Cost-benefit analysis refers to an assessment of the benefits of a particular course of action, weighed against the costs incurred.
This type of analysis is useful for identifying the best path forward among a range of possible options, each with their own pros and cons. It is most commonly used in economics.
Cost-benefit analysis has two main applications:
- Determining the soundness of a decision.
- Providing a basis for comparing alternative decisions (see: opportunity cost analysis).
A simple example of a cost-benefit analysis would involve an investor weighing up whether to buy real estate or stocks. Each has its own strengths and weaknesses, and they would need to consider their own context to determine which has the greatest cost-benefit (i.e. benefits per dollar).
Definition of Cost Benefit Analysis
Cost-benefit analysis (or benefit-cost analysis) is a systematic approach to deciding between alternatives based on their costs and benefits.
It may be used to compare completed or potential courses of action. It is often used to evaluate business or policy decisions, economic transactions, project investments, and so on.
Cost-benefit analysis identifies and places monetary values on the costs of programs.
Furthermore, it requires weighing those costs against the monetary value of program benefits (Riegg Cellini & Edwin Kee, 2015).
Often, this is achieved through calculating the benefit-cost ratio of a particular course of action, calculated as follows:
Benefit-Cost Ratio (BCR) = Present Value of Expected Benefits / Present Value of Expected Costs
This formula helps to determine whether the benefits outweigh the costs. A BCR greater than 1 indicates that the project’s benefits are expected to be greater than its costs, and vice versa.
Cost-benefit analysis proceeds by a ten-step process (Boardman et al., 2011; Riegg Cellini & Edwin Kee, 2015):
- Analysis Framework Setting: Decide on the type of analysis to be undertaken, such as a cost-benefit analysis or a cost-effectiveness analysis.
- Stakeholder Identification: Recognize whose costs and benefits should be accounted for. Considerations include which stakeholders are affected and who should have standing in the program or policy.
- Costs and Benefits Categorization: Identify and categorize all costs and benefits associated with the program or policy.
- Lifetime Costs and Benefits Projection: Project how costs and benefits will evolve over the lifespan of the program, if applicable.
- Cost Monetization: Assign a monetary value to all or most costs to facilitate comparisons.
- Benefit Quantification: Quantify benefits in terms of monetary units. The goal is to assign a dollar value to every major output or benefit, taking into consideration varying beneficiary groups and program objectives.
- Discounting Costs and Benefits: Discount future costs and benefits to their present values to account for the time value of money.
- Net Present Value Calculation: Compute the net present value (NPV) which represents the difference between the present value of cash inflows and the present value of cash outflows.
- Sensitivity Analysis: Test the sensitivity of the analysis to specific assumptions, determining how different values of an independent variable impact the particular dependent variable under consideration.
- Recommendation Generation: Based on the results of the cost-benefit analysis, make a suitable recommendation. If the program has a positive net present value, especially after a worst-case sensitivity analysis, the policy should be implemented as it would increase social welfare. Conversely, a program with a negative net present value should be rejected (Riegg Cellini & Edwin Kee, 2015).
The concept of cost-benefit analysis and its fundamental formulas are quite simple, but actually carrying out a cost-benefit analysis can be extremely challenging.
10 Examples of Cost Benefit Analysis
1. Investment Decisions
A company is trying to decide between two alternative investments, so it decides to conduct a cost-benefit analysis to compare the two.
- Total costs of the first alternative: $100,000
- Total benefits of the first alternative: $120,000
- Total costs of the second alternative: $150,000
- Total benefits of the second alternative: $200,000
The basic formula to use to decide between the two alternatives is the following:
Benefit-Cost Ratio = Expected Benefits / Total Costs
- Benefit-Cost Ratio of the first alternative: 120,000/100,000=6/5
- Benefit-Cost Ratio of the second alternative: 200,000/150,000=4/3
The Benefit-Cost Ratio of the second alternative is larger than that of the first, so the second investment will be more profitable for the company.
2. Real Estate Development Options
A construction company needs to compare two potential real estate development projects. The company doesn’t have the resources to engage in both, so it has to choose.
Each project has a different number of housing units that need to be constructed, how many of those will be sold and how many will be rented also differs. The rental prices, construction costs, sale prices, personnel costs, durations, and financing costs of each project also differ.
A cost-benefit analysis will have to take account of each relevant parameter to estimate how much each project will cost in total and how profitable each will be. The two projects can then be compared based on the cost-benefit ratio of each (Castle, 2018).
3. Weighing whether to Buy new Equipment
A company wants to decide whether to make a new equipment purchase. The company wants to know whether this new purchase might save money in the long term, so it conducts a cost-benefit analysis.
- Total costs of the new equipment: $100,000
- Annual benefits of the new equipment: $25,000
So the company will make a profit after the fourth year. The company then has to decide whether this is worth it.
4. Whether to Hire more Workers
A company decides to conduct a cost-benefit analysis of hiring 10 new workers.
- Total costs: $200,000
- Total benefits: $250,000
The company can generate an extra $50,000 each year, so they should go through with the decision and hire 10 new workers.
5. Public Infrastructure Decisions
A city council is deciding between building a new public park or a community center. A cost-benefit analysis is carried out for each option:
- Total costs of the public park: $500,000 Estimated societal benefits of the park (increased property value, improved health, etc.): $700,000
- Total costs of the community center: $750,000 Estimated societal benefits of the community center (education, community cohesion, etc.): $900,000
- Benefit-Cost Ratio of the public park: 700,000/500,000=7/5 Benefit-Cost Ratio of the community center: 900,000/750,000=6/5
The public park has a higher Benefit-Cost Ratio and could therefore be a more favorable option, despite the community center having higher absolute benefits.
