A cost-benefit analysis (CBA) is one of the most common methods of economic evaluation in the public sector. It can help you make better resource allocation decisions, by allowing you to assess the alternatives in terms of their economic worth to society.
According to NSW Treasury, CBA is ‘an appraisal and evaluation technique that estimates the economic, social and environmental costs and benefits of a project or program in monetary terms’.
By comparing a number of projects and choosing the option with the highest dollar value in benefits, you’ll be delivering a project that will offer the greatest benefits to society, relative to the other options presented.
Why conduct a cost-benefit analysis?
CBA is the preferred methodology for economic evaluations in the public sector and is often mandated in project plans. According to the Commonwealth Department of Finance, this is because:
- costs and benefits are expressed in monetary terms and therefore are directly comparable with one another
- costs and benefits are valued in terms of impacts on the whole community, rather than the interests of one particular individual or group.
In government, it can be very difficult to compare different investment options. CBA can be useful in comparing a range of projects using a standard monetary scale. For example, it may be used to determine whether a new highway or a new railway will deliver greater benefits to the community.
Although CBA was traditionally used for infrastructure projects, today it is used to assess programs and policies across a range of sectors. Appendix 8 of the NSW Treasury Guide to CBA provides more information on why CBA is preferred over other economic evaluation methodologies.
Developing a cost-benefit analysis
While there will always be small differences in how people develop a CBA, most approaches include the following key steps.
1. Determine alternative projects
Start by specifying the alternative projects you will use for comparison. Given that projects can only be judged in relation to other, there needs to be at least two.
2. Decide whose benefits and costs matter
Decide whose benefits and costs you’ll be calculating in your CBA. For example, if the NSW Government develops a CBA, it’s likely that it will only consider the people of NSW, rather than Victoria.
3. Identify impacts and select measurement indicators
Identify all possible impacts for each option, making sure you demonstrate how each impact will make people better or worse off.
4. Predict the impacts over the life of the project
Quantitatively predict the extent of these impacts over the life of the project. For example, a CBA for a sports stadium would include estimates of the number of events held each year and ticket sales for each event.
5. Attach dollar values to each impact
Monetise each impact for each project. In the case of the sports stadium, this would mean using ticket sales to predict annual stadium revenue, in addition to other revenue sources.
6. Obtain net present values for each project
Convert all future costs and benefits to their present-day value, by discounting them at a set rate (such as 5%). The discount rate must take into account things like inflation, investment risk, capital costs and more.
Determining the net present value accounts for the opportunity cost of pursuing a project and allows people to credibly compare the cashflows of projects run over different time periods. Generally, the higher the net present value of a project, the higher the return on investment.
7. Perform a sensitivity analysis
Conduct a sensitivity analysis to gauge how reactive your findings are to changes in key variables. For example, if a recession occurs and causes stadium ticket sales to halve, how will this impact the bottom line of the project?
8. Reach a conclusion
You should now be able to come to a conclusion about which project is the best option to pursue, having worked out the potential outcome of each project as well as how future variables may change these outcomes.
Pitfalls of cost-benefit analysis
There are two fundamental challenges with using CBA: predicting all potential impacts; and quantifying those impacts in dollar terms.
Many government interventions have multiple impacts, both short and long term, that do not sit within one portfolio. In addition, there is often no evidence base to predict these impacts accurately. For example, an early intervention program for vulnerable or at-risk families and children may have intended outcomes that span physical health, mental health, education, employment and justice outcomes, among others.
Accurately determining these outcomes, some of which may be decades downstream, is obviously very difficult. Even if it could be done, you then need to attach dollar values to these outcomes, which again is very difficult or impossible.
Another challenge with cost-benefit analysis is called distributional effects. Due to its focus on net outcomes for the whole community rather than one individual or interest group, CBAs can be ‘blind’ to instances where the benefits disproportionally benefit one segment of the community over another.
For example, the construction of a highway may be chosen as the preferred option in a CBA as it provides the greatest net benefits overall. However, most of the benefits may go to people who can afford the toll, while those who can’t may not benefit from the project at all.
Given these fundamental methodological and ethical issues, we’d challenge CBA’s position as a mandated economic evaluation methodology in government. Nevertheless, there are occasions when it can be a useful tool to help organisations make logical resource allocation decisions, especially in capital works and infrastructure planning.
To find out how Nexus can help your team determine if CBA is the way to go and work through the process, get in touch.