making these adjustments in cost-benefit analysis and are addressed here. While costs and benefits can be quantified, they remain estimates and are likely to be in error due to future uncertainty. A good cost-benefit analysis will explicitly consider the potential for, and possible consequences of, uncertainty. Cost-benefit analysis is often applied in public sector decisions where there are proponents and opponents. As such, cost-benefit analyses generally become part of a politically-charged dialogue and are viewed by advocates as either an ally to be touted or an adversary to be discredited. We discuss the interaction between cost-benefit analysis and politics. A main thesis of this book is that these political processes can be improved if those involved have a good understanding of the strengths and limitations of cost-benefit analysis.