6. Healthcare Investment
A hospital is considering investing in new MRI technology or in a specialized heart disease treatment program.
- Total costs of the MRI technology: $2,000,000 Estimated patient benefits of MRI technology: $2,500,000
- Total costs of the heart disease program: $1,500,000 Estimated patient benefits of heart disease program: $2,200,000
- Benefit-Cost Ratio of MRI technology: 2,500,000/2,000,000=5/4 Benefit-Cost Ratio of the heart disease program: 2,200,000/1,500,000=44/30
Despite the heart disease program having a lower absolute benefit, it has a higher Benefit-Cost Ratio and might be a better investment for the hospital.
7. Education Policy Choices
A school district is deciding between implementing a new online learning system or hiring additional teaching staff. A cost-benefit analysis helps in decision making:
- Total costs of online learning system: $300,000 Estimated benefits of online learning system (increased learning efficiency, accessibility, etc.): $450,000
- Total costs of hiring additional staff: $400,000 Estimated benefits of additional staff (improved student-teacher ratio, individual attention, etc.): $550,000
- Benefit-Cost Ratio of online learning system: 450,000/300,000=3/2 Benefit-Cost Ratio of additional staff: 550,000/400,000=11/8
Despite the additional staff providing higher absolute benefits, the online learning system has a higher Benefit-Cost Ratio, making it a more efficient investment.
8. Software Upgrade Decision
A tech company is weighing the costs and benefits of upgrading their existing software versus purchasing a new one.
- Total costs of upgrading existing software: $10,000 Estimated benefits of upgrading existing software: $20,000
- Total costs of purchasing new software: $25,000 Estimated benefits of new software: $40,000
- Benefit-Cost Ratio of upgrading existing software: 20,000/10,000=2/1 Benefit-Cost Ratio of new software: 40,000/25,000=8/5
Upgrading the existing software has a higher Benefit-Cost Ratio, indicating it might be a more cost-effective choice for the company.
9. Environmental Policy
A government is considering investing in a renewable energy project or continuing to support fossil fuel-based energy production. A cost-benefit analysis is needed:
- Total costs of renewable energy project: $1,000,000
- Estimated societal benefits of renewable energy (lower pollution, sustainability, etc.): $1,300,000
Total costs of fossil fuel support: $800,000 Estimated societal benefits of fossil fuel support (job retention, immediate energy supply): $900
10. Whether to add a New Service
A software company is planning to speed up its delivery dates. But doing so would require hiring three additional coders, which requires investments like buying new furniture, and computers, and leasing additional workspace (Castle, 2018).
- Assume that the yearly revenue is $100,000 but it will increase by 50% as the capacity increases.
- Assume that each coder earns $10 per hour.
A cost-benefit analysis will have to take the following costs and benefits into account:
- Rental cost per year: $15,000
- Furniture costs: $10,000
- Hiring costs per year: $23,040
- Hardware & software costs: $10,000
- Downtime costs: $10,000
- 10% annual revenue increase: $50,000
Summing up the costs, we can see that they amount to more than $68,000, so the costs of the project would be larger than their benefits.
Cost-Benefit Analysis vs Cost-Effectiveness Analysis
In economics, cost-benefit analysis is related to cost-effectiveness analysis:
- Cost-effectiveness analysis: this compares the relative costs and outcomes (instead of benefits) of different decisions. It aims to be more holistic.
- Cost-benefit analysis: this tends to assign a monetary value to a course of action to identify the best course to pursue (Bleichrodt & Quiggin, 1999).
Riegg Cellini and Edwin Kee (2015) define the two as follows:
“Cost-effectiveness analysis is a technique that relates the costs of a program to its key outcomes or benefits. Cost-benefit analysis takes that process one step further, attempting to compare costs with the dollar value of all (or most) of a program’s many benefits. These seemingly straightforward analyses can be applied anytime before, after, or during a program implementation, and they can greatly assist decision makers in assessing a program’s efficiency.
Cost-benefit analysis is an essential part of doing business as it helps businesses to identify the most efficient and productive ways to dedicate resources and time in order to achieve optimal outcomes for both the company and the client. By calculating the benefit-cost ratio, we can directly compare two options.
However, it’s important to note that a cost-effectiveness analysis may provide a more holistic overview that considers outcomes (such as human impact) rather than just costs.
Bleichrodt, H., & Quiggin, J. (1999). Life-cycle preferences over consumption and health: When is cost-effectiveness analysis equivalent to cost–benefit analysis? Journal of Health Economics, 18(6), 681–708. https://doi.org/10.1016/S0167-6296(99)00014-4
Boardman, A., Greenberg, D., Vining, A., & Weimer, D. (2011). Cost-Benefit Analysis: Concepts and Practice, 4th edition.
Castle, K. (2018, February 13). Cost Benefit Analysis Example and Steps (CBA Example). Projectcubicle. https://www.projectcubicle.com/cost-benefit-analysis-example/
Riegg Cellini, S., & Edwin Kee, J. (2015). Cost-Effectiveness and Cost-Benefit Analysis. In Handbook of Practical Program Evaluation (pp. 636–672). John Wiley & Sons, Ltd. https://doi.org/10.1002/9781119171386.ch24
Dr. Chris Drew is the founder of the Helpful Professor. He holds a PhD in education and has published over 20 articles in scholarly journals. He is the former editor of the Journal of Learning Development in Higher Education. [Image Descriptor: Photo of Chris]