7.5 Cost Benefit Analysis

Cost benefit analysis (CBA) is a systematic method to measure costs and benefits associated with a project. For private sector projects, private costs and benefits (i.e., those impacting the firms profitability) are considered whereas in the public sector, social costs and benefits (i.e., those impacting society) are incorporated. Non-monetary costs and benefits are often excluded in private CBA. The steps to conduct a CBA are the following: (1) Identification of objective and options, (2) identification of inputs and outputs, (3) valuation of inputs and outputs, and (4) calculation of net present value (NPV).

For the first step, consider a city wanting to make commuting easier for its residents. The main objective may be to cut travel time but other potential objectives could be a reduction in air pollution and traffic congestion. The options for the city may be a commuter rail, expanded bus service, or expanded highways.

Next, the inputs (cost) and outputs (benefits) need to be identified and expressed in physical quantities to ensure non-monetary items are not excluded from the analysis. In the previous sections on net present value, we did not explicitly present non-monetary objectives, inputs, and outputs but those almost always exists in the public sector.

The valuation of monetary inputs and outputs is straightforward but is more difficult for non-monetary items. The valuation of non-monetary items can be done by calculating shadow prices, which represent the value of these inputs and outputs to the economy. For inputs, the shadow price is based on the marginal opportunity cost (i.e., the value of the input in its next best alternative use). For outputs, it is determined by the marginal willingness-to-pay (WTP), which reflects the value people place on receiving one additional unit of output.

Lastly, the net present value is calculated and a project is rejected if the \(NPV<0\) and accepted if the \(NPV>0\). In the case of mutually exclusive projects, the project with the highest NPV is chosen. Other criteria are a benefit-to-cost-ratio (BCR), which needs to be above 1 or a internal rate of return (IRR) that is higher than the interest rate.