Cost-Benefit Analysis and Cost-Effectiveness Analysis: The basics

Cost-Benefit Analysis (CBA)

This type of economic analysis asks the question, “Do the economic benefits of the given intervention/ policy/ service/ good outweigh the economic costs?”. To answer the question, all costs and benefits are expressed in terms of money.

A CBA may be used to

  • Compare completed/ potential courses of action, or
  • Estimate/ evaluate the value against the cost of a decision/ project/ policy.

There are two main applications of CBA:

  • To determine if a decision is sound by ascertaining if (and by how much) its benefits outweigh its costs
  • To provide a basis for comparing decisions comparing the total expected cost of each option with its total expected benefits

Cost-benefit may be calculated using one of two formulae:

Cost-benefit = Benefits (in a particular currency) – Costs (in the same currency). This yields the net benefits of the item under assessment.

Cost-benefit = Benefits (in a particular currency)/ Costs (in the same currency). This yields the benefit ratio of the item under assessment.

The benefits and costs are expressed in monetary terms of their net present value, regardless of when they are actually incurred.

Example: A project will yield benefits over 20 years. CBA will estimate the economic benefits over 20 years in terms of their net value at present. Costs will also be similarly expressed.

Clearly, this approach is imperfect, as currency values change over time, as do the value of benefits. Economists employ a procedure called ‘discounting’ to arrive at costs and benefits in terms of present value.

An intervention should be undertaken if the (financial) value of the benefits exceeds the (financial) value of the costs. If only one activity can be funded, choose the activity with the highest excess financial benefit over costs.

The value of a CBA depends upon the accuracy of the individual cost and benefit estimates. Such estimates may often be flawed and influenced by external forces (agencies).

The obvious disadvantage of cost-benefit analysis lies in its inability to convert everything to monetary terms. In addition, it is time-consuming, and the results of CBA may not be available in a timely manner. Further, CBA is more complex than other types of economic evaluation. Therefore, CBA is unsuitable for many situations- especially those where benefits cannot be expressed in monetary terms. As policy makers are often interested in more than just cost differences between alternatives, CBA provides only partial information.

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