Cost-benefit analysis as a tool to project appraisal

Cost-benefit analysis conducts a monetary assessment of the total costs and revenues or benefits of a project, paying particular attention to the social costs and benefits which do not normally feature in conventional costing exercises.

The underlying object of cost-benefit analysis is to identify and quantify as many tangible and intangible costs and benefits as possible. The aim is then to see a strategy which achieves the maximum benefits for the minimum costs. Only where benefits exceed costs should a project be undertaken.

In business, the usual method for testing the ‘soundness’ of proposed activities is investment appraisal, which requires a calculation of the value of resources to be employed in them ( the costs) which are compared with the value of goods or services to be produced (the benefits). In appraising an investment, it is the normal practice to subtract from the annual value of receipts, all variables or running costs leaving a residual which can be expressed as an annual rate of return on the capital employed. Because money in the hand is worth more than money in prospect, discounted cash flow (DCF) techniques are often used to discount expected future cash flows at arbitrary chosen rates to arrive at present value. If the anticipated return compares favourably with the prospective rates obtainable from the alternative uses to which the capital might be put, the prospective project may be regarded as sound.

In contrast in the public sector many services are provided such as roads and schools without direct prices being charged for them. The cost can usually be calculated, but it is more difficult to place a financial value on the benefits resulting from the satisfaction of group wants. And there may be social costs involved which are difficult to measure. The concept of welfare economics as developed by Professor A.C. Pigou, argues that there are circumstances in which market forces fail to encompass all costs and all benefits. To obtain a full picture of the like costs and benefits of projects in the public sector, it may be necessary to try to assess these social costs and benefits. This is the particular feature of cost-benefit analysis which distinguishes it from the investment or project appraisal techniques used in business.

A cost-benefit analysis is conducted in the following stages:- The project and its overall objectives (benefits) are defined. A more detailed list is prepared of the anticipated benefits and likely costs. Social benefits and costs will be included in the list.

The list of benefits and costs direct and indirect is reduced to monetary values in order to arrive at an estimate of the current net benefit of the project. The assessment of social benefits or costs often relies on judgment and may therefore be questionable. The fact that the term sometimes used, for these values is ‘Shadow Price’ is revealing. For example, in a transportation study, accessibility and speed may be assessed as benefits and noise as a cost. But how is the effect of noise on local residents to be measured?

One way is to ask individuals how much they would pay to have a quieter house. This then becomes an estimate of the value of peace and quiet. This will not of course, give a precise answer. It is not like using a scientific measuring instrument. But the advocates of attaching values to social benefits and costs will say that at least, if consistent methods are used, a basis is provided for comparing the total costs and benefits of alternative projects which is the main object of cost-benefit analysis.

The stream of net benefits is predicted for each year of the project. The net benefits will be the value of the benefits accruing from the project minus the running costs incurred. This stream will be expressed as a positive or negative cash flow depending on whether benefits exceed costs or costs exceed benefits.

The stream of annual net benefits is compared with the capital cost of the project and this can be expressed as a percentage rate of return on the investment. Three methods of appraisal are available:-

In the net present value method a discount rate is chosen and used to convert a time stream of net benefits into present value terms. Investment costs are then deducted and the projects appraised in the light of resulting net present values. The discounted cash flow approach is the preferred method.

The implicit rate of return on capital employed yielded by each project may be found by mathematical method. This resulting internal rate of return can then be used in the appraisal process to identify the project where the rate is highest.

The present value of benefit stream can be expressed as ‘benefits-cost’ ratios with the denominator representing total costs. Choice of project in this case would depend on the size of the resulting ratios.

The final appraisal is made. Crudely, if costs exceed benefits, i.e. the benefit –cost ratio is less than 1, the project should not be considered. The comparison between alternative projects may look at the respective benefit-cost ratios, but it should also consider the different net present values and the discounted rates of return on the investment.

Cost –benefit analysis can be used simply to ensure that value for money, is obtained from a project which requires the investment of funds. It can and does go beyond this by providing a basis for assessing the merits of different projects in terms of the benefits they produce and the costs that will be incurred.

Cost-benefit studies attempt to allow for social costs and benefits. As these are a feature of most , if not all, public sector projects, the discipline of trying to apply a consistent method of measurement in these areas should help to produce better decisions which take important subjective factors into account.

The difficulty is, of course placing realistic values on such things as good health, quiet houses or protection from a potential enemy. Cost –benefit analysts have sometimes attempted the impossible to measure.

In this regard Professor Peter Self commented on the effort of a report on London’s third airport as ‘nonsense’ on stilts. However, cost-benefit analysis concentrates attention on basic issues and the task of listing relevant costs and benefits is in itself a valuable discipline.

The writer is former Director General, EPB. He can be contacted at hassan.youngconsultants@gmail.com